Super LP

Strategy 101

Let's talk about strategy for a second. 

Now, strategy is a topic near to my heart since, you see, I was a young strategy consultant -- one of the "Kids in the Conference Room" during the mid and late 1990s (that New Yorker article -- linked here again in case you missed the link a dozen words back -- offered some menacing portent for the subsequent "The Smartest Guys in the Room.")  Now, I wasn't one of the McKinsey cats, but I was at another of the "B's and M's" (the en vogue catch-all for the then-hip consulting firms.)  And indeed, that article struck just a bit too close to home, as it kept quoting clients talking about "snot-nosed 25-year olds" and I could take cold comfort from the fact that I was almost 27 at the time.

(It was a great experience, though, and one of the most valuable things I learned during those years was the Mike Porter definition of strategy: "strategy is an integrated set of choices that inform timely action."  You couldn't leave an offsite training confab without being able to recite the definition when asked. The lazy, petulant, or merely hung-over soon found that they could get away simply saying: "informed choice/timely action."  Four words and you were on your way . . . )

And so what?  Well, I'm writing about it because I'm amazed at how often companies confuse strategy and tactics.  Tactics are not strategy; tactics arise from strategy.  I'm seeing this muddling a lot of late.

But I don't want to get pedantic about it; I'm really bringing it up to amplify the concept that strategy is a set of choices.  And choices are about the things that you don't do, as well as about the things you do decide to do.  The problem is that deciding not to do things is hard and, in particular, deciding to take a decision to stop doing things that you're currently doing can be even harder.

As you'll recall, I wrote about focus a while back and it seems now that focus is a lot more critical as 2011 business plans are getting finalized and people are starting to get (maybe?) more optimistic about business conditions.  The temptation exists to start doing a lot of things that weren't being done during times of belt-tightening.  And I'm not saying to not to do those things, rather, I'm asking folks to think about doing things in the context of the inegrated set of choices they're making and how they inform timely action that has the Great End and Real Business of optimizing shareholders' (or stakeholders') success functions.   

 

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?”

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

Fat Startups, BMI and The Lorax

So, there I was hanging out in Denver airport again, reading the back-and-forth between Ben Horowitz and Fred Wilson on fat versus thin startups.  They’re both cats that I respect and I think they both make carefully reasoned, nuanced arguments that have far more depth than a quick summary can articulate. 

But all this talk of heft got me thinking about the Body Mass Index; those hip to the BMI calculation know that it's a measure of weight relative to height.  Doctors tend to be fans because it's a decent indicator of body fat which correlates with increased risk of morbidity and mortality.

And BMI tends to work pretty well, except when it doesn't.  For example, serious athletes tend to have more muscle per unit of height than the rest of us and thus have unusually high BMIs: Arnold Schwarzenegger's BMI clocks in at 33 (the "ideal weight range" runs from 18.5 to 24.9).  Even George Clooney clocks in at 29, just shy of the "obese" cutoff of 29.9.

The beauty of muscle, though, is that it's so much more metabolically active than fat.  That's why one can be heavy, but fit; the two are not mutually exclusive.  And  neither, necessarily, are capital efficiency and cash abundance in the startup world.  Indeed, while I do find myself more firmly in Fred's "lean" camp, I am sympathetic to the notion that sometimes a company with a lot of dollars on hand can pivot more quickly as business conditions change, or scale faster to discourage new entrants or build competitive advantages that give them a leg up on existing rivals.  Companies can be well-funded but hungry.  I get it.

But here's my question: sure, bigger companies can earn bigger exits, but if they burn more cash on the way to a big outcome, isn't it almost inevitable that return multiples will be depressed?  Indeed, there can be some positive externalities associated with a big outcome, but as an LP -- the money behind the money -- what I care most about is multiple on investment.  I'm focused on the numerator and the denominator.

