Super LP (www.superLP.com)

DC-8s and Tigers and GPs! Oh my!

A few weeks ago, a local TV station aired a news story about a mostly-forgotten plane crash, the May, 1968 unintentional ditching of JAL Flight 2 in San Francisco Bay.  After an uneventful flight from Tokyo, the nearly-new DC-8, nicknamed "Shiga," was on final approach to an overcast SFO.  Captain Kohei Asoh, a veteran pilot, guided Shiga's descent through the low-hanging clouds.  But planning errors, equipment unfamiliarity, and miscalculations conspired against the crew.  Dropping out of the fog, Shiga was lower than expected and about to crash into the foam-flecked bay just below.  By the time the First Officer cried out, "pull up!" and Captain Asoh applied throttle, it was too late.  The landing gear had struck the brackish water and the plane lurched to a halt, the wheels coming to rest in the muck seven feet below -- two and a half miles short of the threshold of Runway 28 left.

Remarkably, no one was hurt and some passengers had no idea that they had landed in the water until the evacuation began.  And even then, the de-planing was so uneventful that most folks didn't even get their feet wet.  But for me, the best part of the story was popularized by management guru, Jerry Harvey (author of the Abilene Paradox): when Captain Asoh was called before the Transportation Safety Board, the inquisitors opened by asking how an experienced pilot flying a sound airplane on a straight line to an unobstructed runway in generally benign conditions could land in the water miles short of the field?  Offering an answer that resounds across the ages in its clarity and honesty, the Captain replied, "as you Americans say, 'Asoh f@#%ed up.' "

Fast forward 40 years and compare Captain Asoh to the bellyaching finger-pointers that were in the cockpit of the Northwest flight that overflew Minneapolis.  And the public nature of Captain Asoh's taking of responsibility stands in stark contrast to the recent (ahem) screw-ups of Tiger Woods.  Look, I'm not a moralizer or a scold -- I grew up in the anti-role model era heralded by Charles Barkley and Ice Cube -- but Tiger, dude, you make your living by having people look at you; you get paid because people watch what you do.  I'm not sure you get to flick that switch off by pleading for privacy.  Even if you ask, "pretty please."

And what does this have to do with investing?  Recently, I was talking to a buddy who's a GP at an LBO shop (this conversation was explicitly cleared for the blog on the condition of vagueness -- I should note that it's not a group in which I'm an investor).  This GP bemoaned the fact that his LPs had seemingly thrown in the towel on his troubled fund; turnout had been sparse at this year's annual meeting and some investors had stopped returning phone calls.  He insisted that they had Great Stories of Progress to tell for each of their troubled portfolio companies and that if they could just convey these stories to LPs, all would be well.  How, he asked, could he communicate the exciting stuff afoot? 

So I asked him to test drive some of the rap on me.  After a few tales larded with lament over difficult (but improving!) end markets, missteps by (recently replaced!) management teams, and (impossible to please!) crabby lenders, I asked him how many times they'd screwed up in the fund?  Now I don't mean to be harsh, but here's what I heard for the next 90 seconds: "excuse excuse excuse blah blah blah excuse excuse excuse blah blah blah."  No wonder his LPs have tuned out his firm's fund, I told him; I'd just been handed a bagful of excuses devoid of any corresponding accountability or responsibility.  It was the first time I'd heard the fund's story and I was already tired of it.

Look, LPs understand that business has been tough and even the tightest investment theses have been severely tested over the last 18 months.  We get that.  And we also know that investors are fallible.  It's OK to make mistakes sometimes.  Really it is.  Sometimes even good decisions have bad outcomes and vice-versa (more on that next week).  Sometimes people are just unlucky or in the right place at the wrong time.  But when things head south, please be honest and straightforward.  (There's no need to take things to an extreme and self-flagellate, like some GPs do.  There's no joy in that for anyone.)  As GPs and LPs, we're in a long term relationship -- one that's longer than many marriages.  An open, honest, transparent dialogue pays dividends in the long term. 

So my GP buddy asked me for some advice once I climbed down off of my soap box.  The best I could come up with was, "just remember, it's not the break-in that brings down the presidency, it's the cover up."  Sometimes, like Captain Asoh, you've just gotta say, "I f@#%ed up."

Keeping the Window Open

Most people seem to have a favorite Saturday Night Live skit.  One of my favorites is, "Ruining It For Everybody," a 1993 masterwork that features John Malkovich and some cast members discussing how they did something to ruin things for everyone else.  The Adam Sandler character, for example, explains why many restaurant bathrooms are now, ahem, "for customers only."

