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Back of the Napkin #5: Adverse Selection
Are you lucky or a sucker?
Back of the Napkin is an ongoing series by Brian Shih and Sebastian Park featuring a line-by-line deep dive of this interview with Jeremy Giffon on the Invest Like The Best podcast. You can find all previous posts in the series here.
Follow along here on Substack, or Seb’s LinkedIn. If you have any suggestions, comments, or want to join in as a collaborator on a particular topic, please reach out! You can reach Brian on Twitter and Sebastian on Twitter and TikTok.
Back of the Napkin #5: Adverse Selection
Giffon: I think you can take all these signals. Do you really need to know that much about a product? It's serving a niche thing and people are paying millions of dollars for it and they don't leave or whatever. Do you really need to know that much about buying a business if the guy is getting divorced or there's some tax law change or some other exogenous catalysts that you can just tell. I mean this comes back to the people, then you sit down with them and it pains them to be selling the business. That's a great deal. I'm probably going to do that deal just from that fact alone.
One of my favorite quotes that I think about probably every day is the Groucho Marx quote about, "I don't want to be a part of any club that will have me as a member." People never think about this with investing. It's like why has this come to you? You better have a very good reason, and no one ever has a good reason. You believe markets are slightly efficient, then if it's landing on your doorstep, you're either the luckiest person in the world or everyone else has passed on it. And it's probably the latter unless you have a very good explanation.
We’re now getting into Giffon’s bread and butter transactions from his time at Tiny: dealing with incentives and coordination problems as part of buying companies. There’s plenty of stuff out there on how to value a business, how to evaluate strategic positioning, or how to negotiate a deal—standard fare for MBAs—but Giffon notably doesn’t talk about any of that. As he said in The Perfect Investment, he’s focused on the incentives and structural constraints of the parties involved, and you don’t need to know Porter’s Five Forces, or how to build a DCF to understand them.1 So let’s dive in!
In this part, he’s talking about adverse selection.
It should be obvious then, that buying privately owned companies is riddled with the potential for adverse selection. The seller knows far more than you—it’s their company after all. If they’re suddenly willing to sell it, you have to ask yourself why? They think they’re getting a good deal, presumably.
There are plenty of legitimate reasons why the seller might want out. Maybe they’re retiring and want to spend their time elsewhere. Maybe they’re moving to another country. Maybe the company is good, but they can work less hard and make more money at Google. Who knows!3
As an example, Team SoloMid (TSM) recently sold their League of Legends LCS franchise spot to Shopify.4 The LCS is the North America-based League of Legends league (what a mouthful), and TSM has participated since the league was founded over a decade ago. Why are they selling? In isolation, maybe the reason is that esports is struggling as an industry, and they simply want to cut their losses. In which case… should you be buying?
But maybe the reason is structural: Each organization is only allowed to own one team in League of Legends, so if you want to start playing in Asia, you need to sell your team in North America.5 If TSM is a motivated seller due to the structural constraints, then that gives you some leverage, and maybe a bit of confidence that they’re not trying to screw you.6 This is what Giffon is getting at when he asks if you need to know that much about the business itself, “if the guy [our hypothetical seller] is getting divorced or there's some tax law change or some other exogenous catalysts”.
Sometimes transactions are adversarial, but sometimes they’re just markets functioning like they should, trading around some “fair value”. Markets are never perfectly efficient, so there is value to be captured by understanding the structural or non-market reasons the deal is showing up in the first place.
As Groucho Marx observed, the next time a seemingly golden opportunity comes knocking at your door, consider whether you're joining a club you actually want to be a part of—or one that's happy to have you because no one else would join.
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DCF models and Porter’s Five Forces are analyses anyone can run, so you might think of them as table stakes for evaluating a business, and the equilibrium that everyone is starting from. (This isn’t strictly true, since there are plenty of assumptions one has to make in running them.) But broadly you can think of them as the starting point everyone can use to look at the value of a deal.
In poker, there’s the notion of “game theory optimal” plays or GTO – the theoretically best play someone in a given situation should be making in a vacuum, calculated by poker software (“solvers”). Like the business analyses, GTO represents the equilibrium solution that everyone is starting at.
Deviating from the equilibrium opens you up to being exploited (e.g., via adverse selection) but also lets you do the exploiting (e.g., getting a deal due to understanding the structural incentives behind it).
In poker you are at a massive disadvantage if you don’t at least understand the equilibrium solutions. You need to know them because that’s how you develop the ability to exploit them. Just because Giffon prefers to look at structural incentives doesn’t mean he doesn’t know what these other analyses are.
A common example is insurance: Unhealthy or more risk-taking people are more likely to want life insurance, and they have an incentive to obscure as much of their info as possible. The more someone looks like an average, healthy person, the lower their premiums. Sometimes disclosure is unavoidable (this is why insurers require a medical exam), but oftentimes it’s not (you don’t need to volunteer that you like to freedive in shark-infested waters).
There are also plenty of illegitimate reasons that are worth understanding. For example: “We’re buying because we need to defend the peg because we’re a ponzi scheme and if the peg fails, we’ll all go to jail.” That’s a pretty strong incentive to get a deal done!
Does it make sense that Shopify has an esports team? Tobi Lutke, the founder and CEO of Shopify, famously loves Starcraft and esports. Given the current questions around the viability of esports as a business, this might be another case of non-market forces making deals happen.
Though you need to ask yourself why they want to move to Asia then. Are North American economics failing? Knowing the structural reason isn’t enough.
There are plenty of other possible reasons they’re selling: Maybe they’re completely out of money post FTX deal falling through and the LCS team doesn’t make any money. Will it generate the buyer profits? Should the fact that the team slots reportedly sold for ~$40M in 2019 and reportedly $10M in 2023 mean this asset is a buy-low opportunity or is the asset just on a death spiral downwards?
Full disclosure: One of the authors (we’ll let you guess who) was involved in the sale of a couple of esports teams over the past decade, inclusive of teams involved currently and formerly in the LCS.