May 27, 2009

A Hundred Days, A Hundred Months

Sometimes, I envy public market investors; occasionally I think, "wouldn't it be nifty to actually see your investment theses play out in less time than a presidential term or two?"  But then I remind myself how cool it is to watch portfolio companies flourish and strive and struggle and dream.  It's like watching your nieces and nephews – the ones you see only about once a quarter – grow and mature.  And all that waiting and watching pays off.  Doesn't it?

I've been asking that question a lot lately.  After all, on Day One of LP School we're taught that there is compensation for patience. Illiquidity is one of the key risk premia we collect (right?).  At Old Ivy, we always said, “fifteen percent compounded forever is a lot of money . . .”

But I worry that some in the PE world seek illiquidity solely for illiquidity's sake.  Or even more cynically, I occasionally fear that there are some who hide investments gone sideways behind a veil of prudent patience.  So, let me ask heretically: what if all of the talk of long term horizon is misguided?  What if the compensation for holding an investment to the out-years is inadequate relative to the risk?

Let me double-click on that for a moment: nowadays most buyout shops tout their Hundred Day Plans.  Think: Metrics!  Dashboards!  Flash reports!  SWAT teams!  (Or are those SWOT teams?)  Some firms have upped the ante and talk about working to kick off The Plan even before they close on deals (how proactive!).  And all of this stuff is music to LPs's ears, giving the impression of catalytic ownership.  Now we know why we're paying these guys the big bucks: it's because they do . . . stuff (and they do it fast!).  And, sure enough, skilled owners can help businesses achieve real value inflection points.  Some even have grand plans for strategic repositioning that will take many years and a half dozen or more add-ons to come to fruition.

But here’s a question: how long should one hold a company to capture value?  Come in, rock your 100-day plan, catalyze a bunch of change, stabilize the company, get eight quarters of growth under your belt, and hope for a good exit market in years three or four.  Easy.  (Of course, easy can be very, very hard.)   

But think about it another way: if there’s a value creation curve for the typical company, I’d imagine it’s very steep in the early years, with a flattening in the out-years.  There might be an inflection point or two beyond the initial surge, but the rate of change almost certainly slows as time passes.  Meanwhile, business is moving ever quicker – just talk to a biz dev team using The Cloud to fast-cycle product testing and launch, or a manufacturing group using lean production – and execution challenges are unending.  One could even posit that owning companies in the out-years is more risky than anyone expected; there might even be a case to be made that risk-adjusted returns go down in the out-years.  Maybe that’s why so many LPs grouse that their portfolios are full of over-ripe companies.

Perhaps there’s a way to think rigorously about which of the ripe fruits to harvest and which need some more vine time: I know of at least one group that methodically re-underwrites its portfolio every six months and asks, "what is the distribution of the prospective returns for each of our portfolio companies?"  Implicit in the exercise is a belief that at any moment, you’re either a buyer or a seller.  Those companies that exceed a certain hurdle rate stay; those that don’t go out for sale.

Now don’t get me wrong: I’m not saying that folks should sell prematurely or sub-optimize exits.  Instead, I’m talking about a meticulous re-underwriting process that asks hard questions about prospective return, risk, uncertainty, and liquidity horizon.  Of course, GPs are generally incentivized to let their winners run, even as rate of return slouches (as long as the multiple contribution is positive).  LPs, on the other hand, want their money back yesterday.  These divergent views express the tension inherent in unknowables: what does the future hold?  What are the opportunity costs?  For the GPs?  For the LPs?  Is it worse to sell too early – or run the risk of holding on too long?

And whenever I ponder these kinds of questions, my mind wanders back to one of my mentors, a dyspeptic Frenchman who seemed to be forever enshrouded in fogs of Gauloises and cynicism.  Once, after he’d helped me finish a thorny financial model, I asked him what he thought.  “Bof,” he replied with a shrug, “after year three, life is all terminal value anyhow.  The important thing is to make sure you get those three years right and the terminal value will take care of itself.  The first steps are often more important than the last.”

[Originally posted as the 5/27 guest column on PEHub.com]

May 11, 2009

In the Time of Chicken and Broo-Lay

Gah!  It's been a few weeks since I last posted, but I've got an excuse: it's annual meeting season.  Now in good times, the meeting circuit can be like a Saturday night in LA (or so I'm told).  Folks caravan from house to house, party to party, over the hills and though the canyons.  Gentle sea breezes caress the travelers as the complicit stars wink from their high perch.  The venues are different, but the guests are the same.  We hear stories of heroic exploits in far-off lands . . .

But in bad years, the season can be more like the Odyssey.  Adrift on a storm-tossed sea, we find each port more perilous than the last, the gods conspire against us, our hosts are full of treachery and guile, we grow haggard and dispirited . . .

