Somehow I cant believe there are many heights that cant be scaled by a man [someone] who knows the

secret of making dreams come true. The special secret, it seems to me, can be summarized in four Cs. They
are Curiosity, Confidence, Courage, and Constancy.
Walter Elias Disney
Dear Virgo Partners:
In our prior two letters we outlined how the aggregate portfolio for VSPIII has come together and the
relationship between our ideas, completed investments, identified opportunities & risks, and our resulting
performance. Our top priority in 2016 has been asset management. It has been a busy year across the portfolio
relative to this priority. Our portfolio team (the PRC or Portfolio Review Committee) has been actively
engaged with our Industry Lead partners in monitoring business performance, driving value-add initiatives,
course correcting where needed, upgrading management teams, and executing both debt & equity financing
transactions. We have provided pertinent updates on the current portfolio in our 2015 Second-Half Report
distributed in June and in one-on-one meetings with investors.
The credit segment of the VSPIII portfolio is in solid condition. The niche, asset-based segment is
performing well. And, we believe we have material upside optionality embedded in the VSPIII structured
equity portfolio. We have made significant strides in unlocking value throughout 2016. But, we have miles
to go before we sleep in terms of tactical execution. It is always best to talk about results when it comes to
business execution and people (or the topic of human capital). As such, we will be sending around a summary
of completed and in-process value-add initiatives in the coming quarters. We are also planning to launch a
podcast initiative in 2017 to expand upon Virgos approach to human capital and corporate leadership.
From a Firm perspective, we have also been focused on organization development this year, in
particular, evolution beyond the founder phase of the Virgo business. We have made significant progress
against goals established at the beginning of the year with respect to scaling firm processes, specifically on the
portfolio management side. We highlighted some of these initiatives in brief at the annual meeting and have
summarized focus areas and developments in a document for our investors which will be forwarded under
separate cover.
Our letters have always been designed as thought pieces on investing, on the macro environment or
business trends, and on ourselves. As noted previously, on a go-forward basis we will seek to complement our
Disclaimer: This report is being provided on a confidential basis solely to its intended recipients and should not be re-transmitted without Virgos prior express written
consent. While all information contained in this report is believed to be accurate, Virgo makes no warranty as to the completeness or accuracy of the information provided.
Please view the last page of this letter for the full disclaimer.

bi-annual letters with other, more succinct communiques throughout the year. These will include (i) our FirstHalf and Second-Half Reports, which touch on key company developments, and (ii) a Portfolio Risk
Management package for each fund, which is a detailed summary and quantitative review of the portfolio.
These summaries will come under separate cover to our investors to preserve confidentiality, as this letter now
has a broader distribution list and we have multiple funds. As always, we are available to discuss the financial
and operating trends in any of our portfolio companies at your convenience. Housekeeping items out of the
way, we turn to the topic of this letter: financing innovation and re-invention.

What is the Current Macro-economic and Market Backdrop?

Our views on the macro-economy and market backdrop remain unchanged from our last letter. First,
we continue to believe there is limited room for an actionable, differentiated viewpoint on the macro-economy.
Global growth is largely stuck-in-the-mud and corporate earnings have been weak for several quarters.
Companies will likely muddle through. Earnings may catch some near-term wind in the sails throughout 2017
from stabilizing oil prices and a diminished US dollar impact. However, risks are skewed to the downside as
the business cycle matures. Corporate profits will be more uneven. And, sharp, disruptive events in the lives
of companies will likely expand.
Second, it is hard at the moment to define any useful, overarching theory for the trajectory of the
markets. The combination of macro-economic uncertainty, low interest rates, elevated sovereign and corporate
debt, slower growth, and high securities prices makes beta trades unattractive. Large swings in sector favor
(or momentum) makes directional investments complicated. From a beta perspective, risks are skewed to the
downside as the market cycle extends into year seven of the expansion phase. Markets are also positioned for
a corrective phase if only because prices have risen so much relative to the cash flows that assets and companies
are generating today.

The World
Today

What Does
It Mean?

What is the
Opportunity?

Beta Trades Unattractive

Areas of Corporate Change

High Securities Prices

Directional Investments Complicated

Pockets of Inefficiency

Macro-Economic Uncertainties

Have to Create Value, Cant Just Buy It

Low Interest Rates

Arbitrage Opportunities More Limited

Imagine

Reinvent

Traditional valuation metrics for equities are as high or higher than 2007. From a directional perspective, top
sectors or companies in any one period have a strong tendency to underperform in the next time frame as a
result of overpriced expectations. These rapid shifts in market perception have entrapped several large hedge
2

