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On Jerry Neumann’s Productive Uncertainty (Round 2)
Today: A framework for researching Silver Lake, inspired by Jerry & Bill Janeway. A reading list. And schools in Germany.
The Agenda 👇
I decided to move forward with writing “11 Notes on Silver Lake”
My core thesis about Silver Lake was inspired by Bill Janeway
It also resonates with Jerry Neumann’s idea of productive uncertainty
How the two theses relate, and why it matters for Europe
A reading list for Silver Lake and their investment thesis
My children attending new schools in Germany
I’m resuming my research on private equity firms in general, and Silver Lake in particular, and I’d like to use this edition as an opportunity to firm up the framework I’ll be using to analyze Silver Lake’s deals in the tech space. It’s a topic that also lends itself to being my ‘Round 2’ on Jerry Neumann’s masterful Productive Uncertainty essay (see here for ‘Round 1’).
Let me start by simply quoting Bill regarding Warburg Pincus’s investment in Zilog, as described in his book Doing Capitalism in the Innovation Economy:
A lesson was that the best technology was not destined to win; in fact, there were precedents for believing that it was likely to lose. At three critical turning points, the companies that had developed the best implementation of state-of-the-art information technology were run over by those who solved the business challenges of marketing and sales. Too often those who had developed the best technology – and knew it was the best – acted as if they believed that the commercial components of the business were of secondary significance. In their path-breaking work in evolutionary economics, Nelson and Winter had modeled the competition between innovators and imitators: “In our model world, an imitative strategy may, if supported by luck early in the industry’s evolution, be a runaway winner. And certainly imitators will have good luck at least some of the time.”
At the end of the 1970s, Zilog Semiconductors, which had owned the market for first-generation microprocessors that handled data 8 bits at a time, designed the best microprocessor for handling data 16 bits at a time. But the new Z8000 was incompatible with the host of software applications programmed to run on the Z80. As Zilog stranded its customer base, both Motorola and Intel invested in building technically inferior 16-bit microprocessors that were compatible with their respective previous-generation devices. Intel especially exemplified the triumph of marketing: its Operation Crush campaign not only won position as the engine of the IBM personal computer but established Intel’s x86 architecture as the standard for a generation to come.
As it happened, Zilog’s loss became our opportunity: a decade later, one of our first successful IT investments at Warburg Pincus was to back a management team that knew how to apply Zilog’s legacy technology to low-cost consumer electronics. Jointly, we constructed the first ever leveraged (actually, very underleveraged) buyout of a technology company when Exxon, Zilog’s original sponsor and then owner, completed the liquidation of Exxon Enterprises, its utterly failed effort to divert excess cash flow from oil and gas to information technology.
Here’s how I interpret what Bill’s describing here. At first, Zilog had the best technology in its field, which means it was likely to lose the competitive game against contenders more focused on marketing and sales. However, Zilog survived long enough (in this case, as a holding of Exxon Enterprises) to see the market mature, with most new entrants either going bust or moving upmarket, at which point there was renewed interest in Zilog’s superior technology. All the company had to do was survive long enough to see the day when it could stage a comeback, grab a share of a more mature market, and generate profits so as to reward its financial backers.
I don’t think you could talk to anybody else in the private equity industry that says, “We worry a lot about R&D and how we’re productive and innovative.” But that’s a core interest of ours.
And then there’s this from Silver Lake’s journey: ugly tech to the beautiful game (in The Financial Times in 2019):
[Silver Lake used to be about] chasing overlooked but cash-generative castoffs of technology trends gone cold. In the decade from 1999 at the height of the dotcom boom to 2009, the firm backed washed-up companies other investors were reluctant to touch, including SunGard, a data centre operator, and Seagate, a maker of hard disc drives.
It all resonates with what Jerry wrote in Productive Uncertainty: “It is not the risk, it is the uncertainty that matters”. The more a venture is exposed to uncertainty, the higher the returns you can expect from a venture capital perspective. And there’s much more uncertainty in exploring a new market than there is in developing a new technology. The latter is about taking a risk, the former is about uncertainty:
New technologies have a larger long-term societal impact but new markets are better investments.
Firms like Silver Lake differ from venture capital firms in that, far from enjoying uncertainty as an indicator of future returns, they see it as a direct contributor to losing money. So while they might be interested in backing tech companies, they will only do so if two conditions are met:
The new technology shouldn’t be all that new. It’s even better if you can make sure that it’s the best technology on the market, as was the case for Zilog when Warburg Pincus bought it out.
The new market should be evident and well understood. It’s the only way to forecast future revenue and make implementing a leveraged buyout worth the effort.
