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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?

One Strike Away . . .

I’ve been in a bunch of meetings over the past few months with buyout guys who say things like, “we’re in the seventh inning of the credit crunch.”  In fact, it seems like every time I turn on CNBC or read the Bloomberg, the inning metaphor is up at the plate. 

The use of innings as a proxy for time seems like a swing and a miss to me, though.  Since baseball is alone among major sports in allowing the defense to control the ball, the sport is liberated from the tyranny of time marching inexorably forward.  I like football and basketball as much as the next guy, but the practice of running out the clock by taking a knee or dribbling around the floor has always seemed vaguely anticlimactic to me. 

You just gotta get that third out in the ninth inning and it could take all day to get it done.  As a young pitcher, I once allowed six consecutive hits (!) with two outs in the last inning.  In fifteen minutes, a fine pitching performance was undone and I went from complete-game winner to hard-luck loser.  All for want of just one more out . . .

A late inning grand slam can turn a blowout into a tight game and completely reverse a game’s momentum; anything can happen and the clock won’t bail you out.  And that’s what makes the metaphor funky: it almost doesn’t matter what inning of the game you’re in, something totally discontinuous can occur at any moment.   

Maybe that actually makes the metaphor brilliant?  Perhaps embedded in the sense of progress toward the conclusion, there might be an implicit acknowledgement that the credit crunch is not unlike a baseball game.  And we know what they say about ballgames: it ain’t over until it’s over. 

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 . . .”