And then I started thinking about some of the cleavages of interest that may arise from fatter startups.  Most directly, the dollar value of carry to a GP of 2x outcome on a $100 million investment is greater than that of a 5x on $10 million.  I know which outcome I would rather have, but I'm not sure that a random GP's answer would be the same.  Then you get into non-economic motivations: having big outcomes can help build a brand, almost regardless of the profits.  Few people know what multiple Sequoia, for example, generated on Cisco's IPO twenty years ago, It could be a 100x, or it could be a 2x.  Most likely, it's somewhere in between, but either way it's an awfully spiffy logo to have on the web page.  Entrepreneurs, too, can get a lot of jazz from landing a big round of funding; it's an endorsement of their idea and the vote of confidence that makes for good press releases and generates respect.

Further, aiming to build a large enterprise fundamentally changes a startup's optionality profile.  No longer are a wide range of exit scenarios compelling; suddenly, a happy outcome for all becomes limited to one of the handful of large exits that take place in a given year.  With expectations of a modest number of IPOs (which I fear is a structural thing,) and a few dozen M&A transactions in excess of $250M, all those fat startups are like so many well-prepped high school seniors looking to land a spot at Top College.  It's just tough arithmetic.  It may be a fun ride for the entrepreneurs and GPs, but it can be nerve-racking for us LPs at the tail end of the whip.

And the risks are different, as well.  "Fatter" startups imply either fewer portfolio investments or larger funds (or perhaps even imbalanced funds where a few large bets compete for GP time with many small ones).  None of these are particularly positive outcomes for fund investors. 

I could go on, but it would start to stress me out.  And one of my sources of stress is that entrepreneurs and GPs are pretty well represented in these discussions, but we LPs tend to be distant observers.  Who speaks for us? I wondered out loud.  And just at that moment a little man appeared out of the breeze:

[With apologies to Dr. Seuss]

“Mister!” he said with a sawdusty sneeze,
“I am the Lorax.  I speak for LPs
I speak for LPs for LPs have no tongues.
And I’m asking you sir, at the top of my lungs” –
He was extremely upset as he warned retribution –
“What’s that THING they have done with our cash contribution?”

“Look, Lorax,” I said, “it's easy to get crotchety.
GPs deploy billions; it sometimes still bothers me.
In fact,” I continued, “some think it’s a lottery.
A lottery whose tickets can be a new social network,
A diversion to give cube-dwellers ways to shuck work.
But it has other uses.  No, we’re not out of the woods.
You can use it to serve ads or sell virtual goods.
Or crowdsource a date or find homes in new ‘hoods.”

The Lorax said,
“Sir! You are crazy from drinking the potion.
There is no one on earth who would buy that fool notion!”

But the very next moment we were shown to be wrong.
For, just at that moment, a ‘tween came along.
And she thought that the club we’d just ridiculed was great.
She happily subscribed for thirty-three ninety-eight.

I laughed with the Lorax.  “You poor stupid guy!
You never can tell what some people will buy.”

“I repeat,” cried the Lorax,
“I speak for LPs!”

“All GPs are top quartile,” I told him.
“Those marks are a tease.”

Tyranny of the Relativists

There’s a great riff in John McWhorter’s book, The Power of Babel: A Natural History of Language, that describes how expressive force in language diminishes over time.  His poster child is the word “terrible” which once meant “causing dread or fear or terror,” but now is used as a mild negative modifier (e.g., “I’m such a terrible putter that my wife got me personalized golf balls that say, ‘three putt.’ ”) 

Similarly, the language of business is littered with expressions that slouched from overuse: phrases like “best of breed” went from insightful to hackneyed over the course of mere years.
Of course, private equity has its very own once-powerful phrase that’s meandered to meaninglessness: Top Quartile.  Now we all know how Top Quartile got to be the gold standard: a couple of cool graphs in the Book of David some McKinsey studies, an endorsement by an influential pension fund or two and Top Quartile was the place to be. 

Everyone wanted to be in the Top Quartile, and, soon enough, most people were – if you accepted their pro forma returns based on aggressive multiples of EBBS (earnings before, ahem, bad stuff) or included estimates of what an acquirer might pay for a start-up once it had perfected its swell product and revenues had started their inevitable ramp.

