Bad Drivers

I’ll never forget the day I told old man Moran that I wanted to go to college at Berkeley.  It was nineteen eighty-nine (a number, another summer) and I said it just to see if I could get a rise out of the oldster by naming a school as far away from Brooklyn as I could think of.  His craggy face crumpled up as if he’d suffered sudden-onset gastric distress and Moran (who’d left Brooklyn exactly once in his life to attend Basic Training before going island-hopping across the Pacific) spat: “Berkeley?  Berkeley?  That friggin’ place makes Woodstock look like friggin’ Parris Island.”

It’s a real shame that he passed a few years ago (rest well, sir,) because I would’ve loved to see the look on his face when I told him that I’d been invited to help teach a class at Berkeley’s Haas School (thanks, Terry!)  I would’ve made sure to tell the old man that people were nude moonbathing or some such nonsense.  He would’ve eaten it up.

Anyhow, the whole thing was a blast and the kids were pretty sharp.  The lesson for the day was (insert moment of reverence here): The Yale Case.  For those who haven’t actually seen the HBS case in question, it’s basically a 20-page precursor to David Swensen’s seminal opus, Pioneering Portfolio Management; it lays out how Yale was able to generate returns that became the envy of the investment world.

Of course, people read the case (or the book) and their response was: we gotta get us some of that illiquid private stuff!  You could say that the case study laid the intellectual groundwork for the PE boom.  But hey, I’m not complaining; after all, it laid the groundwork for me having a job . . . 

So there I was talking about how so many people had taken away the wrong message from the book.  The message wasn’t necessarily “do private equity” (or do anything else specific in the book for that matter),” but rather, the message was: “if you’re going to do any of this stuff, you’ve got to do it well!”  I mean, look at page 20 of the 2007 Endowment report.  Those cats added $11 billion over the trailing 10 years relative to their composite benchmark.  Now that’s execution!  And execution is critical because the meager (sometimes nonexistent) compensation you typically get for straying from plain vanilla US equity falls far short of compensating you for the risk, illiquidity, and brain drain of playing in those funky asset classes.

But then I started thinking about it and realized that for most people there’s no functional difference between, “do this,” and, “do this well.”  Why?  Because over 80% of drivers think they’re better than average on the road; most people have a positive bias to their self-image.  Come on, if Swensen can put up Top Quartile numbers, why can’t I?  After all, I’m good enough, I’m smart enough, and doggone it, people like me!

Of course, that’s private equity’s analogue to the preponderance of drivers thinking they’re better than the average bear: the comically-large cohort of managers who claim to be top quartile.  In fact, I’ve been wondering lately if someone should start a top quartile verification service that would provide seals of approval for pitchbooks (or maybe special gold stars to sprinkle liberally in track record sections of PPMs).  Not that it matters: the opportunity costs are so high (particularly today) that being top quartile likely won’t even begin to cover those high opportunity costs.

So the more I noodled on it, the more I thought that maybe Pioneering Portfolio Management should come with a disclaimer: don’t try this at home.  Of course, trying this at home was exactly what the next book was about.

Tyranny of the Relativists

There’s a great riff in John McWhorter’s book, The Power of Babel: A Natural History of
, that describes how expressive force in language diminishes over
time.  His poster child is the word
“terrible” which once meant “causing dread or fear or terror,” but now is used
as a mild negative modifier (e.g.,
“I’m such a terrible putter that my wife got me personalized golf balls that
say, ‘three putt.’ ”) 

Similarly, the language of business is littered with
expressions that slouched from overuse: phrases like “best of breed” went from
insightful to hackneyed over the course of mere years.
Of course, private equity has its very own once-powerful phrase that’s
meandered to meaninglessness: Top Quartile. 
Now we all know how Top Quartile got to be the gold standard: a couple
of cool graphs in the Book of David some McKinsey studies, an
endorsement by an influential pension fund or two and Top Quartile was the
place to be. 

Everyone wanted to be in the Top Quartile, and, soon enough,
most people were – if you accepted their pro forma returns based on aggressive
multiples of EBBS (earnings before, ahem, bad stuff) or included estimates of
what an acquirer might pay for a start-up once it had perfected its swell
product and revenues had started their inevitable ramp.

The problem with that kind of thinking is that it obscured
the true aim of private equity: return enhancement (relative to the opportunity
cost of equity capital, i.e., some
appropriate public benchmark).  Success
was no longer about getting adequately compensated for taking incremental
risks; it was now about beating the next guy (or more specifically, the next
three guys).  

And that’s the paradox, of course, of any peer-group
measure: when new entrants deploy capital, their extra dollars will likely
depress returns across the spectrum – since the marginal dollar tends to set
the price of assets – but the cohort of “winners” (with victory defined as
being Top Quartile) grows.  The club gets
less elite as people enter from the bottom.

Of course, measuring private performance against a public
benchmark can be pretty tricky and is fraught with tough questions like: what’s
the appropriate evaluation horizon, how do you equalize for appraisal effects,
should you beta-adjust? to name a few. 
As a result, it’s tempting to fall back on an easy measure like peer
group rank.

A while back, I started asking VCs what they thought the top
quartile breakpoint for venture over coming vintage years might be assuming
reasonably “normal” public market conditions. 
In my informal and unscientific survey, more than half of those I asked
guessed that the top quartile line would be at or below zero.  Surely, some firms will do fantastically
well, but if the VCs I sampled are right, it will be really amazing that dozens
and dozens and dozens of firms that tinker in one of the riskiest corners of
the financial world will be able to call themselves successful even though they
will have lagged the public market – not to mention cash – by many hundreds of
basis points.  What’s more amazing is
that merely by surviving, these firms will earn billions of dollars in fees in
aggregate and the folks who funded them will dance a jig for having done a
great job.

It’s enough to remind one of an old story: two campers are
awakened by the sounds of a bear sniffing at their tent.  While one of the campers starts panicking,
the other calmly starts putting on his sneakers.  “Why are you putting on your shoes?  There’s no way you can outrun that bear,”
whispers the first camper.  “I don’t need
to outrun the bear,” replies the second camper, “I just need to outrun you.”

That kind of thinking may work for relativists, but the
important return-enhancing role that PE plays in institutional portfolios
demands that we instead ask: for all the extra risk and illiquidity we incur,
if you can’t outrun the bears (and the bulls) why bother?

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

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?