Why does Silver Lake matter from a European perspective? Quite simple: as I wrote in Can Private Equity Firms Make Money in Tech? (Round 1),
Silver Lake... has been in the news quite a lot recently—with landmark deals with Expedia, Airbnb, Reliance Jio Platforms in India, and others. What especially interests me is how Silver Lake went from “chasing overlooked but cash-generative castoffs of technology trends gone cold” to backing the symbol of cash-burning tech unicorns that is Airbnb. It’s a mystery I intend to solve because I think it’s the key to understanding the current funding landscape and how we can guide European tech companies toward more liquidity 🇪🇺
Also, Europe is about markets that are smaller and more fragmented, but also more regulated and served by more tangible industries. This means uncertainty is much lower than on the large markets explored by tech startups that US-based venture capitalists are used to backing. It might feel like less of an adventure than what Silicon Valley-style startups are pursuing at the frontier, but it’s also much more in line with what private equity firms such as Silver Lake are looking for—even if it’s all happening in the very same tech world. As I wrote a few months ago in Sifted,
Some will ask if European markets are big enough, if backing less ambitious startups will still be attractive for investors. But those with capital to deploy are seeing that tech entrepreneurs are now founding startups in more tangible industries (mobility, real estate) and in more regulated markets (healthcare, financial services). Because scalability is harder in such cases, tech investors are learning to cope with less impressive returns, while investors from outside the tech world are starting to get interested in backing startups whose risk-adjusted returns they recognise as more familiar. And so, in a world where software is eating more difficult industries, European startups focused on smaller markets could become more attractive to a broader range of investors, particularly relative to other options.
This all still feels a bit blurry, as I’m trying to reconcile different streams (Jerry’s thinking about productive uncertainty, reflecting on private equity firms such as Silver Lake and their interest in tech, and funding opportunities for tech entrepreneurs in Europe).
However, I’m certain that the idea of “Productive Uncertainty” is the key to understanding how Europe might position itself on the global tech scene. If your addressable market is large enough, as is the case for Silicon Valley-based startups, then a high level of uncertainty might be the key to reaching for the stars. If on the other hand you’re stuck in fragmented Europe, then maybe the key is about reducing the uncertainty to a bare minimum and then talking to financial backers such as Silver Lake or their local equivalents to fund your scaling up.
What do you think? Does it bring anything to mind?
Here’s a reading list on Silver Lake:
Investor Spotlight: How Silver Lake's 'Four Amigos' built a tech buyout behemoth (Kevin Dowd, PitchBook, April 2018)
Private-Equity Firms Create Funds That Are Built to Last (Miriam Gottfried, The Wall Street Journal, January 2019)
Glenn Hutchins transcript (Chrystia Freeland, The Financial Times, January 2008)
The Case for Silver Lake Not Being Evil Incarnate (Sarah Lacy, TechCrunch, June 2011)
Egon Durban: The Deal Maker Behind the Dell Buyout (Shira Ovide And Anupreeta Das, The Wall Street Journal, February 2013)
Silver Lake’s journey: ugly tech to the beautiful game (Mark Vandevelde and Murad Ahmed, The Financial Times, November 2019)
Will PE strategies score? A dive into Sport and Entertainment Investing (Bocconi Students Investment Club, December 2019)
Private equity firm Silver Lake promotes new leaders (Private Equity Insights, December 2019)
Silver Lake to Retool Top Leadership Positions (Miriam Gottfried, The Wall Street Journal, December 2019)
Silver Lake wants to make travel deals happen (Lucinda Shen, Fortune, May 2020)
Silver Lake’s coronavirus bets: a make-or-break moment for Egon Durban (Miles Kruppa, James Fontanella-Khan and Arash Massoudi, The Financial Times, June 2020)
Silver Lake Launches New 25-Year Investment Strategy Backed by Mubadala (Miriam Gottfried, The Wall Street Journal, September 2020)
🇩🇪 Today was my 9-year old son Ferdinand’s first day at the local Grundschule. He was rather nervous when we brought him to the new school, since he barely speaks German. But the school looks like it’s very good, Ferdinand’s teacher speaks perfect English, and the other students seem nice and welcoming. At the end of the day, he was in a good mood, with only one very deep question: how exactly will he learn German? What will bring him from barely understanding a word to being perfectly trilingual? We’re sure it will happen—but how exactly? That’s quite a mystery indeed!
As for my daughter, 12-year-old Béatrice, she’s reached the age when you have to decide if you attend a vocational Realschule or the more academic Gymnasium. Given her experience, background and interests, the obvious choice is the Gymnasium. However, since her own German is far from perfect (even after already attending a German school for one semester), being admitted to a local Gymnasium seems like quite the challenge. We’re currently maneuvering to that effect, and I’ll make sure to keep you posted!
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From Munich, Germany 🇩🇪