Tradecraft

November 14, 2008

An Open Letter

Dear Portfolio Company CEO,

Hi, my name’s Chris and I fund the folks who fund your
company.  I’m the money behind the
money.  I can’t remember if we’ve met,
after all, I’ve got several hundred cats just like you in my portfolio.  There’s a chance that we talked at your
backer’s last annual meeting; maybe I visited your factory; or perhaps I called
you for a reference check.  You may not
remember me, but I was the dude wearing the red t-shirt under my dress
shirt.  I took good notes during your
talk and told daffy stories during the breaks. 
Yeah, that’s me.

Anyhow, I wanted to drop you a note since I’m a bit worried
about you.  You see, the last time the
economy slumped, we LPs heard endless tales of management teams that just
couldn’t stay ahead of the game.  “We
discovered we had a bull market CEO on our hands,” was a common refrain.  “Those guys were a great growth team, but
when the going got tough . . .” 

It seemed like private equity funds went through CEOs like the
Yankees used to go through managers (although I’ll note that Stump Merrill couldn’t
have been fired fast enough, but that’s another discussion.)

So there I was, talking to my Operating Partner buddy,
Bruce, about this phenomenon and he made a clarifying point:  “Management is always an exercise in battling
entropy,” he opined.  “Order tends to
disorder and the application of energy is required to restore order.  It’s an immutable law of the universe and
it’s a law of management.”  Consequently,
he continued, “in tough times, the disorder comes at you a whole lot faster and
requires a lot more energy to manage.” 

I don’t think that it’s too much of a stretch to say that
energy is a function of time and people who are cavalier about time become
magnets for disorder.  It’s like Lucy and
Ethel in the chocolate factory: the conveyor belt speeds up and there’s just no
place for all those blasted bon-bons to go.

Indeed, the ingredients of any business are: ideas, people,
capital, and time.  And of those
elements, time is the most immutable, the most obstinate, the most
tyrannical.  They’re just not making any
more of it!

You have but one weapon against this cruel oppressor: focus.  
In  good times, managers don’t
have to focus as acutely because the creation of good stuff outstrips the slouching
to disorder.  The great all-weather
managers, on the other hand, have to focus because they realize that time is
really expensive and when the creation of good stuff slows, entropy lies in
wait.  Choose what to do and what not to
do.  Just choose quickly and be explicit
about your choices.

We’re all in this together. 
Your success becomes my success (less, ahem, the GP carry) and I’m
rooting for you.  You guys are the
beating heart of the entrepreneurial economy. 
You guys rock nonstop.  Stay focused
and be careful out there; you’re facing the greatest enemy of all: time.

Forging ahead,

Chris

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?