So I've been working on a blog post called the
Epistemology of Investing for about the past year. Now, epistemology is a ten-dollar word that
those — like me — with five dollar brains rarely sling around, but sometimes
I think investing could be called applied epistemology.
As investors — specifically, investors in opaque,
illiquid markets — we spend our days asking the epistemological questions:
what do we know about our investments, companies, markets, people? How do we come to know what we know? What are the sources and limits of our
knowledge? How are our beliefs different
from The Truth? Said another way: what
investing hypotheses do we form? How do
we form them? And how do we seek out,
analyze, and integrate the data we use to test those hypotheses?
[As an aside, my sophomore-year philosophy professor (who
didn't see any irony in calling my mid-term paper sophomoric and didn't
appreciate my pointing out his lack of ironic sense) might be vaguely proud to
see that I'm still thinking about something I learned from him two decades ago,
although more likely he'd be surprised that I'm actually a contributing member
But every time I grasp my virtual pen to blather away on
the topic, I end up down a wordy path of nuanced nuances. Instead of answers, there are only more
questions. And one of the questions that
keep coming up is: why do good decisions sometimes have bad outcomes and
Therein lies one of the tricky things about investing in
private equity funds. We suffer the
brutal tyranny of the law of small numbers; sometimes there aren't enough
outcomes for skill to trump randomness.
If a buyout fund has a dozen investments, or a venture fund has maybe
twice that many, a lot of exogenous factors, timing, and — dare I say — luck
can determine an individual fund's returns.
It's sort of like taking a few hundred bones to the craps table and
rolling the dice only a couple of dozen times.
Of course, a good craps player can play for quite a while, cleverly managing
their betting to (temporarily) defy the inexorable negative expected return of
about 1.5% per roll. But most players
bet too heavily too quickly, lose their stakes, and leave the tables dejected. And it's not the aggregation of those percent-and-a-halfs
that pays for the dancing fountains, replicas of the Eiffel Tower, or museums
dedicated to the tribal elders and their nearly-forgotten way of life. Instead, it's the law of small numbers that overweights
the bad side of the binary outcomes. If
the binary outcome comes up "1," you've only earned the right to roll
again (and perhaps walk away,) but if it comes up "0," you're done;
you can't toggle that PIK. The casino's
1.5% vig can turn into a 50% or 100% tax.
Even for a good player. Trust
And since we're illiquid, we don't get to control when we
leave the casino. We're forced to leave
that up to others, our GPs. Which is why
we all spend so much time on people in our diligence. When GPs ask me to talk about my
"process," I often say that I focus primarily on the people (devoting
considerable time to understanding their hopes, fears, dreams, and
motivations,) second on the strategy (and the resonance between the investors'
skills and their proposed strategy,) third, I take a deep dive into the existing
portfolio (because that's the people and the strategy in action,) and fourth on
performance (which is a lagging, not a leading, indicator, no?) I like to think that if I'm doing my job
well, I have a fly-on-the-wall's insight into the Monday meeting machinations,
able to predict the reactions of each partner to different scenarios.
And so all of us do a lot of reference calls. We go off-list and try to get an unbiased
bead on people (a GP once offered me the "off-list list." I replied that I'd have to then go off
off-list!) But sometimes we're wrong and
sometimes we're just unlucky, despite all out hard work. And it can be frustrating when everything
points to "no" and a fund blows the doors off. You knew something shouldn't, but it
did. Don't get me wrong; I never root
against anyone, but there are extreme cases like the one of the GP who tapped
his portfolio companies' CEOs phones and would just pay hush money whenever he
got caught (you can't make some of this madness up). In that case, prudence tells you to steer far
clear, but those guys have actually done pretty darn well. Despite that, there are scores of things we
find when we start turning over rocks and one's tingling Spidey Sense rarely
leads you astray. But sometimes you kick
yourself. Warren Buffett may say that,
"there are no called strikes in investing," though there are days when
it feels like that aphorism doesn't apply to PE, a business in which a handful
of winds drive industry-wide returns.
But when you get that hinkey feeling, and you pass on
what becomes a big winner — a good decision leads to a bad outcome, i.e. a sin
of omission — you just have to think of the 1986 New York Mets. Never has such a such a flawed team played
the game of baseball so brilliantly.
Their off-field shenanigans were captured in a book entitled: The Bad
Guys Won! (As a lifelong Yankees fan, my
distaste for the Red Sox is matched only by my disdain of the Mets; that 1986
Boston-NYM World Series seemed like a fortnight of punishment.) And in fact, some thought that the
talent-laden Mets could have been the winningest team of the 1980s, but their
personal demons prevented them from scaling the heights of lofty
expectations. And indeed, if wins are
the currency of baseball, the workmanlike Yankees ended the decade with the
fattest wallets, but no championships.
They were the great risk-adjusted bet of the 80s, even though the Mets,
Cardinals, Reds, and A's got more attention.
The phone-tappers described above may dazzle, but they're likely little
more than the '86 Mets of Investing.
And maybe that's the lesson from 1980s baseball and the
craps tables: sometimes the bad guys do win, but stick around long enough and
we, the LPs, do get enough rolls of the dice to let skill trump luck. One just needs to have the patience,
conviction, and courage to not walk away at just the wrong moment; that's when
the casino wins.
I think you misunderstand gambler’s ruin. With a negative expected value per gamble (which is true for craps), you will eventually go broke (i.e., lose 100% of your initial stake, not 1.5%). Large n is what makes this work.
[post fixed to reflect Stats 101 refresher]
Blast! Good catch. I was trying to make the small numbers / markets can remain irrational longer than you can remain liquid point w/o resorting to actually pulling out the oft-used Lord Keynes quote . . .
Thanks very much for the comment and the Stats 101 refresher.
Another great post Chris. As an LP, if I wander around epistimology too long I start feel like I’m stuck in some sci-fi thriller where my pet weiner dog turns into a baby clown with a knife. But, I digress. . .
I’m forced to admit my decisions are biased. I think that’s the reason why my organization (and many GP’s) have processes, to mitigate individual biases.
I’m an L.P., I grew up in the midwest, espouse judeo-christian values, speak fluent spanish and love college football. If/when I meet GP’s with similar experiences/belief systems, my mind is automatically biased in their favor. The result may/could be a type of representative or anchoring bias whereby I hold to certain information/data to justify my support. This could be conscious or sub-concious, that’s the problem. I’m always asking myself, “do I like them because they’re good investors? Or potentially for some other reason?” Conversely, sharp-elbowed autocrats who chew with their mouth open are going to have an uphill battle. But does that make them bad investors? Maybe not. That’s why I rely on robust internal dialogues and outside opinions to help mitigate my conservative biases.
In the end though, I just think jerks are less likely to be successful. It’s the kind of stuff that leads to friendly fire and they get shot in the back. And I don’t want to drag their carcass off the battle field.
Successful jerks far outnumber successful non-jerks. At least in the finance world.
I’m not sure, but I definately think we REMEMBER the jerks more.
@Chris, Forget Stats 101, re-read the Black Swan.:)
@Mark, I can’t say for jerks in the world of finance (even a bona fide sociopath can operate a Bloomberg terminal brilliantly.) But, doing research on people management, I found that outside of a very few companies that operate truly democratically, the jerks may have an edge in the short run (1-2 years) while the non-jerks in the long (3-30 years). Well-organized democratics beat them all, short or long. Hence, unless PE firms exit portfolio firms very quickly, their mostly jerks CEOs and operating partners are a true drag on returns.
Meanwhile, it’s hard to know who’s the real jerk, unless you work for him/her.