So Cindy Crawford walks into a bar and a swarm of dudes approach her, brandishing their best pick-up lines: "Was your father a thief? Was your uncle a robber? Well if not, who stole the sparkle from the stars and put it in your eyes?" or, "My, what a beautiful mole you have" and even, "Well, aren't you MILF-y tonight?"
Sounds like the beginning of a joke, no? Well, actually, welcome to my life! Well, not just my life, but actually the life of any LP . . . after all, being the cat with the checkbook can make you the most attractive girl in the bar. And being the hottie of the honky-tonk comes with a cost: an endless stream of pick-up attempts.
And the lines we hear from GPs can be remarkable for their homogeneity. In fact, when I hear a buyout fund talk about Proprietary Dealflow or Operating Partners, or a healthcare fund talk about the Aging Population or the Patent Expiration Timebomb, I can't help but think that I've heard this story several (hundred) times before. In fact, I've got a visual reminder in the form of my oppressive inbox of just how many times I've heard some such story. Here's a sampling:
As you can see, the leftmost column contains the folders I've created for funds that have sent me information since I started at my current employer in mid-2004. In this view, you can see about 30 of the 452 VC firms with whom I've corresponded. I have a similar LBO/growth capital folder that contains another 377 firms and an international folder that contains stuff from about 275 additional fund managers. Add in the 75 managers that are in my "active" bucket (running the gamut from the latest GP over whom I'm breathless to the oldest, most tired fund that 's in run-off mode) and that's close to 1200 funds from San Francisco to Stockholm to Shanghai. Throw in my tenure at Old Ivy and I probably saw another 300 incremental funds over and above those 1200. And compared to some other folks on the LP side, that tally of 1500 seems like a rookie's breakfast.
Speaking of Old Ivy, when I was just starting out as an apprentice in the craft of PE investing I asked an Old Timer in the office about the early days of institutional investments in PE — I mean, this guy was my Hubble Space Telescope back to the cottage industry-era of the PE universe. And one thing that he said stuck with me all these years: "in those days, we kind of figured out what kinds of strategies we wanted to back, looked around at the four of five managers who were doing those kinds of things and then invested in about half of them." Remarkable . . . when I think about my "funnel" today, the line we used in my Old Ivy days seems to ring ever more true with each passing day: "It's harder to get into our portfolio than it is to get into our college."
And I believe that all the competition has to be challenging for overall returns. Or maybe, paradoxically, overall returns won't suffer as tradecraft generally improves, but instead the dispersion of those returns tightens as the industry professionalizes and best practices are copied and losers fade away and become exemplars of survivorship bias. In that vein, I'm reminded of a great Stephen Jay Gould article I read about 25 years ago in which he talks about the maturation of an endeavor (in that case baseball) and the disappearance of outcomes that are several standard deviations (positive or negative) off the mean:
"Variation in batting averages must decrease as improving play eliminates the rough edges that great players could exploit, and as average performance moves toward the limits of human possibility … Declining variation arises as a general property of systems that stabilize and improve while maintaining constant rules of performance through time. The extinction of .400 hitting is, paradoxically, a mark of increasingly better play."
What if that's true? What if the fabled dispersion of top-to-bottom quartile returns starts to narrow, (like the pennant-shaped graphs exhibited by many styles of investing that show wide dispersions in the early, pioneering, wild west years on the left side and narrower spreads in more recent years)?
Well, one implication may be that the "better execution" story (i.e. "we're good at this") becomes commoditized while the "we're doing something different" story becomes even more compelling. After all, do I need an n-th mid market buyout fund with operating partners and a geographic focus? Or the m-th early stage Sand Hill Road firm? Maybe, maybe not. That's just post-heroic private equity and there's indeed a place for that in a portfolio as a return enhancer. But I fear that those types of firms in the aggregate are slouching toward an paradigm of little more than what the public market guys would call enhanced-indexing.
But what about someone who's doing something innovative in style? Structure? Terms? That might add some spice to the portfolio. That's where the true octane (on a risk-adjusted basis) might lie. It's definitely the higher volatility play, both in potential returns (for the LP) and in fundraising success (for the GP,) but to do something outstanding takes audacity. And indeed, private equity should be all about audacity. After all, heroic investing lives at the intersection of courage and conviction.
Great post. Although I would posit two additional thoughts:
1) Is it possible that you’re seeing tremendously increased deal-flow relative to prior generations because of improved communications & pervasive access? In the past life of this business, the only way to communicate was word of mouth or introductions. There are certainly more formal funds out there today than three decades ago, but are their funnels also correspondingly larger too? Would that not mean that the concept of increased “competition” really is only theoretical (if the pond is in fact an ocean…)?
2) Better yet, is it the case made only by structurally inflexible incumbent players or the middling players? The “better execution” story is tired and a recipe for sub-par returns (mostly, with exceptions). For better or for worse, the skills required to be a successful PEVC investor 10 years ago are not the same as they are today. Two main things have and are happening, one is that little thing called the internet, which is changing everything in more ways than we can imagine, and, two is the globalization of every industry (and the portfolio companies of PEVC firms). The skills needed to creatively find successful investments in a global marketplace & help build leading companies today are unquestionably different than the white glove business of old. Is it not a brave new world…
Obviously, both of these posits could go on for quite a dissertation, but they are tangential to your main post so thought I’d share the thoughts.
Thanks for the thoughtful comments. Both good points. In fact, I’ve been thinking a lot lately about your first point in particular: is the pond really an ocean? Are the number of ideas finite in such a way that we feel them to be finite? finite to such an extent that they feel infinite because of their vastness relative to available capital and bandwidth? or just plain ol’ infinite? My bet lies somewhere between 1&2 and where along that spectrum has some implications for the business, broadly speaking.
As to the second point, I agree that the skills are different today . . . it’s amazing how much more complex the ecosystem is today than it was even a scant 10 years ago. It’s a shame that investors don’t get returns scaled by degree-of-difficulty factors . . .
This Steven Jay Gould article is a favourite of mine, too, but I doubt it fully applies here. See, he was talking about MLB, which already is a selection of the best players in the world. With your 452 VC pitches, I bet that there are quite a few minor-leaguers, bush-leaguers and even weekend-warrior leaguers there. The number is just too high.
So, in a nutshell, you still have an important job to identify who major-league players are. Sure, there may not be 25% ROIs anymore, but you have to protect against the -15% ers…
True that . . . my hope has always been that the “minor leaguers” don’t get funded, but the market is rarely that efficient (and certainly there are a lot of double-A ball pitchers among those that have thrown me pitches …)