funds in 2014/15 and 2016, who had larger exposures in energy and healthcare, respectively. We remain
curious with respect to a correction in technology shares (the day when the FANGs lose some of their teeth).
Given the variables outlined above, we expect a see-saw between periods of fear and greed as the
consensus moves on the margin relative to alternating perceptions of economic growth, on the one hand, and
slowdown or recession, on the other. Though the possibility of a worst case scenario has faded into the
background for the time being, we certainly have not run out of things to worry about. A hard landing in
Chinese heavy industry or real estate markets is still plausible. Chinese money markets are awfully curious at
the moment. OPECs strategy may continue to create volatility in the energy markets. And, Deutsche Banks
woes are a reminder of the unresolved plight of the European banking sector.
Finally, from a longer-horizon perspective, many of the key drivers of historic US equity market
returns favorable demographics, expanding consumer leverage, declining interest rates, and rising consumer
spending no longer exist as strong tailwinds to earnings growth. These factors are now neutral or are
becoming headwinds. As such, forward return expectations are muted across traditional asset classes. There
is a clear need for an evolution in approach which is driving a movement in the fault lines and tectonic plates
of the investment industry.
Passive and low-cost managers, like iShares, have seen large inflows recently. All-weather, modelbased asset managers, like Bridgewater or AQR, have scaled up dramatically. Investors seeking more active
management are searching for good risk/return in credit, earnings growth at a reasonable price in equities, and
the next driver(s) of returns in a complex market environment. This is challenging. Many historic arbitrage
windows have closed. Managing long-short approaches has become difficult. And, buyout prices have risen
at the same time that growth slows. As such, in tandem with the maturing of the traditional alternative asset
landscape, limited partners (investors) are seeking strategies and the next generation of managers that can
deliver attractive, differentiated, and less correlated returns (that is, returns that are different from returns on
liquid bonds and stocks). Me toos will fall by the way side, alternatives to traditional alternatives will
emerge and investors will increasingly tie fees (for active management strategies) to true value-add measured
both in terms of proprietary sourcing and the ability to enhance business performance. From this cauldron of
challenges and needs, emerges an opportunity that Virgo was founded to capitalize on as a business.

The State of the State in the Investing Business

The private equity industry has grown tremendously from the time we entered the business as
professionals in the mid-1990s to 2000. With the maturing of traditional private equity strategies, such as
LBOs, the price for control is higher today. The supply of capital chasing deals is larger. Similarly, in growth
equity, the number of investors pursuing high-quality software, media, and healthcare companies has
expanded. Limited partners recognized this trend starting in the mid-2000s and have supported a wave of
more specialist managers under the thesis that specialization facilitates more proprietary sourcing and more
effective asset management. Similarly, increasing product-ization has defined the competitive landscape as
industry founders have expanded from deal shops into global alternative asset managers. Differentiation is
critical to raising capital at a certain scale. Once the capital is raised, investors must imagine new ideas,
innovate in the search for deals, creatively structure transactions, and proactively manage investments as never
before.

As with many industries, the 2008-09 Great Recession accelerated the underlying business trends
within the investment business. The volatility of the crisis left baby boomers and pension funds yearning for
enhanced stability as they retire and seek to close underfunded gaps, respectively. Low sovereign rates that
were the solution to global macro-economic woes have all investors searching for yield. The pull-forward of
future market returns by central banks, has similarly left a glut of global savings searching for returns. And,
finally, the fallout of the 2008-09 financial crisis was a wave of increased government regulation of the banking
sector, which has led to certain business lines and risk-taking activities being reduced or eliminated all-together
from FDIC-insured institutions.
The search for yield and increased government regulations, has underpinned the growth of the shadow
banking sector in the US and Europe with a resulting explosion of assets under management by all sorts of
private credit managers, BDCs, specialty lenders, etc. Credit has been the biggest source of growth for global
alternatives asset managers. Furthermore, as regulated, commercial banks become, at least for the time being,
government-serving utilities within a shrinking box of allowed lending and market-making activities, the
taking of credit risk has shifted to the unregulated, private sector. The economic model of the modern,
commercial bank whether Wells Fargo, Deutsche Bank or Tokyo Mitsubishi in terms of generating returns
for public shareholders, is under siege.
Although we capitalized in 2010-2012 (thru Partnership II) on the void in middle-market lending, a
moment of market inefficiency we have not built Virgo to be a substitute for commercial banks. It is hard to
differentiate in credit if one is trying to build a scale business. The product is well defined and has more limited
degrees of structuring freedom. Furthermore, financing private equity sponsors accounts for a large portion of
the US private credit marketplace and is a commodity business with a market-clearing cost of capital and lower
margins. Finally, the credit markets are cyclical and only present the opportunity to make equity-like returns
at certain moments in time. In hindsight, we are glad we took this view. The direct lending business has
institutionalized significantly since the early 2000s, has seen a wave of new market participants since 2010,
is crowded and is arguably overcapitalized presently as evidenced by diminishing coupons. Yes, a levered
first lien portfolio or mezzanine portfolio will generate a net return of 6-9%, which certainly outpaces <2%
ten-year sovereign bonds or 3-8% corporate bonds. Yes, 6-9% likely even outperforms equity market returns
for a period of time. But, the business is not unique or innovative. We would have been one in a sea of minime toos to the credit businesses of the global asset managers, who already have achieved economies of
scale. We didnt see how we could challenge these incumbents, in an intellectually satisfying manner, or have
our voice rise above the pack. We also aspire to be the Apple versus the Lenovo of our industry. We want to
be unique, innovative, and produce higher returns as a result. We want to have fewer, but more profitable
customer relationships. And, we wish to build these customer relationships in a differentiated fashion where
there is a virtuous ecosystem of idea exchange, collaboration, and profit.
At Virgo, the market seams we pursue fall into three main categories: market dislocations, areas of
corporate change, and pockets of identified inefficiency within the capital markets. Human nature fear and
greed is the one constant in the capital markets. So, we are certain that (i) market dislocation moments to
capitalize on the forced selling of traded securities (as in 2008-09) or (ii) periods of market-wide inefficiency
moments to back up the truck in credit originations (as in 2010-2012) will repeat. But, we do not wish
to be dependent on them. As such, the Firm has been built to execute in both the recession and expansion
phases of the market investment cycle. With volatility diminished and earnings generally peaking there is little
in the way of fruitful market dislocation, presently. Therefore we have been focused of late primarily on areas
of corporate change, and, to a lesser extent pockets of inefficiency (including the niches pursued by our
4

Zephyrus and Kavanah strategies). As noted below, we have been focused on financing innovation and reinvention.