Of course, finance is full of people who ruin things for everybody, too (thanks for the SarbOx, Enron!)  But the most insidious wreckers are those companies that go public and then miss their numbers within a few quarters (what's up, Rosetta Stone?!?)  It's those flubs that have a chilling effect on the market for emerging growth companies. 

And as the IPO backlog builds, I hope the bankers take out only those companies that can keep the momentum going, not just those that will pay enough fees to help them get out of arrears at The Stanwich Club.

I say this because, as institutional investors, we've seen that movie before.  And I worry that the IPO market for IT companies could start to look like the market for biotechs: long stretches of desolation punctuated by sporadic frenzies of activity that end when public investors start to feel snookered. 

There are some good companies in the IPO pipeline right now and I wish them all well.  Their success should lead to more opportunity for other companies.  I just hope that the backers and bankers of some of the hundreds of other companies considering a public offering think long and hard about pushing a marginal or unprepared company into the arena.

Please don't be that guy; don't ruin it for everybody.

Pain Points

Along the way, the kids on the block started calling old DiPietro “Boch.”  I didn’t know what it meant, but always guessed it was short for some term of endearment in La Bella Lingua.  And it was a great nickname for the generous old guy: whenever a Spaldeen would crack in two – a pretty frequent occurrence in our stickball marathons – the cry would rise up from the boys to his ever-open apartment window: “Aaayyyyy, Boch!  Yo Boch! Bocheroonie!  You got a spare Spaldeen up there?”  Sometimes it took a minute or two, but eventually, a pink rubber ball would fly out of that window on the third floor and go bounding onto East 2nd Street below.  I swear he bought those things by the case. 

Boch had seen a lot since boarding a ship for America all by himself in Palermo on his fourteenth birthday.  And he loved to tell us stories; his favorite was about how he snuck into a game at Ebbetts Field on the very day he cleared quarantine at Ellis Island.  But the thing Boch liked best was dispensing advice to the growing boys enjoying some post-stickball lemonade on his stoop.  “In life,” he often warned forebodingly, “someone’s always got you by the coglioni.  The only thing you can control is how hard they squeeze.”

It’s advice I ponder frequently, doing the voodoo I do. 

* * *

Lately, I’ve been a bit bummed out, though: “don’t waste a good crisis,” the new mantra goes.  So let me ask this: why aren't we using this epic downturn to fundamentally re-frame the relationship between GPs and LPs?  Instead, people are battling along the same lines across which LPs and GPs have been skirmishing for years.  It's like World War I: fierce battling yields a few acres of pockmarked muddiness.

But what if it doesn't actually matter if the fee offset is two-thirds or three-quarters?  What if it really doesn't make a difference whether the no-fault is triggered by 66% or 80% in interest?  Maybe the the LP-friendly/GP-favorable axis needs to be discarded in favor of some entirely new, orthogonal continuum that re-thinks how interests are aligned?   

Let me put a finer point on it: currently, LPs worry that the carry system grants GPs a free option in times of frothy markets; LPs ask: why pay an incentive to people who simply capture beta?  GPs on the other hand bellyache about how long-dated carry payouts can be; after all, those wacky hedgies get paid every year (watch those high watermarks, boys).  But what if we rethought the way in which carry is paid?  What if we instead paid people on a deal by deal basis, but only when they beat the opportunity cost of an appropriate public index?  And let's acknowledge that the public markets are a fast rabbit, so we should pay people a substantial portion (25%? 50%?) of the excess return above equity-substitute cost of capital.  You would have true-ups every couple of years to ensure that groups didn't get paid more than X% of the net profits on the fund.  

Something like that could be a win-win: LPs get a formalization of private equity's return enhancing essence while GPs pull carry forward (increasing the PV!) and could even get paid on flat (or down!) investments, as long as they exceeded public market comps. 

While we're at it, we could also get everyone on a budgeted fee (now I'm getting Pollyanna -- sorry: I've exceeded my daily Diet Coke allotment).  Pay yourselves well, folks; this is America and there's a market for your services, but let's not be bonusing back millions of dollars in excess fees . . . let's focus on cap gains, not W-2 income.

Of course, there are a million reasons why we'll never see a radical departure from the status quo: the fundraising "haves" don't need to mix it up while the "have nots" may be perceived as desperate for offering something new.  And indeed, LPs find themselves trapped in a prisoner's dilemma.  Most perniciously, the legal and accounting costs of a new structure could be prohibitive.

