The Value of Expertise
In our last post, we started with this hypothetical. If you read the last post, feel free to skip down to “Expertise Matters.”
Imagine yourself in this situation: you are planning a high-priced vacation and you have two key choices to make about the upcoming trip.
Choice 1: You can go to one of two destinations:
One of the most beautiful places in the world that is not crowded with tourists
An average location that is extremely crowded
Choice 2: Who plans and accompanies you on the trip?
An experienced tour guide who understands the intricacies of the city, its history, and has relationships with its major vendors
A fellow tourist who has never really spent much time in this part of the world, but thought it looked beautiful in a magazine
The answer should be clear: you want a beautiful, less crowded location with an expert to maximize the experience.
The same logic applies to how one should invest. If you are relying on generalist fund managers with a broad mandate to generate investment outperformance, then you are choosing the investing version of a crowded, average location with a fellow tourist leading the way.
We also outlined the core tenets to Discerning Capital’s view on how to maximize returns:
Returns are maximized by concentrating in your best ideas in the most attractive parts of the market
Groups with context and expertise generate excess returns and mitigate more risks
In that post, we outlined the reasons that online gambling is a highly attractive, fast growing market for venture capital. Now it’s time for the second part – defining the value of expertise, which we view as equally important.
Why Does Expertise Matter?
We believe that expertise drives better decision making and ultimately better outcomes in complex industries. A person’s ability to build context, relationships and a deep, visceral understanding is largely determined by time: if you spend 100% of your time in one market, you will fundamentally learn more and often outperform more consistently in your area of expertise. Being on the outside of an industry and parachuting in will systematically build context and understanding over time, but you cannot generate deep expertise through osmosis.
A generalist investor skillset is valuable as it allows you to leverage pattern recognition, an understanding of issues related to growth, broad investment legal concepts and, most importantly, some heuristics that will allow you to start understanding how to discern likely winners from likely losers. Those are very valuable in most investing, the problem is that in regulated complex markets (e.g. healthcare, gambling, fintech, etc.) those can often breakdown entirely.
Allow us to draw a comparison to the field of medicine. Students graduate from medical school and are ‘ready’ to practice medicine after passing their boards. They are generalists. However, those doctors all must undergo a residency before they are prepared to practice in the field. If you are looking at the more complex fields, the residencies can last more than 6 years. Turning that analogy to investing in regulated gambling companies, if you are looking at ecommerce companies, consumer technology or general consumer – then you can probably find lots of individuals who can appropriately evaluate and diligence those businesses. However, we believe that online regulated gambling investing is one of the more difficult focus areas in investing (similar to fintech or healthcare). If you are making investments in or on the edge of regulated gambling via a generalist fund, then you are asking for a hip replacement surgery from a doctor focused on family medicine.
We call generalists in this market ‘tourist investors’. They come in, think the market looks beautiful, get their heads turned by someone and then get pick pocketed.
Why Does Online Gambling Require Expertise?
Online wagering is not one thing. It is a web of suppliers and operators finding a way to comply with the relevant rules and regulations in 100+ jurisdictions globally. While we mostly focus in regulated online gambling (sports betting & iCasino), there are other interweaving laws/regulations that might actually apply – skill-based gaming laws, daily fantasy laws, lottery law, sweepstakes law, and then layer in the fact that over 30 states in America often have different rules in each one of those categories.
We estimate that roughly 20-25% of the companies we evaluate are operating illegally today. These are companies that are often backed by family offices or individuals who know nothing about the relevant laws or regulations or the need to obtain gaming regulatory counsel. Those investments will often show promise and early returns as illegal gambling operations are surprisingly profitable without taxes or regulatory oversight. When they become large enough to matter, regulators will step in and the investment will and should go to zero.
It is not just the investors who do not know as often the entrepreneurs do not know. We had an entrepreneur pitch us in 2021 on a $10M investment after having raised a similar amount of money already. As he walked us through how bitcoin was the future of gambling in the US, we asked him how his business intended to comply with the Federal Wire Act (summary: makes it illegal to facilitate gambling & related payments across state lines), the entrepreneur said that the Wire Act had nothing to do with payments across state lines. I googled it, read it to him and that was the end of the conversation. He went on and raised more money from generalist venture investors and family offices. Inside of a year, that business and its investors were effectively wiped out in an asset purchase.
