Patience in the Time of Least-Worsts

Yesterday, I caught myself chain-drinking Diet Cokes again.  With about ten ounces left in my Double Big Gulp, I'd start waltzing over to the 7-11 on Lytton.  By the time I got through the door, it'd be time to reload. 

Maybe it was the caffeine, but back in the office after my third trip – cumulatively $2.97 lighter in one kind of liquidity, but 192 ounces heavier in the other – I started freaking out.  After all, there are a lot of chemicals in Diet Coke.  Would my habit end with a baseball size tumor in my head?  I am the lab rat. 

I once talked to my pal Ross about my Diet Coke problem.  He's a legit M.D. (as in Medical Doctor) and he went on a riff about caffeine addiction.  He then talked about the psychological issues that caused me to chug DC.  Cliche that I am, I drink up in times of stress.

And what stressful times we live in!  You can't take a meeting nowadays without hearing tales of struggling portfolio companies.  And some of these companies need serious cash infusions to stay alive.  Good money after bad?  Bad money after good?  Who knows?  Either way, people are spending a lot of time facing dilution and worrying about company mortality.

And then, there's the constant stream of managers asking for amendments to their documents allowing them to do crazy stuff like borrow money so they can buy Elbonian sovereign debt (don't worry about UBTI or style drift, lad, we're being opportunistic!).

Now, LPs want to be supportive, but only to a point.  And for some LPs, GPs are getting perilously close to crossing a line.  And some of those LPs are starting to talk about pitching out every last one of their seemingly-hapless managers.  Or at least refocusing their portfolios on something that's hot.  Like secondaries.  Or distressed.  Or distressed secondaries.  Or secondary distress. 

Now I'm not against being nimble, but we've gotta guard against being rash.  After all, rashness is the curse of the public market investor.  In charitable moments, I like to think that we private market investors are more patient, more thoughtful.  At less sanguine times, I'm glad that the PE fund structure keeps us from being too quick on the trigger, like those wacky individual investors.

Which leads me to my all-time favorite bit of research: there's a great Morningstar study that recounts the experience of mutual fund investors over a five year period beginning at the end of 1989.  Over that time, the S&P returned 12.22% per annum over the period (ahhh, the good old days!)  And in the same period, a group of funds Morningstar examined returned 12.01% (on a time-weighted basis).  Fair 'nuff.  But the kicker was that the actual investors in those funds only achieved a 2.02% dollar weighted annual return.  That's over a thousand basis points of leakage (!) due largely to market timing.  There's a lesson there about chasing performance.

But wait a second: it's not just the individual investors who are buying high and selling low.  I mean, look at commitments to VC about a decade ago, or to megabuyouts a couple of years back.  I guess it's just human nature to chase the shiny new penny (and to take comfort in the fact that other people are doing it alongside you).

Sometimes, too, people fixate on running from something, instead of what they're running to.  We've all had anywhere-but-here moments — they're particularly common nowadays — but it's important to resist the whip-saw.  After all, our managers didn't collectively take a buffoon pill during late-2008.  Of course, we may have missed potential land mines in our diligence, or perhaps the stress of funky markets has exposed previously-unseen flaws.  But we loved all our GPs once, and we loved them for a reason. 

And every now and again, we need a little reminder of those reasons.  So when I find my conviction a-flaggin', I'll pull open the bottom drawer and re-read some old investment memos.  That's a great way to pull yourself back from the ledge. 

And in a time when people want to do something (anything!) to feel like they're in control of uncontrollable events, it might be worth taking a moment to reflect on the admonition that Truman's Secretarty of State, Dean Acheson, directed at staffers who were getting over-excited during the early days of the Cold War: "don't just do something, stand there!"  And just as in those days, we're living in a time of least-worsts.  Maybe now, as then, patience may end up being a critical element of the road out of this mess.

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! 

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.

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."  

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.

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.

Heading to Abilene?

So I’m a huge fan of a good story.  And I also love thinking about how decisions get made in organizations.  Put the two together and I’m hooked; you had me at hello – or in the case of the Abilene Paradox, you had me at “hey, y’all.”

For those of you who don’t know the Abilene Paradox, it’s a management parable about a family in a dusty Texas town that ends up traveling fifty miles to Abilene for dinner because nobody spoke out against taking a trip that none of them had wanted to take, not even the person who had halfheartedly suggested they go to Abilene!