But, unfortunately, the most difficult hurdle to surmount is that any out-of-box thought would "make people's heads hurt."  It's a common complaint.  The status quo is easy to support and difficult to dislodge.  Maybe old Boch was right?  Maybe by trying to avoid headaches, we're sealing our destiny to keep squeezing each others' coglioni?

But what if we used this juncture in the short history of the private equity business to do something extraordinary?  What if we tried something new to make us all better off?  Almost a half-century ago, President Kennedy exhorted us to go to the moon, not because it was easy, but rather because it was hard and surmounting the difficulties would bring out the best in us.  Maybe trying something new might beat the squeeze-off to which we've otherwise consigned ourselves?

In the Time of Chicken and Broo-Lay

Gah!  It's been a few weeks since I last posted, but I've got an excuse: it's annual meeting season.  Now in good times, the meeting circuit can be like a Saturday night in LA (or so I'm told).  Folks caravan from house to house, party to party, over the hills and though the canyons.  Gentle sea breezes caress the travelers as the complicit stars wink from their high perch.  The venues are different, but the guests are the same.  We hear stories of heroic exploits in far-off lands . . .

But in bad years, the season can be more like the Odyssey.  Adrift on a storm-tossed sea, we find each port more perilous than the last, the gods conspire against us, our hosts are full of treachery and guile, we grow haggard and dispirited . . .

Needless to say, this year feels more like the latter.  I thought about trying to write an Odyssey parody, but before I could say, "sing in me, Muse," it hit me that maybe I could offer (with help from friends) something more interesting: an answer to that perennial GP question, "how could we make our annual meeting better next year?"  So I informally canvassed some LPs and collected thoughts on best and worst practices.  I'll share those below, but I'd love more good ideas.  The GP you help may be your own . . .

***

The Good

Better annual meetings are marked by high levels of information sharing and candor.  After all, we're not just investors, we're Partners, right?  I've talked in the past about Partnership with a capital P and at the heart of such a relationship is an open and honest dialogue between peers.  An annual meeting can't in itself be the be-all/end-all, but it can help set a tone for the relationship.  To that end, here are a handful of crowd-sourced ideas that might be worth considering (some sublime, some miscellaneous):  

• Breakout Sessions: The most tedious meetings sometimes feel like interminable lectures.  The presenters drone on, often reading slides verbatim (engendering the too-common, "I flew here for that?" reaction among investors).  As an alternative, some LPs suggested devoting a chunk (if not all) of the annual meeting to topic-focused breakout sessions with a GP or two leading an interactive talk among a manageable subset of people . . . something akin to college discussion sections (but without the ill-tempered, Gauloise-puffing grad student). 

• Portfolio Company Speed Dating: One VC fund has a biennial "science fair" at which LPs rotate among breakout rooms, checking out different technologies and talking to entrepreneurs.  Other VCs schedule days for portfolio companies to have rapid-fire meetings with BigCo biz dev or M&A teams.  Why not use those as a model for a couple of hours of few-on-1 meetings between interested LPs and portfolio company managers?  Think of it as the "speed dating" alternative to the meat market that is the pre-dinner cocktail party.

• Simple Scoring:  Sometimes it's hard to get a really good sense for company progress, especially during the staccato sprint through 30 company slides in 15 minutes.  Sure, the EBBS (Earnings Before, ahem, Bad Stuff) margin at one firm is up 23 basis points from last year, but how is that company doing?  Sometimes the torrent of numbers crowds out the analysis and handwriting atrophy that arises from all the typing we do prevents us from scribbling notes as fast as we once did.  A couple of folks suggested using a consistent green/yellow/red rating system for portfolio company assessment.  The slides could even break out the ratings along critical dimensions: strategic positioning, team development, execution, progress to exit, etc. 

• Year Over Year Accountability: Too many company discussions take place in a vacuum.  Sure, we like to hear about metrics, but some LPs asked for those metrics to be contextualized relative to last year's expectations.  Maybe gross margins at firm X grew 36 basis points, but what if you said last year that you expected them to grow 50?  Or to grow 25?  There's some interesting discussion fodder in that delta.  Sure, we all dust off last year's notes (I gotta admit that I'm just getting around to typing up notes from last October,) but it would be helpful to take more of a longitudinal view, rather than a snapshot. 

