Super LP

Cindy Crawford in a Bar

So Cindy Crawford walks into a bar and a swarm of dudes approach her, brandishing their best pick-up lines:  "Was your father a thief?  Was your uncle a robber?  Well if not, who stole the sparkle from the stars and put it in your eyes?" or, "My, what a beautiful mole you have" and even, "Well, aren't you MILF-y tonight?"

Sounds like the beginning of a joke, no?  Well, actually, welcome to my life!  Well, not just my life, but actually the life of any LP . .  . after all, being the cat with the checkbook can make you the most attractive girl in the bar. And being the hottie of the honky-tonk comes with a cost: an endless stream of pick-up attempts.

And the lines we hear from GPs can be remarkable for their homogeneity.  In fact, when I hear a buyout fund talk about Proprietary Dealflow or Operating Partners, or a healthcare fund talk about the Aging Population or the Patent Expiration Timebomb, I can't help but think that I've heard this story several (hundred) times before.  In fact, I've got a visual reminder in the form of my oppressive inbox of just how many times I've heard some such story.  Here's a sampling:

As you can see, the leftmost column contains the folders I've created for funds that have sent me information since I started at my current employer in mid-2004.  In this view, you can see about 30 of the 452 VC firms with whom I've corresponded.  I have a similar LBO/growth capital folder that contains another 377 firms and an international folder that contains stuff from about 275 additional fund managers.  Add in the 75 managers that are in my "active" bucket (running the gamut from the latest GP over whom I'm breathless to the oldest, most tired fund that 's in run-off mode) and that's close to 1200 funds from San Francisco to Stockholm to Shanghai.  Throw in my tenure at Old Ivy and I probably saw another 300 incremental funds over and above those 1200.  And compared to some other folks on the LP side, that tally of 1500 seems like a rookie's breakfast.  

Speaking of Old Ivy, when I was just starting out as an apprentice in the craft of PE investing I asked an Old Timer in the office about the early days of institutional investments in PE -- I mean, this guy was my Hubble Space Telescope back to the cottage industry-era of the PE universe.  And one thing that he said stuck with me all these years: "in those days, we kind of figured out what kinds of strategies we wanted to back, looked around at the four of five managers who were doing those kinds of things and then invested in about half of them."  Remarkable . . . when I think about my "funnel" today, the line we used in my Old Ivy days seems to ring ever more true with each passing day: "It's harder to get into our portfolio than it is to get into our college."

And I believe that all the competition has to be challenging for overall returns.  Or maybe, paradoxically, overall returns won't suffer as tradecraft generally improves, but instead the dispersion of those returns tightens as the industry professionalizes and best practices are copied and losers fade away and become exemplars of survivorship bias.  In that vein, I'm reminded of a great Stephen Jay Gould article I read about 25 years ago in which he talks about the maturation of an endeavor (in that case baseball) and the disappearance of outcomes that are several standard deviations (positive or negative) off the mean:

"Variation in batting averages must decrease as improving play eliminates the rough edges that great players could exploit, and as average performance moves toward the limits of human possibility … Declining variation arises as a general property of systems that stabilize and improve while maintaining constant rules of performance through time. The extinction of .400 hitting is, paradoxically, a mark of increasingly better play."

What if that's true?  What if the fabled dispersion of top-to-bottom quartile returns starts to narrow, (like the pennant-shaped graphs exhibited by many styles of investing that show wide dispersions in the early, pioneering, wild west years on the left side and narrower spreads in more recent years)? 

Well, one implication may be that the "better execution" story (i.e. "we're good at this") becomes commoditized while the "we're doing something different" story becomes even more compelling.  After all, do I need an n-th mid market buyout fund with operating partners and a geographic focus?  Or the m-th early stage Sand Hill Road firm?  Maybe, maybe not.  That's just post-heroic private equity and there's indeed a place for that in a portfolio as a return enhancer.  But I fear that those types of firms in the aggregate are slouching toward an paradigm of little more than what the public market guys would call enhanced-indexing.

But what about someone who's doing something innovative in style?  Structure?  Terms?  That might add some spice to the portfolio.  That's where the true octane (on a risk-adjusted basis) might lie.  It's definitely the higher volatility play, both in potential returns (for the LP) and in fundraising success (for the GP,) but to do something outstanding takes audacity.  And indeed, private equity should be all about audacity.  After all, heroic investing lives at the intersection of courage and conviction. 