Needless to say, this year feels more like the latter.  I thought about trying to write an Odyssey parody, but before I could say, "sing in me, Muse," it hit me that maybe I could offer (with help from friends) something more interesting: an answer to that perennial GP question, "how could we make our annual meeting better next year?"  So I informally canvassed some LPs and collected thoughts on best and worst practices.  I'll share those below, but I'd love more good ideas.  The GP you help may be your own . . .

***

The Good

Better annual meetings are marked by high levels of information sharing and candor.  After all, we're not just investors, we're Partners, right?  I've talked in the past about Partnership with a capital P and at the heart of such a relationship is an open and honest dialogue between peers.  An annual meeting can't in itself be the be-all/end-all, but it can help set a tone for the relationship.  To that end, here are a handful of crowd-sourced ideas that might be worth considering (some sublime, some miscellaneous):  

  • Breakout Sessions: The most tedious meetings sometimes feel like interminable lectures.  The presenters drone on, often reading slides verbatim (engendering the too-common, "I flew here for that?" reaction among investors).  As an alternative, some LPs suggested devoting a chunk (if not all) of the annual meeting to topic-focused breakout sessions with a GP or two leading an interactive talk among a manageable subset of people . . . something akin to college discussion sections (but without the ill-tempered, Gauloise-puffing grad student). 
  • Portfolio Company Speed Dating: One VC fund has a biennial "science fair" at which LPs rotate among breakout
    rooms, checking out different technologies and talking to entrepreneurs.  Other VCs schedule days for portfolio companies to have rapid-fire meetings with BigCo biz dev or M&A teams.  Why not use those as a model for a couple of hours of few-on-1 meetings between interested LPs and portfolio company managers?  Think of it as the "speed dating" alternative to the meat market that is the pre-dinner cocktail party.
  • Simple Scoring:  Sometimes it's hard to get a really good sense for company progress, especially during the staccato sprint through 30 company slides in 15 minutes.  Sure, the EBBS (Earnings Before, ahem, Bad Stuff) margin at one firm is up 23 basis points from last year, but how is that company doing?  Sometimes the torrent of numbers crowds out the analysis and handwriting atrophy that arises from all the typing we do prevents us from scribbling notes as fast as we once did.  A couple of folks suggested using a consistent green/yellow/red rating system for portfolio company assessment.  The slides could even break out the ratings along critical dimensions: strategic positioning, team development, execution, progress to exit, etc. 
  • Year Over Year Accountability: Too many company discussions take place in a vacuum.  Sure, we like to hear about metrics, but some LPs asked for those metrics to be contextualized relative to last year's expectations.  Maybe gross margins at firm X grew 36 basis points, but what if you said last year that you expected them to grow 50?  Or to grow 25?  There's some interesting discussion fodder in that delta.  Sure, we all dust off last year's notes (I gotta admit that I'm just getting around to typing up notes from last October,) but it would be helpful to take more of a longitudinal view, rather than a snapshot. 
  • Management Team Videos: Some folks are big fans of meetings where CEOs are present, but in lieu of a live presentation they show edited 3-5 minute videos of portfolio company teams describing the voodoo they do.  That way, attention can be focused on the most critical topics while avoiding the too-frequent CEO presentation that rambles on for twice its allotted time.  Don't get me wrong, I love portfolio company management teams, they just happen to be more fun at the cocktail hour than up on the podium. 

  • Traveling Light: I've had annual meeting road trips for which I've packed an empty duffel bag just for all the binders I'm sure to collect.  Offering to FedEx meeting materials back is a huge help (and here's a cost saving tip: we'll probably still be on the road when those binders arrive, so you can save a few bucks and send the packages second day).  Some people even send CD-ROMs or USB keys.  To that end, my buddy Du (the SuperDuperLP) even suggested a green twist: BYO (bring your own) USB to give to a staffer for instant download.  Saving postage and saving the Earth.  Brilliant! 
  • Eat, Drink, Be Chatty:  On the networking front, several LPs asked for longer cocktail hours and one even described the cocktail hour/heavy hors d'oeuvres combo as being preferable to an outright dinner.  For those who do opt for a dinner, some LPs suggested having the speaker talk during the meal or dessert, rather than having us wait until after everyone finished.  Emily Post may protest, but the last thing people want after a day of travel is any more chair time. 
  • A Wacky Idea:  Speaking of dinners, I've got a love-hate relationship with formal meals.  Usually the tables are too large and the conversation atomizes into pods of two or three.  Most of the time, that's ok, but sometimes, the chemistry is funky (and I always feel bad for the folks stuck talking to a blowhard like me!)  What if tables were reshuffled between courses, giving everyone a fresh set of people with whom to chat?  It might be a nightmare of choreography, but could be really cool if well-executed, doubling (or more) the number of interactions one could have. 

