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.

Comments

[Ron]

Thanks for the post. I think the problem in business is that people don't always know they are continuing to dig their hole. Sometimes the only way to determine whether you've stop digging is to seek an outside mentor or resource that can take an objective stance and analyze your situation. I'm not a VC but I imagine VCs are constantly seeking assistance by a mentor. In my field of small business growth coaching, we suggest that each client find a mentor that fits their mold... http://www.readtheanswer.com/index.php?RTA=web2

[Sam]

Talk about digging a hole … “man looks in the abyss, there's nothing staring back at him. At that moment, man finds his character. And that is what keeps him out of the abyss.” Well, we’ve got plenty of abyss. And, now its time to look.

The pendulum is here to stay, sometimes is just cocks back a little longer, but it eventually comes a swinging, and this time wielding financial weapons of mass destruction (a nod to Buffett there).

Along with this visit from the pendulum is a clear signal for greater alignment between who gets paid and who owns the source of those cash flows. It applies to Wall Street public banks just as it does to GPs (and LPs for that matter).

Why in the world are 2% (or so) management fees allowed on large and mega fund sizes? And stacked? It is easy to agree that it is both the money and the manager that generates the return. And, therefore you can conclude that there should be a sharing on the profits, at an appropriate split. But management fees of that size, especially if there is a layering effect?

Ah, no.

Tack it on the profit split, if there is push-back. Staring at the abyss to earn some fees would weed out a fair number of pretenders out there.

[Chris Douvos]

Sam, I love the Lou Mannheim quote. It is amazing how much fee (and other) income is sloshing around out there and how sloppy OPM (other people's money) makes people. It's amazing how much more focused people are when they have real skin in the game.
Lou had it right: "Kid, you're on a roll. Enjoy it while it lasts, 'cause it never does."

[Chris Douvos]

@ Ron: a great point. Mentoring and coaching are critical issues. I've been wondering if there was a way to make the whole mentor/mentee selection process more efficient (almost like an online dating service)? Maybe something like that exists, but if it doesn't I think it would be a great idea . . .