It’s not just little start-ups, we are aware of multiple businesses that are operating as “Daily Fantasy” or “skill based contest” businesses that we believe are fundamentally illegal gambling offered into states without regulated competition (Florida, Georgia, California & Texas). They price gouge the consumers with bad prices and make a lot of money as they do not have any competition. These companies have raised tens of millions of dollars and are generating hundreds of millions in revenues. If/when the regulators and state AG’s do their job, at least one of them should go to zero as it has no backup plan to build a regulated business.
We saw another company where it lacked any controls to stop wire transfers across borders. It was a crypto casino in the sky that raised $20M+ from some top VCs in Silicon Valley and a failed large Bahamian crypto exchange. When we asked a simple question around ‘how do you stop people from using the betting exchange to facilitate wire transfers to fund terrorism’ or similar, the answer was essentially ‘but it’s for betting.’ Good luck explaining that one during the trial for breaking the US Patriot Act.
One last concept here is “legal opinions.” Lawyers give companies a legal opinion stating that their business is legal, which is intended to allow them to operate and then raise money from investors. Not all legal opinions are created equal. There are a few reputable regulatory law firms in this market, and when a regulatory-focused partner signs a legal opinion, it should be taken seriously. Sadly, many general practice lawyers with no experience in gambling are happy to write up a legal opinion for $2,500 and sign it. We have seen companies raise money using legal opinions that were unsigned by their attorney, which is a huge red flag. If you don’t live and breathe this market, you could be hoodwinked by a legal opinion signed by a local Saul Goodman (Better Call Saul reference). Context matters.
While you might be thinking “these are a few examples” – the thing is that these examples have raised more money at higher valuations than the groups doing it the right way. These were all companies that raised big dollars from smart investors (often with big brand names) who lacked the context to understand how and why those businesses were illegal. The concept of “move fast and break things” does not work well in highly regulated business spaces (e.g. Theranos, FTX). We are not representing that we are legal experts ourselves, but we have enough context from our time inside a large, regulated organization to know the relevant concepts and importantly, who and what to ask. As a process point, we always run our deals through regulatory counsel. Every. Single. Time. Consider that we do this for a living, and we still bring in regulatory expertise on each deal – generalists who show up to these capital raises rely on legal opinions that often times have little underlying value.
What is the Value of Discerning Capital’s Expertise?
While we have outlined the funding pitfalls that may arise if you are a generalist investor allocating to the space or a company raising money from an investor that fits the description, there are also clear positives associated with working with a specialist.
RRegulatory Context: We address this above, but its without a doubt the most valuable thing that an investor can bring to the table. It goes beyond understanding the legality of a business, but it permeates every decision you have to make in this industry, especially in structuring the transaction and product expansion.
Context & Access: By focusing on a specific market, niche investors will see more investment opportunities in the space, be able to better access competitive positioning and help portfolio companies navigate more effectively.
Network: There is a small but powerful network in the gambling industry. Once you have built the relationships, you are only 1-2 people away from almost anyone. That can result in introductions to potential acquirers and/or customers, to strategic partners for distribution, or simply to other people who can share their relevant expertise. By living in this niche market, you can drive incremental value for portfolio companies that is not possible as a generalist.
Valuation: Generalist investors massively overpay in our sector. In the last 24 months, we have seen multiple deals done for vaporware companies where investors without context for the industry overpaid by 10x or more. Generalist investors often are excited by the regulatory moats in our industry, but they do not realize that the regulations also have other impacts on the businesses (e.g. sales cycles are longer, geographic expansion takes time, etc.).
As an entrepreneur, you might think “that’s great that they overpay.” However, investors get preferred shares that often have features that cram down the management’s common equity during an eventual down round. By raising in an appropriate, measured, and upward trajectory, you in fact protect yourself at the cost of a little additional dilution along the way instead of a big, negative surprise.
Structuring: Understanding how regulatory considerations should impact deal structuring is a really important consideration in this industry. In an industry where personal licensure accrues to anyone with control – the wrong structure can put both investors and the portfolio companies in a very precarious position.
Particular vs. General Skills
We will close this post out with this same concept but delivered through a movie quote (our favorite way to communicate anything). In the 2008 film, Taken, Liam Neeson’s daughter is kidnapped by an organized ring of criminals. He famously speaks with the kidnappers and says:
“I don't know who you are. I don't know what you want. If you are looking for ransom, I can tell you I don't have money. But what I do have are a very particular set of skills, skills I have acquired over a very long career.”
Can you imagine that quote with him saying ‘I have some general good dad skills and I’m going to figure out how to do this’? Certainly, wouldn’t make for a great movie. The average retired dad couldn’t have done anything except call the police and ask for help when something went wrong. Expertise matters whether its in an action movie or in investing.