Availability of Credit

Recession

Market Dislocation
(Secondary Purchases)

Recovery

Market Dislocation
(Primary Originations: Restructuring Capital &
Shareholder Recapitalization)

Pockets of Inefficiency
in the Capital Markets

2009-2010

2010-2013

Expansion

Corporate
Change

Pockets of Inefficiency
in the Capital Markets

2013 Present

Finally, in terms of competitive positioning, we also did not think we could build a differentiated
business competing in traditional distressed investing alone. As with private equity, the liquid distressed
business has institutionalized significantly since 2003/04. With expanded competition, there is a diminished
return potential on a go-forward basis. The opportunity set is also inherently cyclical and feels overcapitalized
presently. Finally, we at Virgo believe the approach to distressed investing will have to be different than it
was historically coming out of the 2000-02 and 2008-09 recessions. We do not expect a V-shaped rebound
in either the economy or capital markets as occurred in those time frames, respectively. On the one hand,
global growth is sluggish both cyclically and longer-term. On the other hand, the Fed has additional tricks up
its sleeve, but has already done an awful lot to buoy capital markets. As such, we believe investors should
expect a longer hold period for acquired securities and, therefore, demand lower purchase prices. In addition,
we remain wary of many businesses that are distressed today. Retail, old technology, established media, and
certain oil & gas businesses are cheap for a reason as they face terminal challenges.

The Virgo Approach

Taking these observations and predictions together, we have applied our credit and private equity skills
to position ourselves as a leader in what we expected would be a growing wave of allocation to a new
opportunistic, tactical, or absolute return bucket within institutional investors portfolios. The glut of
global savings searching for returns has underpinned the growth of this new bucket and created an opportunity
for the next generation of creative, private financiers.

Innovation exists in the seams between traditional public asset classes and the gaps between incumbent
alternative asset buckets. Furthermore, with demographics now more relevant1 institutional investors are
looking for middle-duration, middle-return strategies that balance illiquidity, time, and an acceptable
multiple-of-capital. We believe portfolio construction will increasingly focus on these variables and more
refined liquidity trade-offs. Finally, we are operating within a time period of increased volatility and widespread, more rapid corporate change. Change is abundant across Virgos Core Industries. And, there is a
large and multi-decade opportunity set to finance this change. Against this backdrop of investor needs and
market opportunities, we established Virgo - not in the mold of the English theory of commercial banking of
which todays shadow-banks are an off-shoot - but in the mold of the French theory of entrepreneurial banking.
The theory of the entrepreneurial bank that is, the purposeful use of capital to generate economic
development was formulated by Comte de Saint-Simon. Saint-Simon, his predecessors (Cantillon) and
contemporaries (Jean-Baptiste Say and ALC De Stutt de Tracy) were nineteenth-century French economists
that were focused on political economy ideology (the science of ideas) in the context of a society, which was
transitioning in both social and economic ways from agriculture and a landed gentry to the industrial revolution
and nascent capitalism. To Saint-Simon, industrialism meant the triumph of technology over backwardness,
of science and reason over superstition. The French school of thought put the entrepreneur at the core of this
entire new process of production and distribution, and the continual succession of [commercial] exchanges
that began to define society. The entrepreneur was also fundamentally linked to the process of capital
formation. Innovation and risk were a part of this early definition of entrepreneurship, but the conception was
more focused on the entrepreneur as a universal mediator between quantities demanded and quantities
supplied in a market-based (or transactional) economy between landlord and capitalist, between scientist
and laborers, and between producers and consumers. The entrepreneur assumed risk; supplied financial
capital; was an industrial leader, manager, and coordinator of economic resources; acted as an arbitrageur, and;
allocated capital. The entrepreneur applied certain scientific knowledge to a useful purpose that leads to the
creation of utility and value.2
Change was abundant at this time. Saint-Simon imagined a society of producers whose skills were
tested in the crucible of competition. Technology was altering production, distribution and consumption across
industries. The emergence of financial products and practices tracked these innovations in the business realm.
Together corporate change and the evolution of finance represented a turning point in the industrial revolution.
Until then (up until the Napoleonic wars), bankers lent against security (i.e., the taxing power of a prince).
By contrast, Saint-Simons entrepreneurial bank was designed to invest, that is, to create a new wealthproducing capacity.3 Two of Saint-Simons disciples, the brothers Jacob and Isaac Pereire, established the first
entrepreneurial bank, Credit Mobilier, in 1852 and ushered in what is now called finance capitalism, with an
initial focus on the development of European railways. From the very beginning there was a synergy between
the revolution in transportation the national railway system and the revolution in finance the new banking
system.4
So what context exists today? Strong US equity market performance from 1980-2000 was supported
by positive demographic trends, falling interest rates, expanding consumer leverage, and rising consumer
spending. These variables are now neutral or are becoming headwinds. In addition, technology and the
Pension funds underlying clients were in their 30s when private equity began in the 1980s, but, like endowments have always been, are now
consumers of wealth
2
Robert F. Hebert, A History of Entrepreneurship
3
Ivar Jonsson, The Political Economy of Innovation and Entrepreneurship
4
Ralph Roth & Gunter Dinhobl, Across the Borders: Financing the Worlds Railways in the Nineteenth and Twentieth Century
1