• Management Team Videos: Some folks are big fans of meetings where CEOs are present, but in lieu of a live presentation they show edited 3-5 minute videos of portfolio company teams describing the voodoo they do.  That way, attention can be focused on the most critical topics while avoiding the too-frequent CEO presentation that rambles on for twice its allotted time.  Don't get me wrong, I love portfolio company management teams, they just happen to be more fun at the cocktail hour than up on the podium. 

• Traveling Light: I've had annual meeting road trips for which I've packed an empty duffel bag just for all the binders I'm sure to collect.  Offering to FedEx meeting materials back is a huge help (and here's a cost saving tip: we'll probably still be on the road when those binders arrive, so you can save a few bucks and send the packages second day).  Some people even send CD-ROMs or USB keys.  To that end, my buddy Du (the SuperDuperLP) even suggested a green twist: BYO (bring your own) USB to give to a staffer for instant download.  Saving postage and saving the Earth.  Brilliant! 

• Eat, Drink, Be Chatty:  On the networking front, several LPs asked for longer cocktail hours and one even described the cocktail hour/heavy hors d'oeuvres combo as being preferable to an outright dinner.  For those who do opt for a dinner, some LPs suggested having the speaker talk during the meal or dessert, rather than having us wait until after everyone finished.  Emily Post may protest, but the last thing people want after a day of travel is any more chair time. 

• A Wacky Idea:  Speaking of dinners, I've got a love-hate relationship with formal meals.  Usually the tables are too large and the conversation atomizes into pods of two or three.  Most of the time, that's ok, but sometimes, the chemistry is funky (and I always feel bad for the folks stuck talking to a blowhard like me!)  What if tables were reshuffled between courses, giving everyone a fresh set of people with whom to chat?  It might be a nightmare of choreography, but could be really cool if well-executed, doubling (or more) the number of interactions one could have. 

The Not-So Good

Some of the most frequently reported-on worst practices were little more than poor executions of good intentions.  Said another way, every vice is just a virtue taken to an extreme:

• A Bad Start: Please don't spend 15 minutes and four slides at the outset of the meeting describing the fund's strategy.  We get it, we've already bought the ticket and we're on the ride; yet several LPs reported amazement at how many GPs go through the same exact "what we do" slides year after year. 
  

• The Never-Ending Story:  I love portfolio company managers, I really do.  But every time one bounds enthusiastically up to the podium, LPs communally draw a deep breath.  Will we get a crisp overview of the company and its progress?  Or are we going to meander endlessly through a jargon-laden discussions of the product/channel matrix and SWOT analyses of key competitors?.  One comrade described it thus: "I want to know enough about each portfolio to be able to ask the right questions, but I don't need a daily flash-report familiarity.  That's what I pay GPs for."  

• Corollary #1 (Pecked to Death By Ducks):  Some funds instead do rapid-fire short presentations; someone mentioned once sitting through three hours of such 10 minute-long CEO talks.  After the first few, they inevitably start to blur together.  That LP's view on this topic: "thank God for Blackberries."  

• Overscripting:  Few things are more painful than the verbatim read through of the slide deck . . . just send us the presentation and save yourself the room rental fee.  Double demerits for using a teleprompter.

• Biology:  The length of time a meeting can run without a bathroom break should be regulated by either OSHA or the Geneva Convention.  Sure, one can scoot out for a restroom break, but who knows what you'll miss? 

• A Riot of Numbers:  I love fund CFOs and I appreciate that they should get some airtime, but there are some who do little more than recap the data from the most recent quarterly report.  Assume we read the QR; please peer instead into your crystal ball to tell us something about expectations for the fund going forward.  The best such discussions explore what you need to believe to get the fund to a given return threshold. 
  

• Cruelty to Fake Animals: Lastly, we've all got enough fleece to have stripped bare a large herd of polypropylene sheep; no mas, please!  (Titleist Pro V-1s, on the other hand, make for swell souvenirs.)

A Meta-Thought

I spend a lot of time talking about the difference between transparency and intimacy: transparency is simply a line-of-sight, but intimacy is about having an intuitive sense for what goes on in the Monday meeting, understanding how the cast of characters lines up on key issues, having a feel for which companies are doing well or poorly, knowing which partner on a roll and which one lives under his own personal raincloud.  Transparency is about data, intimacy is about information. Transparency is about investments, but intimacy is about Partnership.

