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.

Midas, Son of Gordias

People think of the Midas Touch as a good thing . . . So did King Midas of Phrygia — for a while.  After all, what could be better than having everything you touch turn to gold.  Forget quantitative easing and other modern-day Federal Reserve shenanigans; King Midas is the archetype for printing money first and asking questions later . . . 

And, indeed, not thinking through things was the beginning of the end for the good King.  After all, a Golden Touch is an epic gift right up until you need to eat (or in later recountings, hug your daughter.)  So there sat poor Midas with a glass of golden ice where his water had been and plate of gleaming food before him . . . and that's when his belly started getting rumbly.  Pretty soon, Midas cried out to Dionysus to reverse the gift the wine-god had given him (the Touch was payback for helping sober up a lushy-pants satyr.)  Dionysus — never one to pass up a glass of wine or a chance to teach a lesson — told Midas to head down to the banks of the river Pactolus and wash everything in its waters, thus returning the gilded items to their original states.  In the end, Midas was poorer, but wiser (for the moment.)

But some cats never learn: Midas decided to take his newfound wisdom and go hang out in the woods for a while with Pan, the god of mischief.  Always feisty, Pan challenged Apollo to a music contest.  Of course, Pan with his rustic pipes stood no chance against Apollo and his Golden Lyre on that week's episode of Olympian Idol.  When the notes were played, all the judges raved that Apollo had the better tune . . . except for Midas.  And not only did he vote against Apollo, but Midas also got mouthy with the Patron of Delphi much like an ancient Simon Cowell.  For his insolence, Apollo said, "you have an ass's ears!" and a pair of floppy donkey ears grew from Midas's head that stuck with him the rest of his days.

Aside from being a great exemplar of the Greek Tragic Cycle, what does this parable have to do with investing?  

Well, first off, you've got to admire Midas for his willingness to be contrarian during the Pan vs. Apollo battle of the bands.  I often note that the fear of being wrong and alone pushes people in finance to do conventional stuff and run with the crowd.  But in doing so, they take the possibility of being right and alone out of play.  This is what Lord Keynes was talking about when he said, "worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally”.  But being non-consensus right is where fortunes and reputations are made; that's the heroic investing quardant.  Of course, Midas probably pushed it a bit far in defying an Olympian god.  Indeed, while Mr. Market can be a harsh taskmaster, underperformance is rarely punished with the rageful pique that the Immortals could muster.  The two-by-two matrix below lays out the scope of outcomes for the financier.

Screen Shot 2013-05-09 at 10.46.55 PMAnd that's where this post comes full-circle: Back in 2005, I was pitching our then-latest private equity fund of funds offering to a salty investment committee.  Toward the tail end of the discussion, one of the most cynical of the members of that committee asked, "but how many Midas Listers are in your portfolio?" in referring to Forbes' annual ranking of venture captialists.  I started giving an answer that approximated a 2005 version of Dan Primack's critique from this morning, but after a few moments, I stopped and said, "but wait a second: you're not paying us to invest in the Midas List of 1999 — that's just conventional wisdom –you're really paying us to invest in the people who will be on the Midas List in the 2010s, that's the real challenge.  Some of them might be the same, but many will be different."  I didn't really believe in the Midas List, but the line made for great rhetoric.  I remember that discussion vividly because immedaitely after, I met my friend Josh Kopelman from a then-nascent First Round Capital for the first time for memorable lunch outside of Philadelphia.  

And indeed, while it seemed like a really contrarian move back then to invest in First Round's pre-institutional funds — among other things we did in those heady early days of the micro-VC movement — I always knew that there was something disruptive about the voodoo those guys were up to collectively.  Even though I remain pretty cynical about the Midas List, it has been gratifying to see some of the folks I've known for a while in the micro-cap VC space like Josh and now his partner Rob Hayes, Mike Maples and Steve Anderson (and cats like Bryce Roberts in recent years) get some well-deserved recongition.  Congrats to everyone on the List (even if I don't buy into it entirely.)  And thanks for making all of us that invested in you look good.  Keep putting that moolah in the coolah!

Cindy Crawford in a Bar

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. 