globalization of labor markets have weighed on job creation, wage growth, and GDP expansion in all
developed economies since 2000. These trends were masked for nearly a decade by three reinforcing forces:
(i) a Chinese economic development revolution, (ii) an associated boom in emerging market economies, and,
(iii) the deployment of foreign savings (accumulated by manufacturing and commodity exporters) into US
mortgages. The US mortgage boom underpinned a housing boom that, in turn, extended the run for US
consumers beyond what wages alone would have allowed. These forces were fundamentally unbalanced and
the music came to a screeching halt with the US housing collapse and the ensuing global financial crisis of
2008-09. Governments responded with aggressive monetary policy to stave off another Great Depression.
Their policies appropriately softened the macro-economic landing, but, by definition, also pulled forward some
aggregate demand and a lot of financial asset returns. Seven years later the financial markets are still slurping
from the punch bowl of central bank stimulus, while the real economy searches for the next driver(s) of
sustained corporate earnings growth and job creation or wage expansion.
That said, change is again abundant. Technology has again altered production, distribution, and
consumption across industries. Manufacturing supply chains have been re-arranged globally and now core
production processes are being reconsidered. Service industries are leveraging labor in a fluid, transformative
matter (the so-called shared-economy model). And, society is again transitioning in both social and economic
ways. As in the industrial revolution where labor moved from agriculture to industry, labor in developed
economies is looking for a post-industrial (post-manufacturing) home with good wages. Technology has
enhanced corporate margins and spawned a few giant, cash-producing internet machines, but has dimmed the
earnings potential for many laborers. Imported goods are cheap; it is easy to engage globally in all sort of less
costly, improved services, but, as a result, wage growth is not there to support the expanded consumption of
these products and service offerings. Furthermore, a new generation of consumers is emerging with different
aspirations, trade-offs (on work versus leisure), and perspectives on savings deployment. As a result, as in
the industrial revolution, labor dislocation and burgeoning inequalities have underpinned a global strain of
populism that has thrust itself onto the political stage in dramatic form.
In a world of low interest rates, stability is over-priced. Tail risk exists in the presumption of sovereign
integrity and of corporate incumbency. In a maturing business cycle, near-term, and a more zero-sum growth
environment, longer-term - as a function of developed country demographics one cant just buy value,
presently. Arbitraging values is also challenging. Rather, it is necessary to create value (to generate new
wealth-producing capacity). In a world of retiring savers (the post WWI generation and the post WWII baby
boomers in the US, Europe, Japan & China) and transitioning economies (the US, China & the Middle East),
there is a glut of savings seeking attractive (>6-9%) investment returns. However, it is critical to focus on
disruption, on change and on complexity to deliver attractive returns. In a world of low growth, innovation is
highly rewarded.5 Re-invention that invigorates earnings is also well received. The time has come again for
the Saint-Simon entrepreneur that connects corporate change investment opportunities with the next leg of
innovation in finance. As the Pereire brothers did in 1852 (although hopefully with more lasting success!) our
mission in Virgo is to connect our industry knowledge to a useful purpose (i) that leads to the creation of utility
and value and/or (ii) that enables economic development.

There are also many governments seeking businesses that can diversify existing reliances and create jobs, which will support this innovation
7

Have To
Create Value,
Cant Just Buy It

The World
Today

Create Utility

Innovation

Enable Economic Development

Reinvention

Stable cash flows are over levered and overpriced

Arbitraging Value is Challenging

Evolutionary
Corporate Change
Opportunities

Generate New Wealth-Providing Capacity

At Virgo, we are LONG CASH FLOW and LONG change. Why? First, because we believe interim
cash distributions are critical to successfully compounding invested capital in any environment. Collected
cash reduces our principle at risk, moderates the impact of year-to-year valuation changes, and reduces the
impact of exit timing on realized IRR returns. This is particularly important in the go forward environment,
which is likely to consist of shorter business cycles, expanded corporate unknowns, and more volatile asset
prices. Returned cash also creates patience for the seeds we have planted to germinate and to be harvested (as
reflected in the Virgo logo, which is a sheaf of wheat). As such, our Funds portfolios are structured as a
convertible bond (or a high dividend yield stock) with a quarterly yield and capital appreciation potential tied
to the successful execution of idiosyncratic investment theses.

Long

Neutral

Short

Value
Investor

Long

But a
Value Investor,
Seeking Change

Marc Andreessen
Neutral
Focus on
Innovation

Contrarian
Disposition

Short
Warren Buffet

Second, we believe the go-forward market environment requires innovation and re-invention in
partnership with asset owners and existing shareholders. One must imagine to discover unique ideas and to
find/create differentiated investment opportunities. One must re-invent businesses to achieve outperformance
versus the markets. Our focus at Virgo is as follows:

we want to finance and build innovative, market leading businesses that offer novel, but evolutionary
products;

we want to re-invent companies that are navigating periods of industry or company-specific volatility
by serving as a financial + operational bridge to more certain times and higher values;

we want to find and scale unique, credit-like streams of cash flow to a size where they can be
accessed by insurance companies, pension funds, and retail investors that are searching for these
pockets of differentiated yield.

Our vision, when we launched the Firm, was to connect ideas and human capital with the savings provided by
our shareholders (presently, our limited partners). Our vision was to support corporate growth, to enable
corporate repositioning, and to create or institutionalize niche, asset-based markets. The investment pallet
for what we do is outlined on the following page:

Middle-Market,
Specialty Finance

Niche,
Asset-Based

Corporate,
Structured Equity

Opportunistic credit investments with

equity-like target returns

Credit and structured equity transactions

that are backed by asset collateral that
generates current cash flow

Non-control and shared control equity

transactions

Financings for out-of-favor industries,

Credit-like streams of cash flow (e.g.,
storied companies, and complex situations power purchase agreements, music royalties,
highly structured credit investments
pools of specialty finance credit assets,
aircraft leases)
First and second lien credit securities

Credit securities or ownership of assets that

generate consistent cash flows (with no
leverage or modest leverage)

Differentiated earnings growth and business

re-invention opportunities where we seek to
structure an investment with an attractive
upside/downside
Situations that typically combine credit and
preferred equity securities
Preferred equity securities
(with a liquidation preferences)

VSP III Examples

VSP III Examples

VSP III Examples

(Kavanah Platform)

What is Old is New Again

The genesis for this letter was a summer trip to Mendocino and Fort Bragg, California to attend the
77th Annual Paul Bunyan Festival (think log sawing, wood chopping and chainsaw games), and to ride the
Skunk Express (as our 18 month old son has a passion of trains).