And a good annual meeting can improve intimacy.  In addition to the obvious information gathering, the tone of the meeting and what is not said can be as important as what is said.  When I was surveying folks, a handful of LPs wished out loud that some of their GPs had showed some humility and had taken more responsibility for their portfolio struggles, rather than blaming "the environment."  Even in the best of times, the markets can be a humbling place, sometimes favoring the lucky, but mediocre investor at the expense of the unlucky but good one.  A bit of candor and self-reflection goes a long way towards creating durable goodwill while obfuscation and buck-passing makes people crabby.  Don't be afraid of bad news; it's an opportunity give your partners a peek behind the curtain.  After all, we're in this together.  

Fundraising Trials

So I’ve got this presentation that I give every now and again to young VCs, LBO firm associates, business school students, or anyone who wants to listen.  It attempts to describe the voodoo we institutional investors do.  Back in 2004 when I first put the deck together, I included a slide called, “Many Hats,” which tried to enumerate some of the roles that LPs play: “high throughput screener,” “investigative journalist,” “professional skeptic,” and “good cocktail party guest,” among them.

So before heading up to Tuck to help out at the “Field Studies in Private Equity” class (what a great course name, by the way!  I imagined the students would be wearing pith helmets and binoculars,) I revised that slide for the first time in five years.  Boy, has the world changed!  I added a “Many Hats, 2009 Update” to include some of the new roles we play: “referee,” “therapist,” “bargain hunter,” “accountant,” “whipping boy,” etc.  You get the idea.

It turns out that I missed one major role that I’m playing nowadays: informal fundraising advisor.  After all, it seems like everyone who’s raising a fund today is engaged in a Sisyphean rock-roll.  And of course, I’m always glad to brainstorm with folks who have differentiated investing strategies about how they might magnetize some moolah.

But I've got a confession to make: I'm worried that I've been giving people the wrong blanket advice by telling cats who have some money raised -- but perhaps not as much as they'd like -- to wrap up fundraising, get back to investing, and live to fight another day.  After all, fund size is a function of time. If you raise half the amount of capital you'd like, deploy it at the same pace in about half the time.  Then come back when the sand has been lubricated out of the gears of the financial system.  Sure, there's a bit of a fee stream impact, but the brain drain associated with dealing with institutional investors right now is just way too high.

But then I had this epiphany: it's not just that there's sand in the gears, it's also that many investors are changing their entire evaluation paradigm.  Between the dreaded Denominator Effect, investor fatigue, and a new impulse to "Keep it Simple" while eschewing complex "modern" portfolio management, I think that the new normal will be "show me," not "tell me a story."  During the recent market madness, the cost of illiquidity was so high that people will remember the sting for a long time.

And then it hit me (largely because I was sitting in a healthcare fund annual meeting at the time): I think a better metaphor isn't "live to fight another day," but rather, "you're in FDA trials." 

Think about it:  when developing a drug, there's the initial preclinical work: can you prove the concept?  Phase I trials test for safety.  Is this drug going to have any zany side effects?  Phase II investigates efficacy: does the treatment work?  And Phase III ascertains whether the treatment is better than the current standard.

Now, in a metaphor for the drug development process, young funds go through a period where the first handful of deals test the proof of concept.  Can these cats pull this off?  Then, you've got another bunch of deals that ask the question, can they scale their strategy without blowing up?  Then, there's the next stretch of transactions -- a larger number, not unlike the larger patient populations of Phase II trials -- where you really start to get a sense for whether a fund is going to work or not.  And then you get to the metaphor for Phase III (which, interestingly, often coincides with fund III) in which you can see a robust test of the hypothesis.  Is this thing better than the alternatives?  (Of course, by then, it's typically too late to get on the bandwagon, so the sweet spot is usually somewhat earlier.)

The challenge for younger funds, then, is to have some self-awareness of where they are on that curve; are they far enough along that a handful of additional deals might offer some incremental proof of efficacy or, perhaps some more time might allow an existing deal or two to ripen?  Or are they so early in their evolution that the risk-averse might still consider them to be only in Phase I when they return to market a few years hence?  In that case, those groups may want to forge ahead in raising money now while the field is relatively uncrowded.  Those hard-won dollars could extend the runway just enough.

But I'm a bit bummed that my reasonong was flawed all along: I'd assumed that the market would generally be more receptive a few years hence when cats came back for their next fundraise.  But I now think it's going to take a lot more than readiness; it'll take good progress in the clinical trials.  Those groups that are tempted to say, "the readiness is all," and come back without making much progress in their portfolio might recall that Hamlet used those exact words and was dead a couple of pages later.

