Super LP (www.superLP.com)

Good Advice I've Gotten

I’ve gotten a lot of good advice over the years . . . it’s really unfortunate that I’ve forgotten most of it.  Two nuggets, however, keep rattling around inside my otherwise sparsely-populated skull. 

First, in my younger and more athletic years I played baseball.  Back then, I was a pitcher, although not one of those fireballers-in-training that got all the attention from the hotties and Division I-A coaches.  Nope, I was a dependable – but less flashy – finesse pitcher with a tragic flaw: whenever I started getting roughed up (which was often!), I always tried to overpower the opposing team’s hitters with fastballs.

Unfortunately, when your three pitch speeds are slow, slower, and slowest, trying to blow the ball past someone can become a dicey proposition.  Whenever this madness set in, Coach C. would come out and say, “don’t compound your mistakes . . . you’re in a hole; stop digging.  Get back to your game plan.”

The second chunk of wisdom was imparted in the early part of this decade by an LBO pro who was reflecting on the just-past ebullience in Venture World:  “Always remember that any form of value-added, hands-on investing works best when time is cheap and capital is expensive.  Unfortunately,” he continued, “in frothy environments time becomes very dear and capital becomes very cheap.”

Implicit to this statement was an assertion that a pendulum swings between ebullience and sobriety, between spirited overextension and thoughtful focus, between openhanded wagering and miserly risk aversion.  Here’s my question, though: whatever happened to the swinging of the pendulum?

Despite a hiccup here or there (including the recent mega-cap buyout world lock-down,) the velocity of money has been accelerating across PE world.  Sure, the deal pace has slowed lately, but transactions are still getting done and double-digit billion dollar funds continue to get raised.  And all those dollars will have to go somewhere.

At the same time, we hear tales of woe about slouching return expectations and I’ve lost countless hours of sleep worrying about compressing risk premia.  It’s a prisoner’s dilemma, of course.  Returns are going down because too much money is being put out, but a sizeable number of GPs (and LPs for that matter) don’t want to stop putting money out because they don’t want to sit on idle cash.

And why not sit on idle cash?  Because that prevents people from going out and raising their next fund which in turn postpones the augmentation of their fee stream.  Maybe I’m painting with too broad a brush, since I know plenty of managers who are still capital gains motivated and not just W-2 focused, but it just seems that a handful of folks are enjoying robust enough fee streams that they can look at their carry as a nifty free option owned at their limited partners’ expense.

Since all economic analysis is done on the margin, it’s these current income focused cats who are inverting the time and money equation.  You can’t begrudge them, though, since their incentives are clear: get the money out fast, get involved in too many things, see what sticks, and raise the next fund.  As long their investors allow them to keep raising subsequent funds, there’s no disincentive to stop.

I just hope that along the way – when times inevitably get tough – we all have the wisdom to know that we’re in the hole and should stop digging.  Compounding your mistakes is the worst thing you can do when trying to compound capital.

Tyranny of the Relativists

There’s a great riff in John McWhorter’s book, The Power of Babel: A Natural History of Language, that describes how expressive force in language diminishes over time.  His poster child is the word “terrible” which once meant “causing dread or fear or terror,” but now is used as a mild negative modifier (e.g., “I’m such a terrible putter that my wife got me personalized golf balls that say, ‘three putt.’ ”) 

Similarly, the language of business is littered with expressions that slouched from overuse: phrases like “best of breed” went from insightful to hackneyed over the course of mere years.
Of course, private equity has its very own once-powerful phrase that’s meandered to meaninglessness: Top Quartile.  Now we all know how Top Quartile got to be the gold standard: a couple of cool graphs in the Book of David some McKinsey studies, an endorsement by an influential pension fund or two and Top Quartile was the place to be. 

Everyone wanted to be in the Top Quartile, and, soon enough, most people were – if you accepted their pro forma returns based on aggressive multiples of EBBS (earnings before, ahem, bad stuff) or included estimates of what an acquirer might pay for a start-up once it had perfected its swell product and revenues had started their inevitable ramp.

The problem with that kind of thinking is that it obscured the true aim of private equity: return enhancement (relative to the opportunity cost of equity capital, i.e., some appropriate public benchmark).  Success was no longer about getting adequately compensated for taking incremental risks; it was now about beating the next guy (or more specifically, the next three guys).  

And that’s the paradox, of course, of any peer-group measure: when new entrants deploy capital, their extra dollars will likely depress returns across the spectrum – since the marginal dollar tends to set the price of assets – but the cohort of “winners” (with victory defined as being Top Quartile) grows.  The club gets less elite as people enter from the bottom.

Of course, measuring private performance against a public benchmark can be pretty tricky and is fraught with tough questions like: what’s the appropriate evaluation horizon, how do you equalize for appraisal effects, should you beta-adjust? to name a few.  As a result, it’s tempting to fall back on an easy measure like peer group rank.

A while back, I started asking VCs what they thought the top quartile breakpoint for venture over coming vintage years might be assuming reasonably “normal” public market conditions.  In my informal and unscientific survey, more than half of those I asked guessed that the top quartile line would be at or below zero.  Surely, some firms will do fantastically well, but if the VCs I sampled are right, it will be really amazing that dozens and dozens and dozens of firms that tinker in one of the riskiest corners of the financial world will be able to call themselves successful even though they will have lagged the public market – not to mention cash – by many hundreds of basis points.  What’s more amazing is that merely by surviving, these firms will earn billions of dollars in fees in aggregate and the folks who funded them will dance a jig for having done a great job.

It’s enough to remind one of an old story: two campers are awakened by the sounds of a bear sniffing at their tent.  While one of the campers starts panicking, the other calmly starts putting on his sneakers.  “Why are you putting on your shoes?  There’s no way you can outrun that bear,” whispers the first camper.  “I don’t need to outrun the bear,” replies the second camper, “I just need to outrun you.”

That kind of thinking may work for relativists, but the important return-enhancing role that PE plays in institutional portfolios demands that we instead ask: for all the extra risk and illiquidity we incur, if you can’t outrun the bears (and the bulls) why bother?

One Strike Away . . .

I’ve been in a bunch of meetings over the past few months with buyout guys who say things like, “we’re in the seventh inning of the credit crunch.”  In fact, it seems like every time I turn on CNBC or read the Bloomberg, the inning metaphor is up at the plate. 

The use of innings as a proxy for time seems like a swing and a miss to me, though.  Since baseball is alone among major sports in allowing the defense to control the ball, the sport is liberated from the tyranny of time marching inexorably forward.  I like football and basketball as much as the next guy, but the practice of running out the clock by taking a knee or dribbling around the floor has always seemed vaguely anticlimactic to me. 

You just gotta get that third out in the ninth inning and it could take all day to get it done.  As a young pitcher, I once allowed six consecutive hits (!) with two outs in the last inning.  In fifteen minutes, a fine pitching performance was undone and I went from complete-game winner to hard-luck loser.  All for want of just one more out . . .

A late inning grand slam can turn a blowout into a tight game and completely reverse a game’s momentum; anything can happen and the clock won’t bail you out.  And that’s what makes the metaphor funky: it almost doesn’t matter what inning of the game you’re in, something totally discontinuous can occur at any moment.   

Maybe that actually makes the metaphor brilliant?  Perhaps embedded in the sense of progress toward the conclusion, there might be an implicit acknowledgement that the credit crunch is not unlike a baseball game.  And we know what they say about ballgames: it ain’t over until it’s over.