Korva is a scroll of the internet’s best ideas.
The business pyramid
American business looks like a pyramid. At the base, in the lower end of the lower middle market, the number of companies is enormous: a tremendous number make two, three, four, or five million dollars a year, and very few make fifty million.
Where efficiency breaks down
A fund that raises more capital ends up competing for the same known, larger assets as everyone else, which makes that market far more efficient. One founder joked in his 2017 annual letter that this corner of the market is the most inefficient legal market in the world, with the market for cocaine perhaps more inefficient. Inefficiency is what lets skill matter.
Two ways to run a firm
There are two ways to run an investment firm. One creates acceptable outcomes on the largest capital base possible, where success is dictated mostly by storytelling and dealmaking with investors and lenders. The other keeps the capital base fairly small and aims for the highest absolute return. Moving up the pyramid follows the first path, and he chose to have no incentive to move up.
Why are small private companies less efficient to invest in?
Economist Eugene Fama formalized the efficient market hypothesis in the 1960s and 1970s, arguing that prices in well-followed markets reflect available information. The idea depends on many informed participants competing over each asset. Small private companies have few analysts, no public filings, and no continuous trading, so information is scarcer and uneven. Fama shared the 2013 Nobel Prize in economics for his work on asset prices.
Why do business sizes form a pyramid?
U.S. Census Bureau data show that the large majority of employer firms have fewer than twenty employees, and only a tiny fraction have five hundred or more. Each step up in size has far fewer firms than the one below. Economists describe skews like this with a power law, and the Italian economist Vilfredo Pareto first documented the pattern in land ownership in the 1890s.
Why do bigger funds need bigger companies?
A fund must put its capital to work in a limited number of investments, because each partner can oversee only so many companies. As a fund grows, each investment has to be larger for the money to be deployed in a reasonable time. A billion-dollar fund buying companies that cost a few million dollars each would need to own hundreds of them.
More from Joys of Compounding
