Super LP

One View of the Future of VC Allocations

So I'm working on a blog post with some fundraising tips for PE and VC pros that are making the rounds.  The thesis is: you've got to come to meetings armed with better rhetoric, as many institutions have become wildly cynical about private equity strategies after feeling the acute sting of illiquidity during the downturn.  Said another way, people realized that the cost of illiquidity was much higher than they had estimated and many asset allocators are now (re)asking the questions: "are we getting adequately compensated for the risk and illiquidity of privates?" and, more importantly, "why bother?"  Talking about being top quartile will get you nowhere when the person across the table reports to a CIO who's obsessed with the opportunity costs of their capital. 

But before I finished that post, I thought I'd put up a slide deck that I pulled together a few months ago; I've presented variants of this storyline to a few different groups since the beginning of the year.  It's a review of some dynamics that impact institutional investor attitudes towards VC, but I think several of the thoughts are generalizable across private equity. 

Now, I don't think there are necessarily any earth-shattering insights embedded in the slides; it's more of a refresher of first principles.  On the other hand, I continue to be surprised at the number of GPs with whom I speak that think LPs will return en masse with open checkbooks at any moment.  I didn't want to be all gloomy and doom-y, so I tried to end the presentation on a optimistic note, but I do hope that people understand that we've crossed over to a new paradigm that's different from the illiquidity bull market that marked the better part of the last 15 years.  This isn't just a "get-a-mulligan" detour on the way back to 2006; instead, I think the fundraising equilibrium we find over the coming quarters and years will feel a lot more like the tough slogs of the late 80s and early 90s.

I sometimes teach "The Yale Case" (insert reverent pause here,) at business schools and I always open by asking the students what they think the key lessons are.  "Diversification!"  "Equity Bias!"  "Asset Allocation!" come the cries from the well-scrubbed students.  "Nope," I tell them.  "the real lesson of the Yale Case is: don't try this at home . . . "  I fear that many institutions have now learned that lesson the hard way and may be reluctant to return for some time.  And, as always, people will return when they see money being made, but, as with the lottery, the worst time to buy a ticket is typically just after somebody else has won the big jackpot . . .

VC Presentation May 2010

Izzy Math

Back in the day, no one in Brooklyn had air conditioning.  Now, we could deal with that, but the real killer was that far too many people had plastic slipcovers on their furniture.  Hot apartments and vinyl seats: a deadly combo! 

After a eighteen innings of stickball out in the summer swelter, we'd all rumble-tumble over to someone's house for video games, lemonade, and, if we were lucky (or unlucky depending on whose mom was cooking,) dinner.  Always in a big hurry to sit down and start playing games, we paid little mind to the inevitable pain of getting up once our leg-sweat had bonded our skin to the infernal plastic.

And the most bittersweet place to visit was the DiPietro place.  There, the plastic slipcover found its most profligate use: the faux-rococo decor lay beneath two layers of 4-mil thick clear vinyl . . . that stuff was everywhere, even on the lampshades!  But it was all worth it: the always-elegant Mrs. D was an outstanding cook and my buddy owned the only Intellivision on a block of Ataris.  And besides, the amiable malevolence Mr. and Mrs. D directed at each other lent a sitcom air to the apartment.

I'll never forget one particularly goofy exchange.  Mrs. D had just brought a dress home from Gimbels and proudly announced to us that she'd saved 20% by buying off the clearance rack.  Mr. D practically spit his Ballantine all over the yellow shag and bellowed, "Izzy, just 'cause ya got twenny poicent off don't mean ya saved anyting.  Fer cryinoutloud, ya still spent money, maybe twenny poicent less than ya would've, but still more than you should've."  

And recently, I've been having  lot of flashbacks to those long-lost languorous afternoons at the DiPietro's.  At least four (remember, I don't blog until I get more than three data points so as to keep confidentiality) LBO-sters raising funds have said to me recently that they were seeing "great deals" again: companies that were previously selling for X times EBITDA were now selling for X minus 1 or X minus 1.5 times. 