Hey, Hotshot

Remember that epic “Get the Feeling” ad campaign that Sports Illustrated ran during the mid-1980s? I seem to recall some print advertisements and perhaps a television spot or two, but it’s the billboards that peppered Brooklyn during those summers that seared themselves into my memory.

Maybe it was the in-action pictures of larger than life heroes rendered at 14 by 48 foot scale? Or perhaps the provocative captions that asked questions most mortals would never be able to answer? One of my favorites accompanied a mid-swing picture of slugger Don Mattingly: “How Does It Feel To Turn a Slider Into a Souvenir? Get the Feeling. Sports Illustrated.” Then there was the one featuring base stealer extraordinaire Rickey Henderson in his classic “I’m about to run” pose: “How Does It Feel To Know You’re About To Break the Eighth Commandment? Get the Feeling.” Of course, that question was a bit less remote in a neighborhood where “thou shalt not steal” was considered more of a suggestion than a hard-and-fast rule.

But it was an over-head shot of some over-sized state college football stadium that captured my imagination. Splayed out across every inch of Astroturf were dozens upon dozens upon dozens of corn-fed Midwestern boys stretching before an early-season practice, all with one question on their mind: “will I make the squad?” The caption below asked, “How Does It Feel To Know You’re Just Another High School Hotshot?”

And lately, when the day's FexEx drop is particularly bountiful and several more private placement memoranda are added to the pile already strewn about the sidetable in the office, I've wondered if that ad might work just as well for the private equity world.  After all, top quartile funds are as plentiful as fleet-footed recievers out of Ottumwa or Odessa.

Indeed, in 2011 a bumper crop of freshmen will be vying for a limited number of open roster spots.  What factors will seperate the starters from the bench-warmers from the water boys?  This year, simply being good won't be close to being good enough; my own two cents is that too few GPs think critically about what makes them and their strategy truly distinctive and defensble. 

So in honor of the new year -- and the inevitable flood of funds expected to come to market in 2011 -- I thought I'd focus the first few posts of the year on fundraising, offering over the coming weeks some going-to-market observations, tips, and maybe even best and worst practices. 

After all, there's little comfort in knowing that the number four quarterback at BCS-bound State U probably has the raw tools to play in the NFL if you actually happen to be that number four quarterback.  Maybe over the next several posts we can work through throwing mechanics and defense-reading a bit in hopes that the competition for the scarce roster spots will be more robust.

Office Hours

When I moved to California, people told me I'd miss the seasons.  And indeed, it can be hard to tell when one season bustles aside another; time passes like mellow west coasters waving each other through at a 4-way stop intersection.  But, alas, I've got the unofficial private equity calendar to keep me in tune with the rhythm of nature.  Instead of falling leaves, I always know its autumn when my wallet grows fat with receipts for cab rides and drycleaning claim checks in the far-flung and disparate cities that comprise the LP rota.

And since I'm going to be in the usual haunts with some regularity and a bit of free time, I thought I'd hold office hours for private equity and venture capital GPs who might have random questions about anything from fundraising pitchbooks to annex funds to partnership tumult -- it can be anything that you wanted to confidentially ask a live LP, but were afraid to ask one of your own.   

But here's the deal: no pitching!  Let me be clear: this isn't an opportunity to get in front of me to sell your fund.  Doing so will dump you in the interminable expanse of despair known as my to-do list.  In fact, just like your introductory macroeconomics or organic chemistry professor, I will probably not even remember your name afterwards, but I will take comfort from having been able to dispense a pearl or two of wisdom in 15 minutes or so.

Here's a good description of what to expect, pilfered from some orientation materials at Cornell:

Most professors and teaching assistants do not have lessons planned for office hours. They expect students to “drive” these meetings with their questions and their thoughts . . . Do not be surprised when the professors and teaching assistants reply to your questions with questions of their own. They are working with you to uncover the source of your questions . . .  They may ask you to generate alternative ways to solve a problem. Hopefully they will help you change how you think about the material so that you can answer many different kinds of questions about it – not just the question on the homework that is stumping you. Don’t be surprised if they ask you to solve another problem before you leave the office.