Patience in the Time of Least-Worsts

Yesterday, I caught myself chain-drinking Diet Cokes again.  With about ten ounces left in my Double Big Gulp, I'd start waltzing over to the 7-11 on Lytton.  By the time I got through the door, it'd be time to reload. 

Maybe it was the caffeine, but back in the office after my third trip - cumulatively $2.97 lighter in one kind of liquidity, but 192 ounces heavier in the other - I started freaking out.  After all, there are a lot of chemicals in Diet Coke.  Would my habit end with a baseball size tumor in my head?  I am the lab rat. 

I once talked to my pal Ross about my Diet Coke problem.  He's a legit M.D. (as in Medical Doctor) and he went on a riff about caffeine addiction.  He then talked about the psychological issues that caused me to chug DC.  Cliche that I am, I drink up in times of stress.

And what stressful times we live in!  You can't take a meeting nowadays without hearing tales of struggling portfolio companies.  And some of these companies need serious cash infusions to stay alive.  Good money after bad?  Bad money after good?  Who knows?  Either way, people are spending a lot of time facing dilution and worrying about company mortality.

And then, there's the constant stream of managers asking for amendments to their documents allowing them to do crazy stuff like borrow money so they can buy Elbonian sovereign debt (don't worry about UBTI or style drift, lad, we're being opportunistic!).

Now, LPs want to be supportive, but only to a point.  And for some LPs, GPs are getting perilously close to crossing a line.  And some of those LPs are starting to talk about pitching out every last one of their seemingly-hapless managers.  Or at least refocusing their portfolios on something that's hot.  Like secondaries.  Or distressed.  Or distressed secondaries.  Or secondary distress. 

Now I'm not against being nimble, but we've gotta guard against being rash.  After all, rashness is the curse of the public market investor.  In charitable moments, I like to think that we private market investors are more patient, more thoughtful.  At less sanguine times, I'm glad that the PE fund structure keeps us from being too quick on the trigger, like those wacky individual investors.

Which leads me to my all-time favorite bit of research: there's a great Morningstar study that recounts the experience of mutual fund investors over a five year period beginning at the end of 1989.  Over that time, the S&P returned 12.22% per annum over the period (ahhh, the good old days!)  And in the same period, a group of funds Morningstar examined returned 12.01% (on a time-weighted basis).  Fair 'nuff.  But the kicker was that the actual investors in those funds only achieved a 2.02% dollar weighted annual return.  That's over a thousand basis points of leakage (!) due largely to market timing.  There's a lesson there about chasing performance.

But wait a second: it's not just the individual investors who are buying high and selling low.  I mean, look at commitments to VC about a decade ago, or to megabuyouts a couple of years back.  I guess it's just human nature to chase the shiny new penny (and to take comfort in the fact that other people are doing it alongside you).

Sometimes, too, people fixate on running from something, instead of what they're running to.  We've all had anywhere-but-here moments -- they're particularly common nowadays -- but it's important to resist the whip-saw.  After all, our managers didn't collectively take a buffoon pill during late-2008.  Of course, we may have missed potential land mines in our diligence, or perhaps the stress of funky markets has exposed previously-unseen flaws.  But we loved all our GPs once, and we loved them for a reason. 

And every now and again, we need a little reminder of those reasons.  So when I find my conviction a-flaggin', I'll pull open the bottom drawer and re-read some old investment memos.  That's a great way to pull yourself back from the ledge. 

And in a time when people want to do something (anything!) to feel like they're in control of uncontrollable events, it might be worth taking a moment to reflect on the admonition that Truman's Secretarty of State, Dean Acheson, directed at staffers who were getting over-excited during the early days of the Cold War: "don't just do something, stand there!"  And just as in those days, we're living in a time of least-worsts.  Maybe now, as then, patience may end up being a critical element of the road out of this mess.

Izzy Math

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

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

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

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

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

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

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

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

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

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

Heading to Abilene?

So I’m a huge fan of a good story.  And I also love thinking about how decisions get made in organizations.  Put the two together and I’m hooked; you had me at hello – or in the case of the Abilene Paradox, you had me at “hey, y’all.”

For those of you who don’t know the Abilene Paradox, it’s a management parable about a family in a dusty Texas town that ends up traveling fifty miles to Abilene for dinner because nobody spoke out against taking a trip that none of them had wanted to take, not even the person who had halfheartedly suggested they go to Abilene!

