[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?”