On the train ride segment of our weekend adventure, following a pleasant trip thru the Redwoods, we came
across a plaque detailing the history of the Skunk Railroad, which read as follows:
In 1884, C.R. Johnson, who with Cal Stewart and James Hunter owned a mill in Kibesilah (north of Fort
Bragg), announced the start of a new mill next to Soldier Harbor. Soldier Harbor is where the fort was located
that formed part of the Pomo Indian reservation until 1867 (when it was abandoned). On November 16 th,
1865, C.R. turned on the new band saw thus officially starting up operations of the new Fort Bragg Lumber
Co.
By the time the new mill started, some track had been laid for C.R.s other business the Fort Bragg Railroad
Co., which included the Pudding Creek Railroad C.R. had purchased from Alexander McPherson and Henry
Wetherbee. The tracks ran from the mill, which existed at Pudding Creek, and followed Pudding Creek east
into the woods. In 1886, a newly purchased 26-ton steam locomotive, a 22, started hauling logs.
By 1887 there was nearly seven miles of track. A second locomotive was purchased along with a San Francisco
cable car. The cable car was converted into a passenger car. C.R. was unique at the time, in that he wanted
his railroad to not only support the lumber business, but also to have it serve social and cultural needs. Right
away the new passenger car started carrying loggers with wives or girlfriends on Sunday picnics.
In 1893, C.R. bought large lumber tracts along the Noyo River from White & Plummer. He merged these
assets and the Fort Bragg Lumber Co. into the new Union Lumber Company. To get logs from this newly
purchased land to the mill a 1,122 foot long tunnel was dug through the rocky slope between Pudding Creek
and the Noyo River. By, 1893, the railroad was 10 miles long. It went far enough inland that travelers could
ride to the end of the line, catch a stage to Willits, another stage to Ukiah, the railroad to Sausalito and the
ferry to San Francisco. In 1904, regular service was extended to Alpine, 18.1 miles inland via curve after
curve after curve and numerous bridges. In 1905, the railroad company was re-capitalized and re-named the
California Western Railroad. Its goal was to reach Willits to meet the Northwestern Pacific Railroad coming
north from Ukiah.
The last row of hills between Fort Bragg and Willits rises to 1,740 feet. To make the ascent it was necessary
to lay eight and one half miles of hairpin track to move forward just one and a half miles. Railroads rarely
have an upgrade of 2.0%. This grade was an unheard of 3.3%. By 1910, there were 27.8 miles of track. The
last five miles as the crow flies took another 12.2 miles of track. Part of the 12.2 miles was a 795 foot long
tunnel at Summit.
Twenty six years after the railroad was started, on December 19th, 1911 the first run from Fort Bragg to Willits
took place. To be invited to ride on the inaugural roundtrip was akin to knighthood. One hundred and fifty
lucky passengers left Fort Bragg amid wild cheering of nearly the whole town of 2,000. Engine #5 pulled the
consist. A straight line from Fort Bragg to Willits is 22 miles. Engine #5 went 40. At Willits nearly the whole
town of 1,200 was there to cheer the arrival. The roundtrip fare was originally $3 a huge bargain compared
to stage coach fares.
Early History of the Skunk Railroad
My wife has always wondered, or should I say questioned, what I do for a living. Similarly, we have
for years sought to simplify, largely unsuccessfully to date, the explanation of: who we are? what we do? how
we do it? In a world of increasing product-ization within the investment business, it is easy to fall into the
traps of buzz words, of mumbo jumbo, and of technical descriptions of securities one invests in (e.g., first lien,
10

second lien, unsecured, mezzanine, preferred equity, common equity). In the days of Comte de Saint-Simon,
everything was one thing, capital. One invested money in an asset or company and sought to get that money
plus some more money back in return. One sought out the C.R. Johnsons of their time and place. It should
not be more complicated today. As an entrepreneurial bank, Virgo seeks out founders, families and
corporate owners who have a purposeful use of capital and who want a flexible partner that can complement
them in executing their vision (or dream) to make it a success.

