All Politics Is Local . . . Maybe Investing Should be Too?

[Ok, ok . . . I've been slow on my long-promised post about out-years risk, but I started writing it last night and the post got unruly.  Back to the drawing board on that one . . .]

In the meantime, I've got another quick thought about this whole Madoff mess: I'm amazed – but unsurprised – by how international the roster of victims has been.  (Harry Markopolis, the man who tried to alert the SEC, suspected that half to three quarters of Madoff's capital came from overseas).  As you read through the list, you can almost imagine Ricardo Montalban or Catherine Deneuve reading off the foreign names with crisp and precise diction (while heavily accenting the American ones: Ferh-feeeld Ghreenesh Ehdvisors . . . Tree-Mon Groope . . .)  It's a far-flung group that now shares a common shame.

And that got me thinking about how we, as investors, do diligence.  I mean, information is the raw material of investing, right?  I'm not talking a Gordon Gekko/Bud Fox sort of information ("Blue Horseshoe loves Anacot Steel.")  What I'm talking about is knowledge.  Do you have a view?  Is your opinion the product of a dialectic?  How was the tension in your thinking resolved?  What data tipped the scales in favor of one route, but not another?  After all, we're just intelligent switches and network nodes, gathering and processing information. 

And if information is our sustenance, how often do we outrun our supply lines?  I've been thinking a lot about the epistemology of investing lately: how do we know what we know?  Is it harder to triangulate information when investing across the country?  Across the world?  How frequently do we not speak the same language (literally or metaphorically) as the people with the insights?  How frequently do we not even know who those people might be? 

And fund of funds have it even worse.  At least the primary investors are buying assets with (hopefully) some intrinsic value or growth potential.  FOFs make investments in the people who buy those assets, placing at center stage the most pernicious irritant in all of finance: the Principal-Agent Problem.  Don't get me wrong: I'm not kicking any of the cats who lost money.  I'm sure they're all smart, well-intentioned people who somehow wandered beyond the frontiers of their expertise or suspended their disbelief.  It reminds me of the exchange in Leo DiCaprio's Magnum Opus Catch Me If You Can:

Frank Abagnale, Sr.: You know why the Yankees always win, Frank?

Frank Abagnale, Jr.: 'Cause they have Mickey Mantle? 

Frank Abagnale, Sr.: No, it's 'cause the other teams can't stop staring at those damn pinstripes. 

Now I don't want to sound provincial.  Investing is a global discipline and we need to seek out the best risk-adjusted returns wherever they might be.  My fear is that we've systemically underestimated the amount of risk in going increasingly far afield. 

In people businesses, it's actually really valuable to see people firsthand, to look them in the eye, to know where and how they live, to bump into them at the grocery store, to interact with them closely in hopes of building a sense of mutual obligation.  That's the genesis of trust.  And in finance – just as in a democracy – someone must be trusted.  And, indeed, trust is always at a premium, it's just that today trust is also in extremely short supply.

Economic Analysis, Silicon Valley Style

I dig lingo.  Sure, a picture might be worth a thousand words, but a nice hunk of jargon has got to be worth at least a few hundred.  And if it's jargon you're looking for, I'd bet there's no better place to find it than Silicon Valley. The cocktail of business and technology – with a splash of disregard for the rules of grammar and spelling – make this place a jargoneer's paradise.  (Although sometimes the whole thing goes too far:  One.  Word.  Sentences.  Quit.  It.  Srsly.  Hey, I wonder if grammr.combeta is taken?) 

Anyhow, there I was at the Fall potluck dinner at mini-LP's nursery school, feeling a smidge out of place since I was the only one not sporting gear emblazoned with the logo of a NASDAQ 100 company, and the topic turned to (bum bum bum buuuuuum) The Subprime Crisis!  Suddenly, all eyes were on me: Financial Dude.  One dad growled, "so how did it get to this?" in that same exasperated tone that TV detectives use as they toss the legal pad and bic pen toward the perp demanding: "write it all down, just like you told me."

