Talking to GPs

July 3, 2008

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. 

June 9, 2008

Tragic Kingdom

When it comes to real twistedness – I mean deeds that are
way out in the tails of the normal distribution of human behavior – the
old-school Greek tragedies are heard to beat. 
Loathsome cunning and guile? 
Check.  Outlandish interpersonal
relationships?  Check.  Unbridled greed and lust for power?  Check.

Of course, the tragedies were morality plays that showed the
audiences of Epidaurus
what vices arose when virtues were taken to their extreme.  Remember that the Tragic Hero was a hero
first and tragic second.  And what made
these stories so compelling and spectacular and gut-wrenching was just this
journey from mortal to casualty of the gods.

A wise man once said that there were only a few dozen
archetypes in all fact and fiction. 
Lately, I’ve been wondering if some private equity pros might not fit
the Tragic Hero archetype.  Now don’t get
me wrong, there are a ton of virtuous and honorable people in private
equity.  I invest in people that are – to
a man (and woman) – decent and upright. 
That said, I sometimes think there are a handful of PE investors out
there that have fallen victim to the ancient unraveling . . . 

The cycle goes like this: first you have arete, which is some kind of
excellence.  Occasionally, this is known
as an outstanding Fund I or II or even VI (or even maybe a single headline
exit).  Once in a while, arete mutates into its sinister cousin: hubris. 
Things get really dicey when the excessive pride of this second step
leads to ate, an unruliness marked by
a loss of sense of human limitations and reckless behavior that offends the
gods.  Now the gods tolerate a lot of
horseplay, but mortals should act like mortals and those that get really out of
hand provoke nemesis, the vengeful
justice of Olympus.

The genius of the tragedies arose from the fact that the
behavior was so outrageous and the punishment so ghastly that the stories
offered powerful warnings of what might happen if folks got too far out of
line.  Of course, I never root against
anyone, but I do sometimes wonder if we’re not getting off too easy
nowadays.  Nemesis used to be pretty badass: offend the gods and you get your
liver pecked out by eagles.  Every
day.  Forever. 

Today, the PE Tragic Heroes who have incurred the wrath of
the gods (or their bankers) are simply consigned to slow their pace of
investment, toggle their PIKs, and maybe get an askance mention in the Wall
Street Enquirer Journal.  If
the fates are particularly unkind, the Journal’s ink dot hedcut of the
Fallen Hero transforms from cheerful and affable to frowning and consternated, a la Dick Grasso.  Not quite the kind of
metamorphosis that Ovid would write about, but I guess that’s the best we can
hope for in a modern world where all the options seem free (but someone else is
paying the price.)

May 27, 2008

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?