It’s an interesting story because businessfolk are constantly making group decisions.  And in a rush to make choices, these founders, GPs, LPs,CEOs, or whatever often seek to avoid the discord that can lengthen or even derail the decision-making process.  But in seeking to tamp down possible conflict, these choice-makers typically fall victim to the ever-lurking, insidious evil of groupthink. 

And over the course of a year, a team can make hundreds of decisions.  Since strategy is an integrated set of informed choices that lead to timely action, decisions build on themselves and all of a sudden the failure to speak up in even the smallest of debates can have repercussions that resonate over time.

In a tough economy the cost of poor choices is higher, since capital is scarcer and sand slips inexorably through the hourglass.  Precisely at the time when people should be emboldened to speak up, the opposite seems true.  The pendulum swings from greed to fear and people are motivated by trepidation, insecurity, timidness.  Upward feedback can take on a rosier glow than usual.  There’s an old Japanese proverb that seems to encapsulate people’s fear during tough times: “the nail that sticks up is the one that gets hammered down.” 

You can also get the blowhards in downturns: the “often wrong, but never in doubt” crowd.  On the one hand, I love those cats.  They get stuff done and they're proud of it!  On the other hand, maybe Yeats was describing them when he said, “the best lack all conviction / while the worst are full of passionate intensity.”

But hey, it’s all self-preservation; people are hard-wired by millenia of evolution and decades of experience to act in certain ways in times of stress.  I can dig that.  Robust debate and intellectual honesty are actually pretty complicated and counter-intuitive.  Sometimes, it’s just easier to go along and get along.

So here’s my Christmas wish: forget the Wii Fit; all I want from Santa this year is for my GPs and portfolio company management teams to crank up the frankness a bit for 2009.  You guys are a pretty honest bunch to start with, no doubt, but maybe we all can make a New Year’s resolution of going out on a limb a bit more, while also cutting everyone else a little extra slack.  The quality of your debates and decision process may well prove to be the difference between an unwanted dinner date in Abilene and an invitation to ring a bell at 11 Wall Street.

Frankie Say: Relax (Don’t Do It)

The first time I saw a swan we were on a class trip to Central Park (Look, kids!  Nature!)  White and fluffy and graceful, that swan was nothing like the flying rats we had back in Brooklyn.  I remember, too, that our teacher said a pair nested every September over at the 79th Street Boat Basin.  I bet this year those swans are black, though.  After all, can there be any other explanation for daily market moves that look like annual returns? 

Of course, volatility decreases with the square root of time — but increases Pepto-Bismol sales exponentially — and spreads a pall over the land.  Go find a trader at day's end; they're a mess.  Better yet, go find a lender looking to make a loan to a PE-backed company.  Good luck: I'm told they've all called it a year.  Nor has the innovation economy been spared: even my neighbor here in Silicon Valley who's working on some cold-fusion, perpetual motion, flux capcitor gadget has his own personal raincloud nowadays. 

But I try to keep upbeat.  Isn't that my duty as an American (or is it to go out and shop?  I forget).  And I was doing a pretty good job of staying positive until my old buddy Copter called.  (Back in the day, we called him Copter because because he was unflappable, he had no flaps.  Get it?)  Anyhow, Copter lives the Wall Street life, complete with pocket square, and he rings me every now and again to take the pulse of an institutional (or as he would say, "institutionalized") investor.  And this time, after some chit-chat, he swooped in on me with some blood pressure-raising questions.

"So how do you think people are fixed for liquidity?" he asked.  "You think cats are going to start defaulting on capital calls?"

"Naaaah," I said.  "We're talking about professionals.  Things would have to get pretty extreme." 

"But what if it got to that?" probed Copter, "Would it make sense for funds to start pre-emptively calling capital to build a cash cushion in case people did default?"

And with those words, a wave of dread washed over me; I suddenly felt like the green-eyeshade bank teller who slides open his window only to be greeted by a line of angry depositors stretching out the door and around the block.  "Copter, you're talking about a run on the LPs.  That's madness!  You quit that right now!  Relax."

"Relax, don't do it?" Copter said.

"Yeah, relax, don't do it,"  I replied.  But quoting 80s songs felt kinda lame when talking high finance, so I decided to go for some gravitas and drop some B. Franklin on old Copter: "Remember, Slugger, LPs and GPs are partners in this thing and if we don't all hang together, surely we shall all hang separately."

"On that note, bruddah, I gotta go hang at Gotham Grill with my girly-girl," and Copter hung up the phone and whirred off into the New York night.