So here's the lineup (you will know me by the crimson of my t-shirt):

[times and locations may change; I'll post updates the day before]

New York City: Weds 10/6 in the Lobby of the Marriott Marquis (1535 B'Way) 1130AM-1PM.

Boston: Thurs 10/7 in the lobby of the Mandarin Oriental (776 Boylston) 6-730PM.

NYC: Tues 11/2 location TBD 1030-noon.

Boston: Thurs 11/4 location TBD 230-4PM.

Chicago: Weds 11/17 in the lobby of the Peninsula (108 E Superior St) 830-1030AM

Dallas: Thurs 11/18 in the lobby of the Rosewood Crescent (400 Crescent Court) 10AM-noon.

I may add a Seattle time and may do a "home game" in Palo Alto.  I look forward to seeing you.

Speak Like the Locals

[Originally written as the guest column for the PEHub Wire, Sept 22, 2010]

In Brooklyn, Old O’Malley would tell us boys about being a Flatbush kid in the Marines in 1942.  He often laughed about meeting hundreds of guys from around America who didn't seem to speak any English.  "Fugghedabouit!  Dose guys all spoke Texan!"

And, indeed, such a language divergence plagues private equity today.  After all, our performance touchstones – quartiles – emphasize the relative in an increasingly absolute world; we’re speaking one dialect and the asset allocators another.  Interestingly, relative metrics gained sway because of the dis-integration of portfolios.  Armed with copies of Pioneering Portfolio Management, asset allocators knew they wanted PE, but they found it challenging to integrate the asset class – with its illiquidity, irregular cashflows, and stale prices – into portfolio analytics.  As a result, this thrilling, but naughty asset became a part of the portfolio, while apart from it in many ways.

Having been a source of illiquid heartache during the downturn, private equity entered its post-heroic phase and many investment committees are contemplating how to re-integrate PE into their portfolios so they can think holistically again; as a result, crises of confidence abound with respect to taking on new commitments.  And perhaps the most serious problem right now is that people around the asset allocation table all speak different languages. 

In fact, a Monday meeting at an endowment or plan sponsor can be like a European Parliament meeting: there's the cat that covers VC, he's speaking a sun-drenched, passionate language analogous to Italian ("sprazzo di sole" has the same hopeful cadence as "cashflow breakeven.")  The real estate manager speaks the frenetic Merseyside Scouse of a BBC sportscaster who's seen too much hooliganism.  Meanwhile, the public market folks speak a frugal Dutch, as they haggle over single basis points in manager fees.  The hedge fund team speaks a precise, formal language that is the finance equivalent of German (too much time thinking about Sortino Ratio can give you weltschmerz, no?)

In such an environment, crowing about top quartile performance, or telling stories about “impact companies” can fall on deaf ears, particularly with the liquid asset constituents of the portfolio still resent that their portfolios were used as ATMs for increasingly frequent PE capital calls between 2004 and 2008.

So how can a GP raising a fund speak in terms that resonate across the portfolio?  First, I think we all in PE need to be more thoughtful in articulating our return expectations while taking an honest accounting of risks.  Focus not just on rear-view performance – which should properly be considered a lagging indicator, not a leading one – but also on implicit assumptions: why are your returns achievable?  In what environments will the fund outperform?  Underperform?    

Said another way, asset allocators live in worlds of probability distributions, observed risks, and well-established performance calculation; they measure and predict performance.  By failing to give thought to their metrics, we are perceived as soft and non-rigorous.  They speak the language of efficiency while we tout inefficiency; they’re from Mars and we’re from Venus.

Remember, PE is a return enhancing asset, one that must be considered in the context of the opportunity cost of equity capital; for asset allocators that cost includes the drag from the cash they have to keep at the ready for PE capital calls. 

To that end, it can be helpful to give people a sense for expectations of capital calls and distributions, with a particular eye toward what one’s doing to accelerate cashflows.  Today, liquidity is prized and it seems most folks are trying to shorten the duration of their portfolios.  Asset allocators worry about facing negative PE cashflows ad infinitum; any visibility into when cash might come back is critical.  After all, there’s nothing like returns to silence critics.  A little “moolah in the coolah” goes a long way toward answering the question on everyone’s lips when it comes to PE: “why bother?”