The Next Phase of the Capital Markets

As noted above, Credit Mobilier - officially the Societe Generale du Credit Mobilier - was a French
banking company and one of the most important financial institutions in the world during the mid-19th century.
A joint-stock company operating on the principle of limited liability, its initial investments came from large
industrialists, but its capital was over time vastly increased by accepting investments from the general public.
It played a major role as a dynamic funding agency in the development of numerous railroads and other
infrastructure projects by mobilizing the savings of middle class French investors as capital for large lending
schemes. It is most famous for the funding of railway construction, but also specialized in mining
development; funded other banks including the Ottoman Bank, Austrian Mortgage Bank, and several insurance
companies, and; had investments in transatlantic steamship lines, urban gas lighting, a newspaper, and the Paris
public transit system.
So what does Fort Bragg, California have to do with French economic philosophes? The Pereire
brothers work in France was ground breaking and became a philosophical system around the creative role of
capital. In turn, Jay Cooke and the American Credit Mobilier established a beach head across the Atlantic,
which helped to finance the transcontinental railroad and regional derivatives like the California Western
Railroad, which C.R. Johnsons initial seven miles of track became a part of in time. Later, J.P. Morgan
established his bank in New York (in 1865) as the conduit for European investment capital into American
industry.6 American, Saint-Simon entrepreneurs have been innovating ever since in the pooling of capital
and distribution of risk from (i) the high yield bond to finance corporate buyouts to (ii) the residential,
mortgage-back security that ushered in the subprime and Alt-A loan.
We believe the next several years will again mark an inflection point in thinking with respect to the
pooling of capital and tranche-ing of risk. First, as in the industrial revolution, the emergence of financial
products and practices should track changes in the business realm. The time is ripe for the next revolution in
finance. Second, there is again a need for a conduit of investment from fiduciaries of capital into corporate
change opportunities. Third, the competitive landscape presents an opening for redefining the relationship
between the Saint-Simon entrepreneur and sources of capital:

As noted above, many risk-taking activities have been reduced or eliminated all-together from FDICinsured institutions. Risk is increasingly securitized and distributed in markets.

The activities of incumbent investment banks have fundamentally changed as a function of DoddFrank and the application of the Volcker rule.

Robert W. Price, What is the Evolution of the Venture Capital?

11

As they have gone public, global alternative asset managers incentives have skewed to AUM growth
and fees on capital as that is what the public markets have valued, versus carried interest profits.

Fourth, as exemplified by KickStarter and the peer-to-peer lending concepts (not what they are investing in,
but who is investing and how), the aggregation of capital is enabled today by technology in ways that were
never possible in the past. Finally, there is a new generation of consumers who have a very different
perspective on the banking system, investment advisors, and how their savings should be deployed.
Millennials will seek the Berkshire of their day.
Virgo was founded to capitalize on these emergent market seams in our own industry. The name of
our funds has included the society concept from the very beginning. Through the Societas vision we are
seeking to innovate in how we align with our investor partners to raise and deploy capital. We view our limited
partners as shareholders in our activities. And, in a world where the large, incumbent players are focused on
zigg-ing (more about management fees), we are zagg-ing (all about profits).

Applying this Capital to the Financing of Innovation and Re-invention

As most of you now know, having said it ad nauseam, Virgo is focused on identified, thematic
opportunity sets, or market seams. Market seams typically take the tangible form of shifting industry dynamics,
sub-sectors in transition, corporate transformations (through major acquisitions), legal or regulatory
difficulties, and business restructurings or turnarounds. Although our investments vary with the market and
business cycle, our Firm applies a consistent approach to idea generation and research. We have built an
Operating Partner Network (see attachment under separate cover) and a web of sourcing counter-parties that
allows us to translate our thematic ideas into actionable opportunities. We have a very pro-active approach to
sourcing, which has turned up compelling investments. We are flexible in the structure of our investments.
And, we have a consistent method of engagement that we believe creates value post-investment.
We remain steadfast that by focusing on market seams, we are most likely to find and capitalize on
either mis-pricings or inflection points in value. We are also certain that relationships are the key to our
business. People repay loans (with the cash flow from their companies). People are also critical to either the
successful execution of a growth thesis or the re-invention of a business. Virgos focus on human capital and
our network of talented executives has allowed us to resource our ideas with the necessary blood, sweat and
tears to turn a thesis into an economic reality.
This letter has been a voyage in late nineteenth/early twentieth century railroads, French political
economy, and the history of banking, because we believe there are many parallels between that period and the
current environment. As Adam Kirch noted, Modernity is a vertigo that began in the sixteenth century and
shows no sign of letting up. It is a subjective condition, a feeling or an intuition that we are in some profound
sense different from the people who lived before us. Kirch in reviewing Anthony Gottliebs book on the
Enlightenment and the philosophical debate regarding the source of truth, which we journeyed through in our
prior letter on Zen and the Art of Motorcycle Maintenance offers an apt summary of parallels between the
two time frames:
We like to think of ourselves as living in an age of unprecedented disruption. Just look at all the commonplace
features of our world that didnt exist a century ago jet travel, television, space flight, the Internet. If you
could transport someone from the year 1916 to the present, we ask a little proudly, wouldnt that person be
12

stupefied by the changes? But one thing would be very familiar to such a time traveler: the pride, and the
anxiety, we feel about being so modern. For people in the early twentieth century were as acutely aware of
their modernity as we are of ours, and with just as good reason. After all, they might have said, imagine
someone transported from 1816 to 1916: what would that person have thought of railroads, telegraphs,
machine guns, and steamships?
Investing is a matter of pattern recognition. At the beginning of any fruitful pattern recognition is
awareness and a sense of ones context: what is the environment in which one finds themselves? What
comparative advantages does one have? And, how does the environment collide with ones insights and
comparative advantages to produce opportunity? Our opportunity, as an investment-focused entrepreneur,
exists in allocating capital, in coordinating economic resources, and in applying our industry knowledge to a
useful purpose that leads to the creation of utility and value. Change is abundant across Virgos Core
Industries, presently. As such, Virgo has a pipeline of imagination-based opportunities. This includes: (i)
investments where industry change creates an inflection point in growth and (ii) businesses with new, novel
products. The Firm is also pursuing re-invention, specifically corporate restructuring and balance sheet realignment opportunities that have emerged in a few sectors. Finally, we combine the two in the search for or
creation of unique, credit-like streams of cash flow.
As we stack up the idea pipeline and start closing transactions in a new fund, two related topics - the nature of
innovation and process of re-invention - have again been on our mind. We have weighed these topics to orient
our idea generation and we are actively considering them relative to portfolio construction.
Types of Market Seams