Hey, Hotshot

Remember that epic “Get the Feeling” ad campaign that Sports Illustrated ran during the mid-1980s? I seem to recall some print advertisements and perhaps a television spot or two, but it’s the billboards that peppered Brooklyn during those summers that seared themselves into my memory.

Maybe it was the in-action pictures of larger than life heroes rendered at 14 by 48 foot scale? Or perhaps the provocative captions that asked questions most mortals would never be able to answer? One of my favorites accompanied a mid-swing picture of slugger Don Mattingly: “How Does It Feel To Turn a Slider Into a Souvenir? Get the Feeling. Sports Illustrated.” Then there was the one featuring base stealer extraordinaire Rickey Henderson in his classic “I’m about to run” pose: “How Does It Feel To Know You’re About To Break the Eighth Commandment? Get the Feeling.” Of course, that question was a bit less remote in a neighborhood where “thou shalt not steal” was considered more of a suggestion than a hard-and-fast rule.

But it was an over-head shot of some over-sized state college football stadium that captured my imagination. Splayed out across every inch of Astroturf were dozens upon dozens upon dozens of corn-fed Midwestern boys stretching before an early-season practice, all with one question on their mind: “will I make the squad?” The caption below asked, “How Does It Feel To Know You’re Just Another High School Hotshot?

And lately, when the day's FexEx drop is particularly bountiful and several more private placement memoranda are added to the pile already strewn about the sidetable in the office, I've wondered if that ad might work just as well for the private equity world.  After all, top quartile funds are as plentiful as fleet-footed recievers out of Ottumwa or Odessa.

Indeed, in 2011 a bumper crop of freshmen will be vying for a limited number of open roster spots.  What factors will seperate the starters from the bench-warmers from the water boys?  This year, simply being good won't be close to being good enough; my own two cents is that too few GPs think critically about what makes them and their strategy truly distinctive and defensble. 

So in honor of the new year — and the inevitable flood of funds expected to come to market in 2011 — I thought I'd focus the first few posts of the year on fundraising, offering over the coming weeks some going-to-market observations, tips, and maybe even best and worst practices. 

After all, there's little comfort in knowing that the number four quarterback at BCS-bound State U probably has the raw tools to play in the NFL if you actually happen to be that number four quarterback.  Maybe over the next several posts we can work through throwing mechanics and defense-reading a bit in hopes that the competition for the scarce roster spots will be more robust.

Strategy 101

Let's talk about strategy for a second. 

Now, strategy is a topic near to my heart since, you see, I was a young strategy consultant — one of the "Kids in the Conference Room" during the mid and late 1990s (that New Yorker article — linked here again in case you missed the link a dozen words back — offered some menacing portent for the subsequent "The Smartest Guys in the Room.")  Now, I wasn't one of the McKinsey cats, but I was at another of the "B's and M's" (the en vogue catch-all for the then-hip consulting firms.)  And indeed, that article struck just a bit too close to home, as it kept quoting clients talking about "snot-nosed 25-year olds" and I could take cold comfort from the fact that I was almost 27 at the time.

(It was a great experience, though, and one of the most valuable things I learned during those years was the Mike Porter definition of strategy: "strategy is an integrated set of choices that inform timely action."  You couldn't leave an offsite training confab without being able to recite the definition when asked. The lazy, petulant, or merely hung-over soon found that they could get away simply saying: "informed choice/timely action."  Four words and you were on your way . . . )

And so what?  Well, I'm writing about it because I'm amazed at how often companies confuse strategy and tactics.  Tactics are not strategy; tactics arise from strategy.  I'm seeing this muddling a lot of late.

But I don't want to get pedantic about it; I'm really bringing it up to amplify the concept that strategy is a set of choices.  And choices are about the things that you don't do, as well as about the things you do decide to do.  The problem is that deciding not to do things is hard and, in particular, deciding to take a decision to stop doing things that you're currently doing can be even harder.

As you'll recall, I wrote about focus a while back and it seems now that focus is a lot more critical as 2011 business plans are getting finalized and people are starting to get (maybe?) more optimistic about business conditions.  The temptation exists to start doing a lot of things that weren't being done during times of belt-tightening.  And I'm not saying to not to do those things, rather, I'm asking folks to think about doing things in the context of the inegrated set of choices they're making and how they inform timely action that has the Great End and Real Business of optimizing shareholders' (or stakeholders') success functions.