Super LP

Dispatches from the Disruption, Part 2

Here's the second half of last week's post:

Now, let's get back to one of my favorite topics: disregard for convention.  A wise man once told me that most investors follow a set of rules that typically make them middle-of-road, B-level investors, but in breaking their rules they can become either  A-level investors (rarely), or (more frequently) C-minus investors.  And indeed, I've always been a bit insouciantly petulant about rules, but as far as guidelines go, but I've got to give James Montier from GMO a tip of the cap for The Seven Immutable Rules of Investing:

1. Always insist on a margin of safety

2. This time is never different

3. Be patient and wait for the fat pitch

4. Be contrarian

5. Risk is the permanent loss of capital, never a number

6. Be leery of leverage

7. Never invest in something you don't understand

And, generally, those are pretty darn good rules.  The value investor in me swoons.  But the Californian in me wonders if these rules are little more than a wind-break against the perennial gales of creative destruction?  In this zip code, after all, those rules are more honored in the breach than in the observance.   And surely, if investors had followed those rules exclusively all along, we'd still be communicating via horse-mounted couriers as we farmed the Appalachian Watershed with oxen, oppressed by the inexorable tyranny of the seasons and the immutable fright of nightfall.  Instead, we live, work, and play in ways that are scarcely recognizable to our parents and would've been unimaginable to our forebears.  Much of that progress was financed by the investors who broke their rules; some made mints while most didn't.

Now, I don't mean to critique value-oriented investing, as assets need an anchor around which to contextualize their valuation.  But if the last century, with its optimists triumphant, suggested anything to us, maybe it's that the value of businesses isn't really the discounted value of their dividends?  Perhaps businesses are better thought of as portfolios of options, some of which are very long-dated and way out-of-the-money.  And maybe the central wonder of the American economy, with California as its exemplar, is that it offers the best framework for capturing the random forward lurch of progress?  After all, the US economy, more so than that of any other nation, seems geared around exercising profitable options while letting unprofitable ones expire, often (and hopefully) cheaply.  This asymmetry is getting even more acute as value chains continue to fragment and the cost of hatching and nurturing an idea continues to drop.  The resulting left- and right-tail opportunities may be hard to differentiate from each other, but those who are unafraid of being wrong and alone will give themselves the electric opportunity of being right and alone. 

I love working on a street thick with start-ups and it's been fun to watch these companies strive and stumble and pivot and grow.  I love visiting them when engineers are piled up on top of each other in a too-cramped space; its a visceral and sensory experience when a startup finds its cadence.  The old east coast value investor in me wonders aloud, "who would invest in this stuff?  It's bananas!  These guys are violating at least four of The Seven Rules!" 

But the west coast Chris hears an echo of Steinbeck's description of Cannery Row: "[Silicon Valley] in California is a poem, a stink, a grating noise, a quality of light, a tone, a habit, a nostalgia, a dream."

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.”

Careening with Smeed

So there I was, thinking about how I was going to start this blog post; I'd been meaning to compare investing to Smeed's Law -- a behavioral theory that predicts the rate of traffic fatalities -- for a while.  Determined to come up with something vaguely witty and quasi-relevant to kick off this post, I sat in my car for a moment before going into the 7-Eleven for my morning Double-Gulp when -- WHAM! -- it hit me!

I mean, really, it hit me ... some cat driving an Audi A4 ran into me in the parking lot.  Seriously, dude?!?  Who runs into a parked car?!?  Oh well, as Old Man O'Malley used to say through the fog of cigar smoke encircling his head: "some days youse da dog and odders youse da hydrant."  Today was shaping up to be a hydrant day, for sure . . .

Anyhow, back to traffic.  There was this great retrospective by physicist Freeman Dyson a while back in Tech Review.  In it, he talks a bit about the things he learned from his old friend, RJ Smeed.  Among many other contributions, Smeed had postulated that deaths on the roads had little to do with speed limits, car safety features, quality of the roads, etc.  Instead, motorway mortality was a function of psychology.  Dyson said it best:

"The number of deaths is determined mainly by psychological factors that are independent of material circumstances. People will drive recklessly until the number of deaths reaches the maximum they can tolerate. When the number exceeds that limit, they drive more carefully. Smeed's Law merely defines the number of deaths that we find psychologically tolerable."