Market
Dislocation

Pockets of
Inefficiency in
the Capital
Markets

Corporate
Change

Imagine

Reinvent

Innovative products

Corporate change that creates an

inflection point in earnings value

Growth capital for an innovative

business model in a changing or
consolidating industry

Balance sheet realignment and

shareholder recapitalization

As a framework for this exercise, we returned to Peter Druckers seminal article on the subject of
innovation. Our goal in Virgo is to consistently find inconsistent opportunities that is, market seams, or
windows of opportunity. Although innovative ideas do at times strike like a lightning bolt, repeated ideation
consistently finding the seams requires knowledge, some ingenuity, and intense focus. For this sort of
systematic innovation, Drucker is a natural guide. As Drucker says, innovation is work rather than genius
13

 what all the successful entrepreneurs I have met have in common is not a certain kind of personality but a
commitment to the systematic practice of innovation. Similarly, at Virgo, we are focused on evolutionary
change. We are not a venture capitalist seeking new, revolutionary business models. Rather, we are seeking
companies that combine different strands of knowledge into a useful product or service that, therefore, earns
a superior return on invested capital. Or, companies that see an opportunity to transform their market position
through capital. We are focused on risk-return. For this, Druckers construct is also the appropriate lens. As
Drucker notes, innovation is about more than just the next big thing. Innovation and re-invention, as Virgo
uses the concepts, are similar processes in Druckers framework: It is the means by which the entrepreneur
either creates new wealth-producing resources or endows existing resources with enhanced potential for
creating wealth. Drucker outlines the process of innovation as follows:
A successful innovation may come from pulling together different strands of knowledge, recognizing an
underlying theme in public perception, or extracting new insights from failure. Purposeful innovation begins
with looking, asking, and listening. The key task is to work out analytically what the innovation has to be in
order to satisfy a particular opportunity. In innovation, as in any other endeavor, there is talent, there is
ingenuity, and there is knowledge. But when all is said and done, what innovation requires is hard, focused,
purposeful work. If diligence, persistence, and commitment are lacking, talent, ingenuity, and knowledge are
of no avail.
Drucker also categorizes the various sources of innovation or reinvention:
Most innovations result from a conscious, purposeful search for opportunities, which are found only in a few
situations. Four such areas of opportunities exist within a company or industry:

unexpected occurrences unexpected markets or product applications, insights from failure

incongruities disconnects or inefficiencies in the logic or rhythm of a process (a new approach to

the process)

process needs enhancements to the production or distribution of goods & services (refinement of
certain steps in an existing process)

industry & market changes industry upheavals, shifts in the structure of the industry or new
approaches to the marketplace

Three additional sources of opportunity exist outside a company in its social and intellectual environment:

demographic shifts changes in the numbers of people, their age distribution, education, occupations
or geographic location

changes in perception changes in mood: whether people see a glass as half full or half empty

new knowledge the emergence of new scientific, technical or social knowledge and its distillation
into usable technology, products or services
The Discipline of Innovation, 1985

14

We have historically described our themes from a top-down perspective with a focus on both (a)
industry & market changes and (b) changes in (financial market) perception. Our 2013 letter on stories as a
means of idea generation highlighted these concepts. That said, our investments in VSPIII have also all
included a bottom-up aspect to the theme, and certainly to the daily execution of the thesis. To date these have
generally been either (a) incongruities or (b) process needs. A table below summarizes the various types of
targeted innovation or re-invention we have pursued in VSPIII.
Top-Down

Bottom-Up

Industry

Unexpected
Occurrences

Incongruities

Process Needs

Industry &
Market
Changes
Changes

Demographic
Shifts

Changes in
Perception

New
Knowledge

Atlas
Hawkeye
LCA
Lonesome Dove
Zephyrus
NOWAccount
Kavanah
Ygrene
Alchemy
Clinipace
Zippy Shell
ARM
Nautilus

We have outlined where we are active presently within each of our Core Industries in the Road Map
for VSPIV, which was distributed under separate cover. To preserve confidentiality with respect to in-process
ideas, we will comment on market seams as we announce completed transactions. That said, we think
Druckers rubric is helpful in that it facilitates a methodical review of both top-down and bottom-up sources
of opportunity within our focus sectors. Filtering ideas through this framework also forces careful analysis of
the needs, expectations, and values of the intended user of any product or service we are considering. And, of
the required capabilities a portfolio company must exhibit to successfully execute. All innovation or re15

invention needs to be specific, clear, and carefully designed. The management required to see it through also
nearly always requires augmentation and evolution.
It is critical to be defensively well positioned for a change in perception in the current markets, as a
tipping point is likely over the coming years. However, we believe there is limited room for an actionable,
differentiated viewpoint on the macro-economy or the trajectory of the markets, presently. As such, from an
offensive perspective, we are focused on incongruities, process needs, industry changes, and demographic
Industry

Unexpected
Occurrences

Incongruities

Process Needs

Industry &
Market
Changes

Demographic
Shifts

Changes in
Perception

New
Knowledge

Specialty Finance

Specialty Finance
(Real Estate)

Niche
Industrials

Media &
Entertainment

Energy

Healthcare
Corporate Change

Imagine

Reinvent

shifts within our Core Industries. We are looking for opportunity from the bottom-up. We have also
observed or experienced some unexpected occurrences that have opened the door to new insights in the last
twelve months. Below please find a brief summary of the types of innovation or re-invention that are likely to
characterize our activity over the coming years.