It’s an interesting story because businessfolk are constantly making group decisions.  And in a rush to make choices, these founders, GPs, LPs,CEOs, or whatever often seek to avoid the discord that can lengthen or even derail the decision-making process.  But in seeking to tamp down possible conflict, these choice-makers typically fall victim to the ever-lurking, insidious evil of groupthink. 

And over the course of a year, a team can make hundreds of decisions.  Since strategy is an integrated set of informed choices that lead to timely action, decisions build on themselves and all of a sudden the failure to speak up in even the smallest of debates can have repercussions that resonate over time.

In a tough economy the cost of poor choices is higher, since capital is scarcer and sand slips inexorably through the hourglass.  Precisely at the time when people should be emboldened to speak up, the opposite seems true.  The pendulum swings from greed to fear and people are motivated by trepidation, insecurity, timidness.  Upward feedback can take on a rosier glow than usual.  There’s an old Japanese proverb that seems to encapsulate people’s fear during tough times: “the nail that sticks up is the one that gets hammered down.” 

You can also get the blowhards in downturns: the “often wrong, but never in doubt” crowd.  On the one hand, I love those cats.  They get stuff done and they're proud of it!  On the other hand, maybe Yeats was describing them when he said, “the best lack all conviction / while the worst are full of passionate intensity.”

But hey, it’s all self-preservation; people are hard-wired by millenia of evolution and decades of experience to act in certain ways in times of stress.  I can dig that.  Robust debate and intellectual honesty are actually pretty complicated and counter-intuitive.  Sometimes, it’s just easier to go along and get along.

So here’s my Christmas wish: forget the Wii Fit; all I want from Santa this year is for my GPs and portfolio company management teams to crank up the frankness a bit for 2009.  You guys are a pretty honest bunch to start with, no doubt, but maybe we all can make a New Year’s resolution of going out on a limb a bit more, while also cutting everyone else a little extra slack.  The quality of your debates and decision process may well prove to be the difference between an unwanted dinner date in Abilene and an invitation to ring a bell at 11 Wall Street.

Frankie Say: Relax (Don't Do It)

The first time I saw a swan we were on a class trip to Central Park (Look, kids!  Nature!)  White and fluffy and graceful, that swan was nothing like the flying rats we had back in Brooklyn.  I remember, too, that our teacher said a pair nested every September over at the 79th Street Boat Basin.  I bet this year those swans are black, though.  After all, can there be any other explanation for daily market moves that look like annual returns? 

Of course, volatility decreases with the square root of time -- but increases Pepto-Bismol sales exponentially -- and spreads a pall over the land.  Go find a trader at day's end; they're a mess.  Better yet, go find a lender looking to make a loan to a PE-backed company.  Good luck: I'm told they've all called it a year.  Nor has the innovation economy been spared: even my neighbor here in Silicon Valley who's working on some cold-fusion, perpetual motion, flux capcitor gadget has his own personal raincloud nowadays. 

But I try to keep upbeat.  Isn't that my duty as an American (or is it to go out and shop?  I forget).  And I was doing a pretty good job of staying positive until my old buddy Copter called.  (Back in the day, we called him Copter because because he was unflappable, he had no flaps.  Get it?)  Anyhow, Copter lives the Wall Street life, complete with pocket square, and he rings me every now and again to take the pulse of an institutional (or as he would say, "institutionalized") investor.  And this time, after some chit-chat, he swooped in on me with some blood pressure-raising questions.

"So how do you think people are fixed for liquidity?" he asked.  "You think cats are going to start defaulting on capital calls?"

"Naaaah," I said.  "We're talking about professionals.  Things would have to get pretty extreme." 

"But what if it got to that?" probed Copter, "Would it make sense for funds to start pre-emptively calling capital to build a cash cushion in case people did default?"

And with those words, a wave of dread washed over me; I suddenly felt like the green-eyeshade bank teller who slides open his window only to be greeted by a line of angry depositors stretching out the door and around the block.  "Copter, you're talking about a run on the LPs.  That's madness!  You quit that right now!  Relax."

"Relax, don't do it?" Copter said.

"Yeah, relax, don't do it,"  I replied.  But quoting 80s songs felt kinda lame when talking high finance, so I decided to go for some gravitas and drop some B. Franklin on old Copter: "Remember, Slugger, LPs and GPs are partners in this thing and if we don't all hang together, surely we shall all hang separately."