And it seems to me that we're running a great test case of Smeed's Law: cell phones in cars.  Now, the nervous Nellies would tell us that gabbing while driving distracts people to a dangerous degree; I've now lived in three states where one can't use a handheld phone (and I've been a good boy ... most of the time ... or at least occasionally).  And indeed, while the number of cell subscriptions has exploded to over 250 million from a base of about zero 15 years ago, the total number of police-reported accidents has fluctuated in a pretty tight band during that time.  The average number of accidents over those 15 years has been about 6.3 million, with a high of about 6.8 million in 1996 and a low of 5.8 million in 2008; the standard deviation is about 4.15% around the mean.  I'd bet dollars to donuts that if you overlaid miles driven on the data, the rate of accidents per mile would be darn near constant.  [Now, I'll be the first to admit that texting/emailing is a whole different story . . . anyone with a Blackberry behind the wheel is a menace to souls and property!]

And that's what makes Smeed an unwitting market philosopher.  Markets are all about calibration of risk, and his insight was that as people feel safer, they get more reckless.  Comfort breeds complacency.  You can fiddle with speed limits, pave roads, install air bags, ticket people for manner of infractions, but folks just end up stretching their envelopes of comfort until they undo the putative progress; they calibrate to the risk.  And the same is true for the markets: just think about the banks that kept stretching (in every way) and the hedge funds that kept getting pushed to add risk because their volatility was too low.  Maybe now that memories of a crack-up are fresh in people's minds, they'll be a little more cautious, but that caution will be thrown to the wind as soon as we all get comfortable again. 

Inevitably, we'll have some regulations and rules thrown at the markets.  But what real effect will that have?  Remember when the "circuit breakers" were established after Black Monday?  Traders joked that trading curbs would give people a couple of hours to write out their trade tickets while the markets were "cooling off."  But no matter the safeguards we put in place, regardless of who we call systemically important, it's darn-near impossible to save us from our reckless selves. 

But maybe it's New Hampshire that has it right: it's the only state in the Union that doesn't have a universal seat belt law.  For those of you who've never seen it, New Hampshire's roadside seat belt signs say: "BUCKLE UP UNDER 18 / COMMON SENSE FOR ALL."  Does it surprise anyone that the Live Free or Die state is number 49 in the among the 50 states in traffic fatalities?  Maybe we all could use a little more common sense and a little less regulation, on the road and in the markets?   

Let's all be careful out there.

   

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]

All Politics Is Local . . . Maybe Investing Should be Too?

[Ok, ok . . . I've been slow on my long-promised post about out-years risk, but I started writing it last night and the post got unruly.  Back to the drawing board on that one . . .]

In the meantime, I've got another quick thought about this whole Madoff mess: I'm amazed - but unsurprised - by how international the roster of victims has been.  (Harry Markopolis, the man who tried to alert the SEC, suspected that half to three quarters of Madoff's capital came from overseas).  As you read through the list, you can almost imagine Ricardo Montalban or Catherine Deneuve reading off the foreign names with crisp and precise diction (while heavily accenting the American ones: Ferh-feeeld Ghreenesh Ehdvisors . . . Tree-Mon Groope . . .)  It's a far-flung group that now shares a common shame.

And that got me thinking about how we, as investors, do diligence.  I mean, information is the raw material of investing, right?  I'm not talking a Gordon Gekko/Bud Fox sort of information ("Blue Horseshoe loves Anacot Steel.")  What I'm talking about is knowledge.  Do you have a view?  Is your opinion the product of a dialectic?  How was the tension in your thinking resolved?  What data tipped the scales in favor of one route, but not another?  After all, we're just intelligent switches and network nodes, gathering and processing information. 

And if information is our sustenance, how often do we outrun our supply lines?  I've been thinking a lot about the epistemology of investing lately: how do we know what we know?  Is it harder to triangulate information when investing across the country?  Across the world?  How frequently do we not speak the same language (literally or metaphorically) as the people with the insights?  How frequently do we not even know who those people might be? 

And fund of funds have it even worse.  At least the primary investors are buying assets with (hopefully) some intrinsic value or growth potential.  FOFs make investments in the people who buy those assets, placing at center stage the most pernicious irritant in all of finance: the Principal-Agent Problem.  Don't get me wrong: I'm not kicking any of the cats who lost money.  I'm sure they're all smart, well-intentioned people who somehow wandered beyond the frontiers of their expertise or suspended their disbelief.  It reminds me of the exchange in Leo DiCaprio's Magnum Opus Catch Me If You Can:

Frank Abagnale, Sr.: You know why the Yankees always win, Frank?