Guys: just because something is cheaper than it was, doesn't mean it's cheap.  As my buddy, Du, says, elegantly updating Mr D, "twenty percent off is still eighty percent on."

Now I've been spared the "things are suddenly cheap" reasoning by my own managers; I like to think that all the weekend ice fishing on Lake Wobegon clears the head.  But I do worry there's a lot of rationalization out there right now.  And it all starts with the poster-child rationalization: the assertion that downturns are the best time to invest.  I'm not saying that they aren't, I'm just a bit suspicious of the data that people cite.  Inevitably, someone whips out a spiffy chart that overlays vintage year returns on GDP growth figures.  The line goes down, the bar goes up.  Beautiful.

But on further review, the number of recessions that have taken place during the mature years of the private equity "business" can be counted on about half of one hand.  Not exactly what one would call a robust data set.  It's just confirmation bias; people look for data that proves their hypothesis, no matter how meager that data.

And remember, it wasn't all that long ago that people were saying that seven was the new five, in terms of multiples one could pay for a business.  But if prices have come down two turns of EBITDA, does that mean that the old five is the new seven?  That just seems like a return to normal pricing.  And normal just isn't good enough right now.  Things have to get a whole lot cheaper.  After all, the public markets are on sale and the opportunity costs of capital are extremely high.  Moreover, people are assigning an incredible amount of utility to liquidity.  Drawing capital today for a new investment means that deal has to be an absolute screamer.

And if folks focus on screaming deals, not just places to dump some dollars, we'll hopefully be able to say in retrospect that this turned out to be another recession during which it was a good time to invest.  I just hope that when we say that, it will be because people invested in great companies at good prices, not because we're seeking confirming data and confusing correlation with causation.

Beware of PE Managers Speaking Greek

So here’s a game I’m playing a lot lately: dueling Greek.  No, I’m not finally fulfilling my father’s long-dead wish that I attend Greek School.  It’s just that a lot of PE managers are slinging the Greek around.  Seven or eight years ago it was really rare for an LBO pro or VC to describe themselves as an “alpha” manager, but it seems commonplace today.

Of course, I understand what people are getting at.  They’re suggesting that they’re after improved risk-adjusted return.  But that’s where it gets dicey: how do you articulate risk in a PE context?  And what’s the appropriate level of return per unit of risk?

When I’m feeling saucy, I ask these self-proclaimed alpha managers: “ok, then, what’s your beta?”  At that point, the GP probably thinks that he’s got a smart aleck on his hands, but the question is sincere.  Really, it is!  (I’m not one of those Dollar and a Dream guys.)

As we all remember, alpha is the excess return of a portfolio relative to the return predicted by a portfolio of similar risk (expressed as beta).  Said more elegantly (note the gratuitous equation inserted to gain credibility with the quants):

Portfolio alpha = Portfolio Return - (Risk Free Rate + Portfolio Beta * Equity Risk Premium)

So assuming a long-horizon nominal equity risk premium around 6.5% and an average nominal risk free rate of about 4.5%, a portfolio with a beta of one should have a return of about 11% and anything above that is alpha, sweet alpha.  [We could quibble about time-varying premia and risk free rates, but the generic point is valid, no?]  Here’s the catch: I just don’t believe that PE betas are anywhere close to one; on the buyout side, higher levels of debt implicitly raise beta while the venture guys have incredible volatility of outcomes.

Fortunately, most folks decide to play along with the spirit of the question and we typically get into good discussions of risk appetite, tolerance, and management.  It’s always a stimulating chat, but people rarely answer my question directly.  To be a sport, a GP once argued – with a grin – that the beta had to be less than 1 because most people thought the correlation of PE to the public markets was about 0.65.  Without skipping a beat, he acknowledged that appraisal effects and stale prices made that number totally meaningless.

So, what is the beta of PE?  Is it 1.25 (kinda like Vanguard’s small-cap Explorer fund)?  Or more like 2.0?  If it’s the former, you’ve got to generate net returns greater than about 13% to have positive alpha; if it’s the latter, your bogey is closer to 18%.  [Interestingly, the time-worn PE goal of 500 bps of excess return probably implies a beta of about 1.75, which is about the beta exhibited by some public managers with concentrated portfolios].