"On that note, bruddah, I gotta go hang at Gotham Grill with my girly-girl," and Copter hung up the phone and whirred off into the New York night.

As I sat there in a vortex of prop wash a continent away, I was relieved to see a email from my buddy Peter that turned the day right around and contained some of the best advice I've seen so far.  Fabricated or not, I gotta say the screen below contains perhaps the best Bloomberg headline ever.  Forget the Fed, I got my bailout from the BOJ (that's Bank of Jamaica, not Bank of Japan):

[Hey, mon, if you created this and own a copyright - or if you're Bloomberg - and want this taken down, email me at the link above]

Moving Parts

Psst!  Hey you!  Yeah you . . . the GP reading this blog to take a break from portfolio company panic attacks.  Here’s a flash: you know those LPs of yours that totally dig the voodoo that you do and rank as your most stalwart supporters?  Guess what: chances are that they’ll be on to the next thing (or even the thing after that) by the time your fund reaches the end of its 10 year (plus however-many-extensions) life.  In fact, if you gave me 9 to 5 odds I’d bet that they’ll be gone by your next fundraise.  Even money says they’re on to the next thing by the fundraise after that.

Whoa, whoa, whoa . . . don’t get me wrong: I’m not trying to stick a thumb in anyone’s eye.  I’ve got a ton of respect for every last one of my Limited Partner brethren.  People who live in glass houses shouldn’t throw stones or walk around in their skivvies and it wasn’t all that long ago that I left Old Ivy either (from Old Ivy’s perspective, it was probably addition by subtraction!)

It’s just that the velocity of money out there is so high and the velocity of people seems even higher.  But it’s not just the bucks that cause people to move around: in some cases it’s taking ownership of a portfolio or starting with a clean slate; in others, it’s finding a better platform; in yet others it’s scratching that entrepreneurial itch; and sometimes, it’s just about better weather.  Folks from endowments, foundations, pensions, funds of funds, you name it are on the move.  The character of their moves may differ, but lots of people are staying one step ahead of the sheriff.  And it’s all good; this is America, Land of Opportunity: God Bless It.

I do remember, though, when I first started thinking about becoming an institutional limited partner.  My buddy Seth beguiled me with tales of long-term working relationships that transcended the transactional, yarns of robust institutional memory, stories of principals, not agents.  These were stories of people with steady hands on the tiller who understood their GPs thoroughly, intimately, and sometimes worked hand in hand with those GPs to stretch the envelope of investing comfort.  (And as you know, I think that there’s a risk premium to be had from the arbitrage of discomfort).  The implication was that stable institutions had better results.  At the very least, good GP-LP relationships (at the individual level) helped you to avoid a bunch of the time-wasting and aggravation that arises from intramural struggles and constant re-education.

So here we are, not quite a decade later and I see GPs fretting about having had nearly a half-dozen coverage people at some institutions over the past several years.  And just the other day, I realized that one of my Advisory Boards (for a solid 2004 fund) has seen seven (!) of its ten institutional investor reps leave their institutions.  Will it matter?  Dunno.

But with so many moving parts, funky behaviors sometimes follow and that’s what worries me. Occasionally, you see increases in institutional inertia as new LPs take a light touch with “valued relationships” that might otherwise be dead wood.  After all, who wants to run the risk of kicking a once-great (or maybe-someday-great) fund out of the portfolio?  It’s easier just to re-up.  ("Everyone else" is doing it anyhow.)  Sometimes, you see the “new sheriff in town effect” where people seek to clean up the portfolios they inherited; sound and fury ensue!  Babies get thrown out with bathwater and the last cat gets all the blame while the new cats think they’ve got a clean slate.  Somewhere between those two extremes is the right approach, but the former is the path of least resistance while the secondary market keeps growing to help facilitate the latter.

But I fear there’s a casualty in all this: Partnership with a capital P.  The best LPs are Partners, while the worst are just money.  And with all the musical chairs out there, I do wonder if we LPs are training GPs to treat all of us like temporary placeholders?  High-touch relationships marked by consistency and predictability lead to a better interactions while weak relationships are governed by the least common denominator: the legal docs.  As an old-time VC once told me, “the minute we have to open the bottom drawer and pull out the fund docs, we’ve all lost.”

I’ve been lucky to see a whole lot of GPs end up doing what’s right, not just what’s allowed.  I just fear, though, that as folks continue to bounce around – resulting in more tenuous relationships and more amnesiac institutional memory – that such behavior will become increasingly rare.