Frank Abagnale, Jr.: 'Cause they have Mickey Mantle? 

Frank Abagnale, Sr.: No, it's 'cause the other teams can't stop staring at those damn pinstripes. 

Now I don't want to sound provincial.  Investing is a global discipline and we need to seek out the best risk-adjusted returns wherever they might be.  My fear is that we've systemically underestimated the amount of risk in going increasingly far afield. 

In people businesses, it's actually really valuable to see people firsthand, to look them in the eye, to know where and how they live, to bump into them at the grocery store, to interact with them closely in hopes of building a sense of mutual obligation.  That's the genesis of trust.  And in finance - just as in a democracy - someone must be trusted.  And, indeed, trust is always at a premium, it's just that today trust is also in extremely short supply.

Economic Analysis, Silicon Valley Style

I dig lingo.  Sure, a picture might be worth a thousand words, but a nice hunk of jargon has got to be worth at least a few hundred.  And if it's jargon you're looking for, I'd bet there's no better place to find it than Silicon Valley. The cocktail of business and technology - with a splash of disregard for the rules of grammar and spelling - make this place a jargoneer's paradise.  (Although sometimes the whole thing goes too far:  One.  Word.  Sentences.  Quit.  It.  Srsly.  Hey, I wonder if grammr.com^beta is taken?) 

Anyhow, there I was at the Fall potluck dinner at mini-LP's nursery school, feeling a smidge out of place since I was the only one not sporting gear emblazoned with the logo of a NASDAQ 100 company, and the topic turned to (bum bum bum buuuuuum) The Subprime Crisis!  Suddenly, all eyes were on me: Financial Dude.  One dad growled, "so how did it get to this?" in that same exasperated tone that TV detectives use as they toss the legal pad and bic pen toward the perp demanding: "write it all down, just like you told me."

And so I started talking about what I thought had really gone on.  At first it was kind of cathartic, but then, the more I talked the worse I felt about the whole thing.  It was like I was describing a case study in the principal-agent problem.  Make that the World's Biggest Principal-Agent problem.  And that's what got me down: professional investors should be attuned to agency issues.  Everyone should've seen this coming, but the good times were rolling and there was always a greater fool in another time zone to take the mess off your hands.  Of course, that's a game that works until it doesn't.  But I digress.

So I'm going on and on about marginal borrowers (my favorites were the NINJAs: No Income, No Job or Assets), CDO tranches, investors looking for spread product, and mark-to-whatever accounting when I notice a few eyes starting to glaze over.  And right then, one dad pipes up: "So it sounds like they were overclocking the financial system."  Now I didn't quite know what that meant, but I sensed some good jargon coming on and I was eager to unpack that box like a kid on Christmas morning. 

Your Humble Narrator: "Overclocking?  What's that?"

Really Smart Dude: "It's when you mess with your computer's processor to get some more performance out of it."

YHN: "Why do that?"

RSD: "Well, most overclockers are gamers looking to push the limits.  Exceeding the processor's specs can result in a major framerate bump.  Others do it for ego reasons; you know, they just want to have the fastest processor on the block.  And some people even go out and buy old processors on the cheap, overclock them and sell them as the latest chip to unsuspecting buyers."

YHN: "Srsly?"

RSD: "It gets pretty crazy!  The problem is that overclocked processors run really hot - often hotter than conventional heat sinks can handle - so overclockers sometimes build crazy structures to keep the whole thing from blowing up."

YHN: "Blowing up?  For real?"

RSD: "Well, blowing up is a bit extreme, but the processor can catch fire for sure.  And once you get a fire inside the machine, the whole system could be at risk.  Either way, if you get to that point it's an expensive fix."

Expensive, indeed.  Aside from the magnitude of their blow-ups, overclockers of the processor and financial variety sounded a lot alike.  Of course, it looked like the financial overclockers were going to get all of us to pick up the tab for their blow-up . . .

When I was a kid, a bank in my neighborhood got robbed and the block was abuzz with talk of the brazen heist.  Among all the hand-wringing and fist-shaking, Old Man O'Malley, ever the neighborhood cynic, dropped a nugget through the fog of Garcia Y Vega smoke that continually encircled his head.  "Morons," O'Malley growled, " . . . if you're going to rob a bank,  don't take down the one on the corner, go hit the Federal Reserve.  That's where the money is."  I've thought of that line a lot recently and I can't help but feel that's exactly what just happened.

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?