Beware of PE Managers Speaking Greek

So here’s a game I’m playing a lot lately: dueling
Greek.  No, I’m not finally fulfilling my
father’s long-dead wish that I attend Greek School.  It’s just that a lot of PE managers are
slinging the Greek around.  Seven or
eight years ago it was really rare for an LBO pro or VC to describe themselves
as an “alpha” manager, but it seems commonplace today.

Of course, I understand what people are getting at.  They’re suggesting that they’re after
improved risk-adjusted return.  But
that’s where it gets dicey: how do you articulate risk in a PE context?  And what’s the appropriate level of return
per unit of risk?

When I’m feeling saucy, I ask these self-proclaimed alpha managers: “ok, then,
what’s your beta?”  At that point, the
GP probably thinks that he’s got a smart aleck on his hands, but the question
is sincere.  Really, it is!  (I’m not one of those Dollar and a Dream
guys.)

As we all remember, alpha is the excess return of a
portfolio relative to the return predicted by a portfolio of similar risk
(expressed as beta).  Said more elegantly (note the gratuitous equation inserted to gain
credibility with the quants):

Portfolio alpha = Portfolio Return – (Risk Free Rate + Portfolio Beta * Equity Risk Premium)

So assuming a long-horizon nominal equity risk premium around
6.5% and an average nominal risk free rate of about 4.5%, a portfolio with a
beta of one should have a return of about 11% and anything above that is alpha,
sweet alpha.  [We could quibble about
time-varying premia and risk free rates, but the generic point is valid,
no?]  Here’s the catch: I just don’t
believe that PE betas are anywhere close to one; on the buyout side, higher
levels of debt implicitly raise beta while the venture guys have incredible
volatility of outcomes.

Fortunately, most folks decide to play along with the spirit
of the question and we typically get into good discussions of risk appetite,
tolerance, and management.  It’s always a
stimulating chat, but people rarely answer my question directly.  To be a sport, a GP once argued – with a grin
– that the beta had to be less than 1 because most people thought the
correlation of PE to the public markets was about 0.65.  Without skipping a beat, he acknowledged that
appraisal effects and stale prices made that number totally meaningless.

So, what is the beta of PE? 
Is it 1.25 (kinda like Vanguard’s small-cap Explorer fund)?  Or more like 2.0?  If it’s the former, you’ve got to generate
net returns greater than about 13% to have positive alpha; if it’s the latter,
your bogey is closer to 18%. 
[Interestingly, the time-worn PE goal of 500 bps of excess return
probably implies a beta of about 1.75, which is
about the beta exhibited by some public managers with concentrated portfolios].

At this point – like Chevy Chase
playing Gerald Ford – I exclaim, “I was told there would be no math here,” so
why sling numbers around in search of a pedantic point?  Because PE supposed to be a return enhancer
relative to public market alternatives (the opportunity cost of risk
capital).  I’m finding that when people
say “alpha,” they typically just mean “top quartile,” and that’s not alpha at
all.  Maybe “top quartile” will equal
positive alpha over time – I have my doubts – but right now it’s just a worn
marketing slogan.  Don’t get me wrong, I
love firms who can outperform their peer group, but unless we can figure out
how to find the folks who are generating true risk-adjusted excess
return, we need to keep asking ourselves the question: why bother? 

Justify My Love

My buddy Peter – a very smart cat – was a pure math major in
college. Once, I asked him what the
difference between pure and applied math was and he told me with an impish
grin: “the applied math guys know how to add . . .” Of course, Peter went to Brown University, a
very funky place, so I’m sure that he could’ve done an interpretive dance about
the Lebesgue Outer Measure and still gotten a passing grade on his senior
thesis (just kidding . . . feel the love, Providence!)

I, on the other hand, studied history in college which means
that I’m good with trivia at cocktail parties, but that’s about it. Every now and again, though, I get to
thinking about arithmetic; specifically, the arithmetic of the venture business
and I wonder if we’re all closer to the pure math end of the spectrum than the
applied end.

VC math should be pretty straightforward: send a dollar out
to a portfolio company and hope it comes back with a few of its friends. Do that often enough and you’ve got a good
fund-level return.

Unfortunately, the LPs who invest a Dollar and a Dream have
prevented the shakeout that we were all talking about in 2002 from happening
and there continue to be too many iffy $500 million “early stage” funds out
there. Now I’ve got nothing against $500
million funds in particular. Despite my
seed-stage and smaller-fund bias (I like being "long idiosyncrasy and short
momentum"), we’ve got a few investments in that size stratum and think those specific
guys have some distinctive advantages.

Here’s where it gets dicey for the masses, though (and I’ll
make some gross simplifying assumptions): if you’re an LP and investing in an
run-of-the-mill $500 million fund hoping to get a 3x net return, that fund has
to generate $1.75 billion in returns ($1.25B in profit less 20% carry equals two
turns of profit). Of course, that’s just
the capital that accrues to the firm’s ownership stake. Since a lot of firms end up owning only
10-15% of their companies at exit, you’ve typically got to gross the $1.75
billion up by a factor of between 6.67 and 10. That suggests that those firms need
to create between $12 and $17 billion of market
cap just to get a 3x
fund-level net return to their LPs. Caliente!

Let’s unpack that box a bit more: at the $15 billion midpoint of the exit range
above, a firm that invests in 25 early-stage companies will have to get, on
average, $600 million exit valuations for each and every one of them. That’s a pretty daunting number when you
consider that the typical M&A valuation has hovered in the high
double-digit millions for quite some time.

Of course, such a batting average would be unprecedented
(this is a slugging percentage business, after all), so if you assume that a
quarter of the companies generate all the returns while the other three
quarters collectively return the cost basis, each of those 6 home run companies has to enjoy an exit valuation
of $1.67 billion (roughly what Google paid for YouTube). That’s livin’ la vida loca!

The situation above is exacerbated by the fact that not all
firms invest 100% of their capital because they reserve up to 15% of capital for
fees. Also, you could make the argument
that the firms most likely to earn the above returns will charge premium
carries, making the hurdle higher for compelling net returns. To be fair, firms have a few levers to pull –
maintaining higher ownership percentages
(!) in companies and recycling capital – that can make the challenge less
daunting. They could also deploy less
capital per company, but that’s tough to do with a larger fund.

Like I said, though, I do still believe that some firms will
be the exceptions that prove the rule; some will be good while some others will
be lucky.

In the meanwhile, a lot of LPs will be serenading their GPs
with the line from that old Madonna song (cue the sensuous and moody bass line):
“I’m just wanting, needing, waiting for you to justify my love. Hoping, praying for you to justify my love .
. .”