As I sat there in a vortex of prop wash a continent away, I was relieved to see a email from my buddy Peter that turned the day right around and contained some of the best advice I've seen so far.  Fabricated or not, I gotta say the screen below contains perhaps the best Bloomberg headline ever.  Forget the Fed, I got my bailout from the BOJ (that's Bank of Jamaica, not Bank of Japan):


[Hey, mon, if you created this and own a copyright – or if you're Bloomberg – and want this taken down, email me at the link above]

Moving Parts

Psst!  Hey you!  Yeah you . . . the GP reading this blog to take a break from portfolio company panic attacks.  Here’s a flash: you know those LPs of yours that totally dig the voodoo that you do and rank as your most stalwart supporters?  Guess what: chances are that they’ll be on to the next thing (or even the thing after that) by the time your fund reaches the end of its 10 year (plus however-many-extensions) life.  In fact, if you gave me 9 to 5 odds I’d bet that they’ll be gone by your next fundraise.  Even money says they’re on to the next thing by the fundraise after that.

Whoa, whoa, whoa . . . don’t get me wrong: I’m not trying to stick a thumb in anyone’s eye.  I’ve got a ton of respect for every last one of my Limited Partner brethren.  People who live in glass houses shouldn’t throw stones or walk around in their skivvies and it wasn’t all that long ago that I left Old Ivy either (from Old Ivy’s perspective, it was probably addition by subtraction!)

It’s just that the velocity of money out there is so high and the velocity of people seems even higher.  But it’s not just the bucks that cause people to move around: in some cases it’s taking ownership of a portfolio or starting with a clean slate; in others, it’s finding a better platform; in yet others it’s scratching that entrepreneurial itch; and sometimes, it’s just about better weather.  Folks from endowments, foundations, pensions, funds of funds, you name it are on the move.  The character of their moves may differ, but lots of people are staying one step ahead of the sheriff.  And it’s all good; this is America, Land of Opportunity: God Bless It.

I do remember, though, when I first started thinking about becoming an institutional limited partner.  My buddy Seth beguiled me with tales of long-term working relationships that transcended the transactional, yarns of robust institutional memory, stories of principals, not agents.  These were stories of people with steady hands on the tiller who understood their GPs thoroughly, intimately, and sometimes worked hand in hand with those GPs to stretch the envelope of investing comfort.  (And as you know, I think that there’s a risk premium to be had from the arbitrage of discomfort).  The implication was that stable institutions had better results.  At the very least, good GP-LP relationships (at the individual level) helped you to avoid a bunch of the time-wasting and aggravation that arises from intramural struggles and constant re-education.

So here we are, not quite a decade later and I see GPs fretting about having had nearly a half-dozen coverage people at some institutions over the past several years.  And just the other day, I realized that one of my Advisory Boards (for a solid 2004 fund) has seen seven (!) of its ten institutional investor reps leave their institutions.  Will it matter?  Dunno.

But with so many moving parts, funky behaviors sometimes follow and that’s what worries me. Occasionally, you see increases in institutional inertia as new LPs take a light touch with “valued relationships” that might otherwise be dead wood.  After all, who wants to run the risk of kicking a once-great (or maybe-someday-great) fund out of the portfolio?  It’s easier just to re-up.  ("Everyone else" is doing it anyhow.)  Sometimes, you see the “new sheriff in town effect” where people seek to clean up the portfolios they inherited; sound and fury ensue!  Babies get thrown out with bathwater and the last cat gets all the blame while the new cats think they’ve got a clean slate.  Somewhere between those two extremes is the right approach, but the former is the path of least resistance while the secondary market keeps growing to help facilitate the latter.

But I fear there’s a casualty in all this: Partnership with a capital P.  The best LPs are Partners, while the worst are just money.  And with all the musical chairs out there, I do wonder if we LPs are training GPs to treat all of us like temporary placeholders?  High-touch relationships marked by consistency and predictability lead to a better interactions while weak relationships are governed by the least common denominator: the legal docs.  As an old-time VC once told me, “the minute we have to open the bottom drawer and pull out the fund docs, we’ve all lost.”

I’ve been lucky to see a whole lot of GPs end up doing what’s right, not just what’s allowed.  I just fear, though, that as folks continue to bounce around – resulting in more tenuous relationships and more amnesiac institutional memory – that such behavior will become increasingly rare.