And so I started talking about what I thought had really gone on.  At first it was kind of cathartic, but then, the more I talked the worse I felt about the whole thing.  It was like I was describing a case study in the principal-agent problem.  Make that the World's Biggest Principal-Agent problem.  And that's what got me down: professional investors should be attuned to agency issues.  Everyone should've seen this coming, but the good times were rolling and there was always a greater fool in another time zone to take the mess off your hands.  Of course, that's a game that works until it doesn't.  But I digress.

So I'm going on and on about marginal borrowers (my favorites were the NINJAs: No Income, No Job or Assets), CDO tranches, investors looking for spread product, and mark-to-whatever accounting when I notice a few eyes starting to glaze over.  And right then, one dad pipes up: "So it sounds like they were overclocking the financial system."  Now I didn't quite know what that meant, but I sensed some good jargon coming on and I was eager to unpack that box like a kid on Christmas morning. 

Your Humble Narrator: "Overclocking?  What's that?"

Really Smart Dude: "It's when you mess with your computer's processor to get some more performance out of it."

YHN: "Why do that?"

RSD: "Well, most overclockers are gamers looking to push the limits.  Exceeding the processor's specs can result in a major framerate bump.  Others do it for ego reasons; you know, they just want to have the fastest processor on the block.  And some people even go out and buy old processors on the cheap, overclock them and sell them as the latest chip to unsuspecting buyers."

YHN: "Srsly?"

RSD: "It gets pretty crazy!  The problem is that overclocked processors run really hot – often hotter than conventional heat sinks can handle – so overclockers sometimes build crazy structures to keep the whole thing from blowing up."

YHN: "Blowing up?  For real?"

RSD: "Well, blowing up is a bit extreme, but the processor can catch fire for sure.  And once you get a fire inside the machine, the whole system could be at risk.  Either way, if you get to that point it's an expensive fix."

Expensive, indeed.  Aside from the magnitude of their blow-ups, overclockers of the processor and financial variety sounded a lot alike.  Of course, it looked like the financial overclockers were going to get all of us to pick up the tab for their blow-up . . .

When I was a kid, a bank in my neighborhood got robbed and the block was abuzz with talk of the brazen heist.  Among all the hand-wringing and fist-shaking, Old Man O'Malley, ever the neighborhood cynic, dropped a nugget through the fog of Garcia Y Vega smoke that continually encircled his head.  "Morons," O'Malley growled, " . . . if you're going to rob a bank,  don't take down the one on the corner, go hit the Federal Reserve.  That's where the money is."  I've thought of that line a lot recently and I can't help but feel that's exactly what just happened.

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?

One Strike Away . . .

I’ve been in a bunch
of meetings over the past few months with buyout guys who say things like, “we’re
in the seventh inning of the credit crunch.” 
In fact, it seems like every time I turn on CNBC or read the Bloomberg,
the inning metaphor is up at the plate. 

The use of innings
as a proxy for time seems like a swing and a miss to me, though.  Since baseball is alone among major sports in
allowing the defense to control the ball, the sport is liberated from the
tyranny of time marching inexorably forward. 
I like football and basketball as much as the next guy, but the practice
of running out the clock by taking a knee or dribbling around the floor has
always seemed vaguely anticlimactic to me. 

You just gotta get
that third out in the ninth inning and it could take all day to get it done.  As a young pitcher, I once allowed six consecutive
hits (!) with two outs in the last inning. 
In fifteen minutes, a fine pitching performance was undone and I went
from complete-game winner to hard-luck loser.  All for want of just one more out . . .

A late inning grand
slam can turn a blowout into a tight game and completely reverse a game’s momentum;
anything can happen and the clock won’t bail you out.  And that’s what makes the metaphor funky: it
almost doesn’t matter what inning of the game you’re in, something totally discontinuous
can occur at any moment.   

Maybe that actually makes
the metaphor brilliant?  Perhaps embedded
in the sense of progress toward the conclusion, there might be an implicit acknowledgement
that the credit crunch is not unlike a baseball game.  And we know what they say
about ballgames: it ain’t over until it’s over. 

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 .
. .”