The problem with that kind of thinking is that it obscured the true aim of private equity: return enhancement (relative to the opportunity cost of equity capital, i.e., some appropriate public benchmark).  Success was no longer about getting adequately compensated for taking incremental risks; it was now about beating the next guy (or more specifically, the next three guys).  

And that’s the paradox, of course, of any peer-group measure: when new entrants deploy capital, their extra dollars will likely depress returns across the spectrum – since the marginal dollar tends to set the price of assets – but the cohort of “winners” (with victory defined as being Top Quartile) grows.  The club gets less elite as people enter from the bottom.

Of course, measuring private performance against a public benchmark can be pretty tricky and is fraught with tough questions like: what’s the appropriate evaluation horizon, how do you equalize for appraisal effects, should you beta-adjust? to name a few.  As a result, it’s tempting to fall back on an easy measure like peer group rank.

A while back, I started asking VCs what they thought the top quartile breakpoint for venture over coming vintage years might be assuming reasonably “normal” public market conditions.  In my informal and unscientific survey, more than half of those I asked guessed that the top quartile line would be at or below zero.  Surely, some firms will do fantastically well, but if the VCs I sampled are right, it will be really amazing that dozens and dozens and dozens of firms that tinker in one of the riskiest corners of the financial world will be able to call themselves successful even though they will have lagged the public market – not to mention cash – by many hundreds of basis points.  What’s more amazing is that merely by surviving, these firms will earn billions of dollars in fees in aggregate and the folks who funded them will dance a jig for having done a great job.

It’s enough to remind one of an old story: two campers are awakened by the sounds of a bear sniffing at their tent.  While one of the campers starts panicking, the other calmly starts putting on his sneakers.  “Why are you putting on your shoes?  There’s no way you can outrun that bear,” whispers the first camper.  “I don’t need to outrun the bear,” replies the second camper, “I just need to outrun you.”

That kind of thinking may work for relativists, but the important return-enhancing role that PE plays in institutional portfolios demands that we instead ask: for all the extra risk and illiquidity we incur, if you can’t outrun the bears (and the bulls) why bother?

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 . . .”

A Dollar and a Dream

Anyone remember Curtis Sharp? A long time ago, Curtis won a $5 million New York Lottery jackpot and he spent the rest of the 1980s sashaying around New York in bespoke suits and bowler hats attracting crowds wherever he went. Curtis was the Man. Charismatic and impish, Curtis was the Toast of the Town.

I once saw Curtis at a Yankee game and the aura around him was palpable. He was Electric. People just wanted to touch Curtis. Maybe some of that luck would rub off.

That afternoon, a few rows behind us, a drunk kept yelling at no one in particular: “You can’t win if you don’t play!” I thought that the guy was pretty creative for exhorting the listless Yanks (it was 1989, after all) to get in the game by using the Lotto marketing slogan within earshot of Curtis. I appreciated the confluence.

I think of Curtis often . . . around my shop, I’ve started calling Curtis the patron saint of LPs who invest in venture capital funds. Don’t get me wrong, I love VC. We continue to find extraordinary people doing venture investing in extraordinary ways.

It just strikes me that when you push some LPs to articulate why they have outsize venture commitments when history shows that only the smallest slice of the business has rewarded the faith, they throw out New York Lottery slogans with Ivy League veneer. They use words like “optionality,” and “asymmetric payoff.” They might as well be mimicking the catchphrases from the Lotto TV commercials: “Hey, you never know,” or “All you need is a dollar and a dream.”

They just want to be Curtis: The Guy That Beat The Odds.

I hope that everyone makes loads of money and I never root against anyone. That’s bad karma. I do find myself asking, though, how many LPs who invest in venture firms are committing the fallacy of composition: Some people have made fabulous returns in venture, therefore venture will provide fabulous returns. But hey, as they say: you can’t win if you don’t play.