PE Arithmetic

October 30, 2015

The Circle of Life and the Exit Sphincter

An old saying goes: “in Silicon Valley, you’re never on your way up or down, you’re always coming around . . . “

It’s a great phrase because it captures the energetic movement of people around this sunny and magical land.   With enough success to give folks a sense of possibility — and just the right amount of failure to keep people moving — the dynamic system that is Silicon Valley nurtures a “pay it forward” culture that’s part long-standing way of life and part necessity.  It’s a place where people are urged to count the number of additional years they wish to work and divide by four (the number of years in a typical vesting schedule) to determine their remaining “shots on goal.”  And everyone seems to believe that favors today pay dividends tomorrow.

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October 14, 2013

Speak Like the Locals, Redux

[I don't love reposting stuff, but this riff from 2010 seemed appropriate since I spent part of last week talking to folks about the the sources of indifference towards private equity in institutional portfolios . . . ]

Speak Like the Locals

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?”

 

September 24, 2013

All About the Benjamins

It’s said that the most meaningless number in sports is the score at the end of the first quarter of a football game; so much will happen before the final whistle sounds, that the first quarter score is a specious predictor at best.  Lately, I’ve been feeling that the private equity equivalent of that oft-misleading tally is Total Value to Paid In Capital (TVPI).  I get it . . . we have to gesture in the direction of a comprehensive interim measure of performance, but look folks (and I’m talking to you, GPs): all we LPs really care about is cash in cash out, moolah in da coolah, ducats in the buckets, and pennies in the piggies.

Now it’s always been clear that interim valuations are prone to tinkering, throwing TVPIs into question.  No surprise there.  But such shenanigans seem to be most frequent as fundraises approach.  We didn’t need academic studies to confirm our suspicions, but they’re out there.  And even if we’re feeling charitable, the vagaries of subsequent financing rounds and the occasional undulations that all business experience can send NAVs gyrating.  No matter what the fair value police (thank you, Accountants and Auditors Full Employment Act of 2002) have to say about it, it’s an incredibly imprecise science.

Advocates of TVPI sometimes say that it’s one of the least-worst quantifications of performance.  And indeed, the perfect may be the enemy of the very good.  Yet TVPI has been feeling pretty useless as a predictor of final performance unless the D(distributions relative to)PI quotient is pretty high.

So what’s a poor LP to do?  How might we think about the success (or lack thereof) of a particular fund?  Setting aside the fact that performance is a lagging indicator, not a leading one, how do we institutional private equity portfolio managers show our face in our Monday meetings when the hedge fund cats speak in tongues, regularly dropping Greek, Sanskrit, and Cuneiform in their discourses on performance?  We need to bring something more compelling to the table than: “check out this new new thing . . .”

To be sure, there are some nifty performance measures that have gained some currency, including public market equivalent and real time discounting analyses, but most are subject to the appraisal effects that can be so confounding.  So here’s my simple proposal: rather than looking at what a portfolio might be worth by guessing at current (or future) company valuations and summing them, what if we instead asked how large an exit each and every investment needed to achieve to return a certain meaningful portion of the fund and then reality checking those putative outcomes?  What if we were to turn the coin on its head?

In venture world, one might ask, how big a company needs to be created in order to return half the fund?  One times the fund?  Those may seem like high hurdles for any one company, but given the high expected loss rates endemic to VC such a discontinuous outcome — or several such big exits — has historically been a prerequisite of generating the types of returns we LPs crave.  My buddy, Brad Svrluga, calls this hurdle the "RTFE," or "Return The Fund Exit.")  In buyout world, one might ask: how big a return do we need for each of our, say, 10-15 portfolio companies to each return twenty to thirty percent of the fund? 

By way of example, here’s what such a table might look like for a $150 million VC fund that wants each company to return half the fund:

 

                    Amt Invested            Stake            Valuation        Required Exit           

Company A    $3,000,000               13.4%            $22.5M            $562.5M

Company B    $1,000,000                3.1%             $32.3M              $2.4B

…

Company X    $1,500,000                26.0%            $5.8M            $290.0M

 

Now Company B might seem like a sporty play, but such an outcome might be in the realm of possible given its progress and potential while Company X may have already seen the market for its new fangled rotary-dial telephone pass it by . . . You see where I’m going with this.  (Of course, dilution needs to be considered in due course, although ownership percentage is one lever that can be pulled; he who owns most of the pot of gold at the lowest basis is the King of the Leprechauns.) 

Indeed, one of the side-benefits of these analyses has been that GPs are forced to think about their underwriting of deals.  An occasional outcome I've experienced on asking GPs to perform this analysis is something along the lines of, “yikes!  Our most exciting company is only poised to return a quarter of the fund using reasonable exit assumptions!  The rest of the portfolio has to work pretty darn hard for us to get a carry-generating return!” 

Now, I’m not hoping (although secretly maybe I am) that thinking rigorously and systematically about exits and fund arithmetic will introduce a value (or at least a GARP) perspective to private investing, but at the very least, I’m hoping we can start to reframe the conversation from what LPs currently are thinking (i.e. “how are you trying to pull the wool over my eyes?”) into a real discussion that starts to unpack assumptions and drive the intimacy and engagement that is so sorely lacking in today’s LP-GP relationship.

May 28, 2010

One View of the Future of VC Allocations

So I'm working on a blog post with some fundraising tips for PE and VC pros that are making the rounds.  The thesis is: you've got to come to meetings armed with better rhetoric, as many institutions have become wildly cynical about private equity strategies after feeling the acute sting of illiquidity during the downturn.  Said another way, people realized that the cost of illiquidity was much higher than they had estimated and many asset allocators are now (re)asking the questions: "are we getting adequately compensated for the risk and illiquidity of privates?" and, more importantly, "why bother?"  Talking about being top quartile will get you nowhere when the person across the table reports to a CIO who's obsessed with the opportunity costs of their capital. 

But before I finished that post, I thought I'd put up a slide deck that I pulled together a few months ago; I've presented variants of this storyline to a few different groups since the beginning of the year.  It's a review of some dynamics that impact institutional investor attitudes towards VC, but I think several of the thoughts are generalizable across private equity. 

Now, I don't think there are necessarily any earth-shattering insights embedded in the slides; it's more of a refresher of first principles.  On the other hand, I continue to be surprised at the number of GPs with whom I speak that think LPs will return en masse with open checkbooks at any moment.  I didn't want to be all gloomy and doom-y, so I tried to end the presentation on a optimistic note, but I do hope that people understand that we've crossed over to a new paradigm that's different from the illiquidity bull market that marked the better part of the last 15 years.  This isn't just a "get-a-mulligan" detour on the way back to 2006; instead, I think the fundraising equilibrium we find over the coming quarters and years will feel a lot more like the tough slogs of the late 80s and early 90s.

I sometimes teach "The Yale Case" (insert reverent pause here,) at business schools and I always open by asking the students what they think the key lessons are.  "Diversification!"  "Equity Bias!"  "Asset Allocation!" come the cries from the well-scrubbed students.  "Nope," I tell them.  "the real lesson of the Yale Case is: don't try this at home . . . "  I fear that many institutions have now learned that lesson the hard way and may be reluctant to return for some time.  And, as always, people will return when they see money being made, but, as with the lottery, the worst time to buy a ticket is typically just after somebody else has won the big jackpot . . .

VC Presentation May 2010http://d1.scribdassets.com/ScribdViewer.swf?document_id=32095003&access_key=key-286car1il8kko71w718v&page=1&viewMode=slideshow

February 4, 2009

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.