A Hundred Days, A Hundred Months

Sometimes, I envy public market investors; occasionally I think, "wouldn't it be nifty to actually see your investment theses play out in less time than a presidential term or two?"  But then I remind myself how cool it is to watch portfolio companies flourish and strive and struggle and dream.  It's like watching your nieces and nephews – the ones you see only about once a quarter – grow and mature.  And all that waiting and watching pays off.  Doesn't it?

I've been asking that question a lot lately.  After all, on Day One of LP School we're taught that there is compensation for patience. Illiquidity is one of the key risk premia we collect (right?).  At Old Ivy, we always said, “fifteen percent compounded forever is a lot of money . . .”

But I worry that some in the PE world seek illiquidity solely for illiquidity's sake.  Or even more cynically, I occasionally fear that there are some who hide investments gone sideways behind a veil of prudent patience.  So, let me ask heretically: what if all of the talk of long term horizon is misguided?  What if the compensation for holding an investment to the out-years is inadequate relative to the risk?

Let me double-click on that for a moment: nowadays most buyout shops tout their Hundred Day Plans.  Think: Metrics!  Dashboards!  Flash reports!  SWAT teams!  (Or are those SWOT teams?)  Some firms have upped the ante and talk about working to kick off The Plan even before they close on deals (how proactive!).  And all of this stuff is music to LPs's ears, giving the impression of catalytic ownership.  Now we know why we're paying these guys the big bucks: it's because they do . . . stuff (and they do it fast!).  And, sure enough, skilled owners can help businesses achieve real value inflection points.  Some even have grand plans for strategic repositioning that will take many years and a half dozen or more add-ons to come to fruition.

But here’s a question: how long should one hold a company to capture value?  Come in, rock your 100-day plan, catalyze a bunch of change, stabilize the company, get eight quarters of growth under your belt, and hope for a good exit market in years three or four.  Easy.  (Of course, easy can be very, very hard.)   

But think about it another way: if there’s a value creation curve for the typical company, I’d imagine it’s very steep in the early years, with a flattening in the out-years.  There might be an inflection point or two beyond the initial surge, but the rate of change almost certainly slows as time passes.  Meanwhile, business is moving ever quicker – just talk to a biz dev team using The Cloud to fast-cycle product testing and launch, or a manufacturing group using lean production – and execution challenges are unending.  One could even posit that owning companies in the out-years is more risky than anyone expected; there might even be a case to be made that risk-adjusted returns go down in the out-years.  Maybe that’s why so many LPs grouse that their portfolios are full of over-ripe companies.

Perhaps there’s a way to think rigorously about which of the ripe fruits to harvest and which need some more vine time: I know of at least one group that methodically re-underwrites its portfolio every six months and asks, "what is the distribution of the prospective returns for each of our portfolio companies?"  Implicit in the exercise is a belief that at any moment, you’re either a buyer or a seller.  Those companies that exceed a certain hurdle rate stay; those that don’t go out for sale.

Now don’t get me wrong: I’m not saying that folks should sell prematurely or sub-optimize exits.  Instead, I’m talking about a meticulous re-underwriting process that asks hard questions about prospective return, risk, uncertainty, and liquidity horizon.  Of course, GPs are generally incentivized to let their winners run, even as rate of return slouches (as long as the multiple contribution is positive).  LPs, on the other hand, want their money back yesterday.  These divergent views express the tension inherent in unknowables: what does the future hold?  What are the opportunity costs?  For the GPs?  For the LPs?  Is it worse to sell too early – or run the risk of holding on too long?

And whenever I ponder these kinds of questions, my mind wanders back to one of my mentors, a dyspeptic Frenchman who seemed to be forever enshrouded in fogs of Gauloises and cynicism.  Once, after he’d helped me finish a thorny financial model, I asked him what he thought.  “Bof,” he replied with a shrug, “after year three, life is all terminal value anyhow.  The important thing is to make sure you get those three years right and the terminal value will take care of itself.  The first steps are often more important than the last.”

[Originally posted as the 5/27 guest column on PEHub.com]

Comments

[Tyler Newton]

Chris,

Great post and dead-on. In traditional buyout (as opposed to VC/growth capital), returns are driven by (1) price paid and (2) A Few Big Strategic Decisions, which are usually known on the way in or shortly thereafter. A euphemism I've heard a few times is "our returns are back-ended", to which your correct response is "yeah, right". Back-ended returns means they overpaid and are waiting for the right moment to get lucky on exit.

[Andrei Vorobiev]

Thank you, Chris. Contrary to the silence of the lambs on PEHub, yours is the most important post on buyouts there in years. For, by asking: "Why can't buyout shops do their 'magic' faster?" you expose utter lack of real innovation in the way buyout shops operate.

I am sure that before writing this piece you asked your GPs what prevents them from doing a quick turnaround, skimming the crème and moving on. My guess you heard something like: "quicker flips can't be done because exits require a multi-year profit record" (read - no one wants their portfolio companies now). But, over a drink, one or two may have admitted that deal finding and due diligence are a bitch (and thus they have no creamier prospects than their current portfolio) and that their 100-day plans never survive contact with reality - the "oops" factor is always there...

Well, bull.

1) Save for some force majeure, the "oops" factor can be virtually eliminated via simple and time-tested management methods - as former manager and management professor I can say this with authority. Moreover, the same methods make possible the task of finding a myriad of pockets of "crème" at least twice as fast as the usual techniques used by turnaround crews.

2) In conjunction with the above, a gradual albeit partial sale of the company to its employees could enable a buyout firm to start exiting in three month and be gone in two years completely. And yes, if a PE shop used those better methods mentioned above, the employees would line up to buy their own companies, no discounts, even in recession.

3) Furthermore, if the methods I am talking about were used in the rest of GP activities, finding new deals and conducting due diligence could be accomplished in half the time at half the cost.

Obviously my statements require a lengthy explanation, but, trust me: the whole approach could do wonders in any economic climate. And, coming on top of the usual profit margin, the savings and efficiencies created this way could add up quickly and furiously (what's Old Ivy's term for 30 percent compounded forever?)

So, given such profit prospects, I can't figure why most GPs continue to stick with the old, slow and utterly deficient turnaround routines. Can you?

[Cyril Demaria]

Thank you for this interesting post. However, you are making some assumptions that may not be systematically accurate. Let me develop them:

1. Quote: "Those companies that exceed a certain hurdle rate stay; those that don’t go out for sale."

Comment: one of the things that strike me is the systematic underestimation of the transaction costs. In your statement, the "hurdle" is usually over estimated by GPs because they don't see the transaction costs that are hurting the returns on the LP side. There are at least three:

> the cost of finding an opportunity which is delivering at least the same return than the current company in the portfolio which is assessed

> the cost of reinvesting in a new company (due diligences, etc.)

> the cost of investing in a new fund, investing in these new companies (set up costs, lawyers fees, etc.)

Given the fact that according to a JP Morgan study of dec 2007, most LPs got and expect around 12 to 13% of net IRR, the simple fact of NOT disposing too fast of a given portfolio company may just increase the overall return. This is also proven by a Josh Lerner study about reverse LBOs where provided that funds would keep their portfolio companies longer, they would substantially increase their overall returns (beyond a trailing IRR).

2. You assume that everyone is chasing liquidity. I am not so sure about that. Pension funds, endowments, insurances are not necessarily shooting for the same level of liquidity, returns and constraints.

3. If an LBO goes beyond the 100 days plan, there is usually a recap which is taking care of the capture of early "value creation" (that is assuming normal credit conditions).

We are in an illiquid world. There are other ways to manage this constraint that necessarily willing to change the holding periods.