The Battle for Alpha

Valuation Games are in many ways conflicts over the perception and control of alpha. For those who aren't familiar with alpha, it's a metric used to understand how well an investment has performed compared to a benchmark market index. Alpha's a score that tells you whether an something has done better or worse than other comparable things.

At a more general level, a person or asset that possesses alpha generates a return that is superior to alternatives. A software engineer who is ten times more productive than their peers has alpha, as does a business with a profit margin twice that of its competitors. To possess real alpha means you have figured out a way to profitably exploit whatever environment you're operating within.

When someone advertises that they're meaningfully different and better in some way, it's a way to claim they possess alpha. This is therefore one of the key points of focus in any Valuation Game: whether you're buying or selling, the perception of alpha is what either makes or kills transactions.

For example, venture capitalists need high-alpha investments to make up for the majority of their low- and negative-alpha portfolio companies. One company with enough alpha compensates for all the losers, so their valuation process revolves around the search for alpha. Entrepreneurs who want funding from VCs who don't understand where their alpha is compared to the rest of the market will fail to get what they want.

Buy-side players are always on the hunt for alpha. It is their Holy Grail, the thing they want most out of their investments. Sell-side players know this, and they do everything they can to maximize the appearance of alpha. Sometimes that means simply highlighting true alpha, and other times it translates into fraudulent claims.

Idiosyncratic Investments & Risks

Alpha is built on idiosyncratic differences, not simple optimizations of existing products, behaviors, and so on. A person or asset with alpha does not just do more of something that has been done millions of times, they do it better compared to everyone else. This means that those who generate alpha are most often experienced risk takers who have committed substantial amounts of time, money and brainpower to their pursuit of alpha.

Those who seek alpha have a sense that the world is filled with things that need to be changed. They're the dreamers of the world, people who refuse to accept conventional wisdom and simply follow the crowd. Because this is commonly understood, an investment in a potential alpha creator is often wrapped in romantic language: they aren't building a business, they're changing the world (or so they say).

This manifests as one of the core levers of any Valuation Game. The players on the sell-side present themselves and their assets as idiosyncratic investments, the proverbial "right stuff." They've been tested by the elements and proven themselves superior through their idiosyncratic differences. All you have to do is invest (at a premium) and you too can be part of this movement.

For example, eccentricity is often viewed as an inseparable element of alpha creation. It is indeed part of the equation sometimes, but not always. That line of thought can be exploited by savvy players who know that we often associate odd behavior with brilliance (and therefore alpha potential), to the point that important red flags are ignored by alpha-seeking investors.

From the buy-side, the Valuation Game is about the search for actual alpha and the concurrent process of pretender identification. When there appears to be alpha present, buyers need to verify that it's real, and, if possible, get it for as cheap as possible. Since most buyers are smart enough to realize that alpha is about difference more than anything else, they think in terms of idiosyncratic risk more than anything else.

Their fear is that the differentiation is a mere illusion or, even worse, it exists but comes with massive downside potential. You don't want to invest in a person or asset that provides profits today but blows up tomorrow. One of the core elements of the Valuation Game from the sell-side then is the imperative to conceal any sort of idiosyncratic risk as long as possible.

The Alpha Dilemma

All true alpha generators face a dilemma when it comes to the exploitation of what they've discovered. On the one hand, anyone who finds a way to generate alpha (either by design or accident) has to conceal and protect it. If the alpha source is revealed to the wrong party, it can be stolen and exploited without the originator gaining any benefit. The world is filled with alpha thieves, so those who seek alpha have no choice but to be secretive and deceptive to protect themselves.

On the other hand, third parties are almost always required to take full advantage of alpha-rich opportunities. The kinds of people who come up with differentiated products, behavior, etc. are rarely the same people who have the resources to turn them into reality. Alpha creators must then go out and find partners who can provide those resources, without handing over the most important details of how the alpha is generated.

This is common problem in both finance and technology. Players on the buy-side will often feign interest in a transaction specifically to steal the source of alpha from the seller. An entrepreneur who doesn't protect their intellectual property or a hedge fund manager who reveals the inner workings of their trading strategy is putting themselves in a position to work for free.

The overall strategy here is about how much trust should be shared between the two parties. Alpha sellers have good reason to be secretive, and buyers have good reason to see proof before they hand over any resources. Some kind of compromise between secrecy and transparency must be made in order for the alpha in question to be expoloited to its full potential.