16

Specialty Finance: Our investments in financial services have targeted innovative products that address
a market need and create utility or value for their customers. By pulling together different strands of
knowledge, they have all involved a twist, which allows both a unique and attractive risk-return for
credit investors and a competitive cost of capital to clients. Our real estate-investments have focused
on economic development versus cap rate arbitrage and have targeted inefficiencies in the markets as
well as storied or out-of-favor operating businesses with supporting real estate collateral. We remain
focused around these market seams. The sources of opportunity for both innovation and re-invention
of existing business models remain broad in the sector presently.

Niche Industrials: Our pipeline in the niche industrial sector is focused both on innovation a new
approach to existing corporate processes as well as re-invention refinement of certain steps in
existing markets where there is a clear process need among customers. Our asset-based activities in
aviation and our strong executive network have offered a window into corporate change opportunities
in aerospace. We are actively cultivating a specialty materials theme and strengthening our Operating
Partner bench in that sub-segment. We are targeting companies with a compelling return-on-invested
capital in plant expansion or, project-level capex and complementary product line development. We
expect the sector to produce a consistent stream of opportunity and perhaps windows of market
dislocation to the extent the earnings cycle roles over.

Media: Whereas our historic focus over the last few years was on content cash flows, our present
pipeline in the media sector is targeting picks and shovels service solutions. We are focused on the
democratization of content creation and a distributed broadcasting theme, technology services
companies supporting the backbone of content distribution and the re-invention of traditional mediums
that still have growth prospects like out-of-home advertising. The pace of evolution is accelerating
and presents many uncertainties and unknowable unknowns. We seek to be long, versus short
change. However, it is challenging to anticipate changes in consumer perception. And, unexpected
occurrences are certain to arise. Therefore, our idea generation centers around incongruities in existing
market practices and customer process needs that emerge out of the digital era of fragmented
audiences, expanded on-line and enterprise video consumption and evolving content production
methods.

Energy: We have entered what should be a highly productive time period for finding and executing
investments in the US energy sector. Volatility is abundant, there is a revolution underway in many
sector business models, and change is widespread. This creates opportunities for both innovation and
re-invention. First, the growth of renewable and distributed power generation and the disruption of
incumbent, fossil fuel-based utility business models presents a wide and diverse market seam.
Investment opportunities emerge from the resulting process needs, marketplace incongruities and
unexpected occurrences of this industry shift. Second, the oil and gas sector has entered a period of
historic market dislocation. The day of reckoning for under-capitalized and over-levered producers
has arrived, which presents ample opportunity for balance sheet realignment transactions, workinginterest deals and highly structured shareholder recapitalizations. Perception has shifted notably from
peak oil to peak demand in the matter of five years with the unlocking of US shale resources.
Finally, Virgo has a robust pipeline of investments targeting energy efficiency, broadly defined,
including innovative capital equipment and service business models that drive better monetization of

17

under-utilized assets through process efficiency. These efficiency opportunities provide very
attractive returns on capital and modest unit level capital commitments.

Healthcare: The healthcare sector offers a steady stream of opportunities to capitalize on corporate
dislocations resulting from unexpected regulatory or legal events. In addition, healthcare is a dynamic
and growing industry in the midst of a paradigm shift in care compensation and delivery, with
disruption from new products and technologies along the way. The healthcare system is changing
dramatically in five major ways. First, the framework for purchasing insurance is evolving. With
greater co-payments and higher deductible insurance plans, consumer behavior is evolving, and
increased consumerism has started to alter the trajectory of healthcare utilization and cost inflation.
Second, healthcare reform has re-written the basic rules of the game in insurance. This has
underpinned vertical integration with insurers acquiring providers to increase their left pocket as their
right pocket shrinks. Third, care delivery is transitioning from a payer-centric to a patient-centric
payment model. Healthcare is moving away from a fragmented world in which individual doctors and
hospitals get paid by procedure and toward larger provider systems that coordinate all of a given
patient's medical needs. This includes a move from a "treat and cure" or "treat and discharge" model
to the integration of care across the continuum of hospital and out-patient care. Fourth, reimbursement
incentives are shifting from fee-for-service payments to compensation that rewards cost efficiency and
care quality outcomes. Insurers are aggregating data that allows health risk vs. care quality vs. care
cost decisions. Providers, in turn, are entering into risk sharing arrangements that split cost savingsbased revenue with insurance companies. Fifth, as blockbuster products roll off patent and are
genericized, pharmaceutical revenues are under pressure at the same time that reimbursement declines
and value-based compensation incentives are gaining traction. Investment opportunities emerge from
the resulting process needs, marketplace incongruities and unexpected occurrences of this industry
shift. Our focus in Virgo is on non-regulated business that achieve one or all of the following
objectives: increasing system efficiency, care efficacy or value to the patient.

Conclusion
At Virgo, we are a conduit of investment from fiduciaries of capital into corporate change investment
opportunities. In our investments, we are focused on evolutionary change. We want to finance the right
railroads at the right time, not the invention of the locomotive. We are looking for the C.R. Johnsons of our
day. We seek preservation of capital, first, and a return-on capital, second.
That said, in our business itself, we are seeking to lead the next revolution in finance. In this letter,
we touched upon of few areas of new knowledge discovery we are exploring (or the dusting off of old
knowledge for the current context, like all good art) to this end. This type of innovation has the longest lead
time and inevitably involves the convergence of circumstance and different kinds of knowledge in ways that
are not linear. We look forward to unveiling these ideas over time. For now, back to some hard, focused,
purposeful work. Hopefully the town of Willits cheers our arrival, one day.

18