Bad Drivers

I’ll never forget the day I told old man Moran that I wanted to go to college at Berkeley.  It was nineteen eighty-nine (a number, another summer) and I said it just to see if I could get a rise out of the oldster by naming a school as far away from Brooklyn as I could think of.  His craggy face crumpled up as if he’d suffered sudden-onset gastric distress and Moran (who’d left Brooklyn exactly once in his life to attend Basic Training before going island-hopping across the Pacific) spat: “Berkeley?  Berkeley?  That friggin’ place makes Woodstock look like friggin’ Parris Island.”

It’s a real shame that he passed a few years ago (rest well, sir,) because I would’ve loved to see the look on his face when I told him that I’d been invited to help teach a class at Berkeley’s Haas School (thanks, Terry!)  I would’ve made sure to tell the old man that people were nude moonbathing or some such nonsense.  He would’ve eaten it up.

Anyhow, the whole thing was a blast and the kids were pretty sharp.  The lesson for the day was (insert moment of reverence here): The Yale Case.  For those who haven’t actually seen the HBS case in question, it’s basically a 20-page precursor to David Swensen’s seminal opus, Pioneering Portfolio Management; it lays out how Yale was able to generate returns that became the envy of the investment world.

Of course, people read the case (or the book) and their response was: we gotta get us some of that illiquid private stuff!  You could say that the case study laid the intellectual groundwork for the PE boom.  But hey, I’m not complaining; after all, it laid the groundwork for me having a job . . . 

So there I was talking about how so many people had taken away the wrong message from the book.  The message wasn’t necessarily “do private equity” (or do anything else specific in the book for that matter),” but rather, the message was: “if you’re going to do any of this stuff, you’ve got to do it well!”  I mean, look at page 20 of the 2007 Endowment report.  Those cats added $11 billion over the trailing 10 years relative to their composite benchmark.  Now that’s execution!  And execution is critical because the meager (sometimes nonexistent) compensation you typically get for straying from plain vanilla US equity falls far short of compensating you for the risk, illiquidity, and brain drain of playing in those funky asset classes.

But then I started thinking about it and realized that for most people there’s no functional difference between, “do this,” and, “do this well.”  Why?  Because over 80% of drivers think they’re better than average on the road; most people have a positive bias to their self-image.  Come on, if Swensen can put up Top Quartile numbers, why can’t I?  After all, I’m good enough, I’m smart enough, and doggone it, people like me!

Of course, that’s private equity’s analogue to the preponderance of drivers thinking they’re better than the average bear: the comically-large cohort of managers who claim to be top quartile.  In fact, I’ve been wondering lately if someone should start a top quartile verification service that would provide seals of approval for pitchbooks (or maybe special gold stars to sprinkle liberally in track record sections of PPMs).  Not that it matters: the opportunity costs are so high (particularly today) that being top quartile likely won’t even begin to cover those high opportunity costs.

So the more I noodled on it, the more I thought that maybe Pioneering Portfolio Management should come with a disclaimer: don’t try this at home.  Of course, trying this at home was exactly what the next book was about.

Comments

[charlie]

Chris,

Of course, all entrepreneurs are 'above average' too!

The only routine exception I know of to the above average perception is when you ask children about their parents.....at least mine are sure they were last on line, and got bottom quartile performers.

[Sam]

Good post, as usual - thank you.

The one thing that surprises (saddens?) me is the opportunity cost comment, in the face of doing VC/PE well - versus leaning on a currently low market for future returns.

A similar opportunity cost existed at end of 2001 and in 2002, but Yale continued to invest in this time period...and do extremely well...because they invested smartly in that lucrative asset class. That meant the top decile firms, sure. But it also meant looking at what new strategies and teams are emerging/emerged that will be the new teams and strategies for success.

A fair question is: can VC/PE do better than public equities, reflective of an illiquidity discount, given where public equities are now? And how would that happen? With which GPs/firms?

The underpinning of all of this is somewhat akin for Publics now...at least in the financial sector but also healthcare, what worked before will not work again.

So, the question is what VC/PE model will work going forward, in particular in the healthcare sector, that sparks great returns in this marketplace. Great returns should be significantly better than what is available in more liquid classes.

I've no doubt that an effective strategy, well executed, in a VC/PE space will far outpace public equities - from now.

One valuable element about venture, at the least, is that it is about creating fundamental value from the bottom up. This works very, very well when the slate has been wiped clean and a new way forward is needed (...that feels like right NOW).

It would seem appropriate for LPs to open up the competition for their dollar to include those effective strategies, versus not evaluating them because the ‘market’ is “so low and it always comes back”.

[Chris Douvos]

Charlie,
Take heart, nobody's actually in the bottom quartile. I'm sure you're at least third quartile in their book . . . .

[Chris Douvos]

Sam,
A great point. The next big thing rarely looks like the last big thing. It takes courage to look off the beaten path for the new, interesting stuff and then you run the risk of being wrong and alone. That's a price too few are willing to pay for a shot at greatness, so they keep on "buying IBM"

[Mark]

I'd also like to add that being in the top-quartile of VC over the last few years means you've returned .7x your money. It's the tallest midgest contest. Sometimes absolutes do matter.

[Ethan Prater]

And the next book very clearly stated, over and over, *don't* try this at home, you can't do this from home.

[Tim]

Floated over after seeing the “big ups” from Venture Blog. Congrats!

Yes, it is a comically large cohort so concede off the bat that every GP team you meet with regardless believes it is or going to be a top quartile fund.

If I worked at Yale, I'd might be pissed at the amount of noise such a book has added to private capital markets. Wait a minute...perhaps the book came out to wipe out the competition once there was a shared confidence that the best of the best were already in the portfolio as meaningfully as can be allowed....sorry for the conspiracy theory, its just habit :-)

Seriously, read the preamble in the book...Dean gets a lot of the credit too and the IC leadership has been fairly static. It’s all about the team perfecting its kung-fu (work ethic, communication, imagination, creativity, filtering and sharing ideas) over a very long period of time. Above all, understand that benchmarks can encourage short term behavior and for most assets are at best dubious.

Go bears!
Haas-MBA '94