The Not-So Good

Some of the most frequently reported-on worst practices were little more than poor executions of good intentions.  Said another way, every vice is just a virtue taken to an extreme:

  • A Bad Start: Please don't spend 15 minutes and four slides at the outset of the meeting describing the fund's strategy. 
    We get it, we've already bought the ticket and we're on the ride; yet
    several LPs reported amazement at how many GPs go through the same exact
    "what we do" slides year after year. 

  • The Never-Ending Story:  I love portfolio company managers, I really do.  But every time one
    bounds enthusiastically up to the podium, LPs communally draw a deep
    breath.  Will we get a crisp overview of the company and its progress? 
    Or are we going to meander endlessly through a jargon-laden discussions of the
    product/channel matrix and SWOT analyses of key competitors?.  One
    comrade described it thus: "I want to know enough about each portfolio
    to be able to ask the right questions, but I don't need a daily flash-report familiarity.  That's what I pay GPs for."  
  • Corollary #1 (Pecked to Death By Ducks):  Some funds instead do rapid-fire short presentations; someone mentioned once sitting through three hours of such 10 minute-long CEO talks.  After the first few, they inevitably start to blur together.  That LP's view on this topic: "thank God for Blackberries."  
  • Overscripting:  Few things are more painful than the verbatim read through of the slide deck . . . just send us the presentation and save yourself the room rental fee.  Double demerits for using a teleprompter.
  • Biology:  The length of time a meeting can run without a bathroom break should be regulated by either OSHA or the Geneva Convention.  Sure, one can scoot out for a restroom break, but who knows what you'll miss? 
  • A Riot of Numbers:  I love fund CFOs and I appreciate that they should get some airtime, but there are some who do little more than recap the data from the most recent quarterly report.  Assume we read the QR; please peer instead into your crystal ball to tell us something about expectations for the fund going forward.  The best such discussions explore what you need to believe to get the fund to a given return threshold. 

  • Cruelty to Fake Animals: Lastly, we've all got enough fleece to have stripped bare a large herd of polypropylene sheep; no mas, please!  (Titleist Pro V-1s, on the other hand, make for swell souvenirs.)


A Meta-Thought

I spend a lot of time talking about the difference between transparency and intimacy: transparency is simply a line-of-sight, but intimacy is about having an intuitive sense for what goes on in the Monday meeting, understanding how the cast of characters lines up on key issues, having a feel for which companies are doing well or poorly, knowing which partner on a roll and which one lives under his own personal raincloud.  Transparency is about data, intimacy is about information. Transparency is about investments, but intimacy is about Partnership.

And a good annual meeting can improve intimacy.  In addition to the obvious information gathering, the tone of the meeting and what is not said can be as important as what is said.  When I was surveying folks, a handful of LPs
wished out loud that some of their GPs had showed some humility and had taken more responsibility for their portfolio struggles, rather than blaming "the environment."  Even in the best of
times, the markets can be a humbling place, sometimes favoring the lucky, but mediocre investor at the expense of the unlucky but good one.  A bit of candor
and self-reflection goes a long way towards creating durable goodwill
while obfuscation and buck-passing makes people crabby.  Don't be
afraid of bad news; it's an opportunity give your partners a peek behind the curtain.  After all, we're in this
together.  

April 2, 2009

Fundraising Trials

So I’ve got this presentation that I give every now and again to young VCs, LBO firm associates, business school students, or anyone who wants to listen.  It attempts to describe the voodoo we institutional investors do.  Back in 2004 when I first put the deck together, I included a slide called, “Many Hats,” which tried to enumerate some of the roles that LPs play: “high throughput screener,” “investigative journalist,” “professional skeptic,” and “good cocktail party guest,” among them.

So before heading up to Tuck to help out at the “Field Studies in Private Equity” class (what a great course name, by the way!  I imagined the students would be wearing pith helmets and binoculars,) I revised that slide for the first time in five years.  Boy, has the world changed!  I added a “Many Hats, 2009 Update” to include some of the new roles we play: “referee,” “therapist,” “bargain hunter,” “accountant,” “whipping boy,” etc.  You get the idea.

It turns out that I missed one major role that I’m playing nowadays: informal fundraising advisor.  After all, it seems like everyone who’s raising a fund today is engaged in a Sisyphean rock-roll.  And of course, I’m always glad to brainstorm with folks who have differentiated investing strategies about how they might magnetize some moolah.