At this point – like Chevy Chase playing Gerald Ford – I exclaim, “I was told there would be no math here,” so why sling numbers around in search of a pedantic point?  Because PE supposed to be a return enhancer relative to public market alternatives (the opportunity cost of risk capital).  I’m finding that when people say “alpha,” they typically just mean “top quartile,” and that’s not alpha at all.  Maybe “top quartile” will equal positive alpha over time – I have my doubts – but right now it’s just a worn marketing slogan.  Don’t get me wrong, I love firms who can outperform their peer group, but unless we can figure out how to find the folks who are generating true risk-adjusted excess return, we need to keep asking ourselves the question: why bother? 

Justify My Love

My buddy Peter – a very smart cat – was a pure math major in college. Once, I asked him what the difference between pure and applied math was and he told me with an impish grin: “the applied math guys know how to add . . .” Of course, Peter went to Brown University, a very funky place, so I’m sure that he could’ve done an interpretive dance about the Lebesgue Outer Measure and still gotten a passing grade on his senior thesis (just kidding . . . feel the love, Providence!)

I, on the other hand, studied history in college which means that I’m good with trivia at cocktail parties, but that’s about it. Every now and again, though, I get to thinking about arithmetic; specifically, the arithmetic of the venture business and I wonder if we’re all closer to the pure math end of the spectrum than the applied end.

VC math should be pretty straightforward: send a dollar out to a portfolio company and hope it comes back with a few of its friends. Do that often enough and you’ve got a good fund-level return.

Unfortunately, the LPs who invest a Dollar and a Dream have prevented the shakeout that we were all talking about in 2002 from happening and there continue to be too many iffy $500 million “early stage” funds out there. Now I’ve got nothing against $500 million funds in particular. Despite my seed-stage and smaller-fund bias (I like being "long idiosyncrasy and short momentum"), we’ve got a few investments in that size stratum and think those specific guys have some distinctive advantages.

Here’s where it gets dicey for the masses, though (and I’ll make some gross simplifying assumptions): if you’re an LP and investing in an run-of-the-mill $500 million fund hoping to get a 3x net return, that fund has to generate $1.75 billion in returns ($1.25B in profit less 20% carry equals two turns of profit). Of course, that’s just the capital that accrues to the firm’s ownership stake. Since a lot of firms end up owning only 10-15% of their companies at exit, you’ve typically got to gross the $1.75 billion up by a factor of between 6.67 and 10. That suggests that those firms need to create between $12 and $17 billion of market cap just to get a 3x fund-level net return to their LPs. Caliente!

Let’s unpack that box a bit more: at the $15 billion midpoint of the exit range above, a firm that invests in 25 early-stage companies will have to get, on average, $600 million exit valuations for each and every one of them. That’s a pretty daunting number when you consider that the typical M&A valuation has hovered in the high double-digit millions for quite some time.

Of course, such a batting average would be unprecedented (this is a slugging percentage business, after all), so if you assume that a quarter of the companies generate all the returns while the other three quarters collectively return the cost basis, each of those 6 home run companies has to enjoy an exit valuation of $1.67 billion (roughly what Google paid for YouTube). That’s livin’ la vida loca!

The situation above is exacerbated by the fact that not all firms invest 100% of their capital because they reserve up to 15% of capital for fees. Also, you could make the argument that the firms most likely to earn the above returns will charge premium carries, making the hurdle higher for compelling net returns. To be fair, firms have a few levers to pull – maintaining higher ownership percentages (!) in companies and recycling capital – that can make the challenge less daunting. They could also deploy less capital per company, but that’s tough to do with a larger fund.

Like I said, though, I do still believe that some firms will be the exceptions that prove the rule; some will be good while some others will be lucky.

In the meanwhile, a lot of LPs will be serenading their GPs with the line from that old Madonna song (cue the sensuous and moody bass line): “I’m just wanting, needing, waiting for you to justify my love. Hoping, praying for you to justify my love . . .”