But I've got a confession to make: I'm worried that I've been giving people the wrong blanket advice by telling cats who have some money raised — but perhaps not as much as they'd like — to wrap up fundraising, get back to investing, and live to fight another day.  After all, fund size is a function of time. If you raise half the amount of capital you'd like, deploy it at the same pace in about half the time.  Then come back when the sand has been lubricated out of the gears of the financial system.  Sure, there's a bit of a fee stream impact, but the brain drain associated with dealing with institutional investors right now is just way too high.

But then I had this epiphany: it's not just that there's sand in the gears, it's also that many investors are changing their entire evaluation paradigm.  Between the dreaded Denominator Effect, investor fatigue, and a new impulse to "Keep it Simple" while eschewing complex "modern" portfolio management, I think that the new normal will be "show me," not "tell me a story."  During the recent market madness, the cost of illiquidity was so high that people will remember the sting for a long time.

And then it hit me (largely because I was sitting in a healthcare fund annual meeting at the time): I think a better metaphor isn't "live to fight another day," but rather, "you're in FDA trials." 

Think about it:  when developing a drug, there's the initial preclinical work: can you prove the concept?  Phase I trials test for safety.  Is this drug going to have any zany side effects?  Phase II investigates efficacy: does the treatment work?  And Phase III ascertains whether the treatment is better than the current standard.

Now, in a metaphor for the drug development process, young funds go through a period where the first handful of deals test the proof of concept.  Can these cats pull this off?  Then, you've got another bunch of deals that ask the question, can they scale their strategy without blowing up?  Then, there's the next stretch of transactions — a larger number, not unlike the larger patient populations of Phase II trials — where you really start to get a sense for whether a fund is going to work or not.  And then you get to the metaphor for Phase III (which, interestingly, often coincides with fund III) in which you can see a robust test of the hypothesis.  Is this thing better than the alternatives?  (Of course, by then, it's typically too late to get on the bandwagon, so the sweet spot is usually somewhat earlier.)

The challenge for younger funds, then, is to have some self-awareness of where they are on that curve; are they far enough along that a handful of additional deals might offer some incremental proof of efficacy or, perhaps some more time might allow an existing deal or two to ripen?  Or are they so early in their evolution that the risk-averse might still consider them to be only in Phase I when they return to market a few years hence?  In that case, those groups may want to forge ahead in raising money now while the field is relatively uncrowded.  Those hard-won dollars could extend the runway just enough.

But I'm a bit bummed that my reasonong was flawed all along: I'd assumed that the market would generally be more receptive a few years hence when cats came back for their next fundraise.  But I now think it's going to take a lot more than readiness; it'll take good progress in the clinical trials.  Those groups that are tempted to say, "the readiness is all," and come back without making much progress in their portfolio might recall that Hamlet used those exact words and was dead a couple of pages later.

March 16, 2009

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.

March 2, 2009

Frenemies

It was the summer of 1985 or ‘86 and my pal Feeney spent an afternoon trying to convince the cat owners in the neighborhood to offer up their felines for a sparring match with his family's black lab, Benny. It was a pretty boneheaded idea and Feeney wasn't having any luck.

Eventually, old man Moran got wind of what Feeney was up to and called out from his stoop to the pack of us kids as we lurched from alley to alley in search of a stray cat stand-in. “What da hell youse guys tinks is gonna happen wit dat cat and yer dog?”

“Benny’s gonna kick some ass!” replied Feeney.

“Never happens dat way,” Old Man Moran called back over the top of The Racing Form, “Youse guys gotta understand dogs and cats; dey want different tings. Dogs just wanna jump around and bounce off da walls and lick people. Cats just wanna be left alone and get fed. But when a dog comes over all crazy and tries to bother dat cat, the cat’s gonna claw dat dog to pieces.”

Cats and dogs and debt and equity: two pairs of things that are more alike than not.  And I'm wondering if I should start getting worried because half the PE managers I talk to nowadays are looking to pick up debt that’s trading on the cheap. And half the bankers I talk to are getting tons of calls from GPs looking to buy out the debt of distressed companies – sometimes in the very companies in which those PE guys own the equity.

Now I’m not against people looking to be opportunistic – or better yet, trying to retire debt and give their companies some breathing room – but a surprising number of folks are out there looking to buy up their companies' paper as a money-good investment that pencils out to a nice standalone return while their equity enjoys some sweet upside.

But here’s my question: debt and equity are like cats and dogs, no? I mean, they want totally different things: the debt wants stability, predictability, visibility. The equity, on the other hand, is the call option on the excess assets of the firm.  And like any good option, the payoff is asymmetric: wins can be very big.  And the losses?  Well, c'est la vie.

Or maybe debt and equity are frenemies.  That's more like it.  They're close, but there's a huge amount of tension in their relationship; they simultaneously love and hate each other; they can't stand each other, and they need each other.  Their relationship is complex and contentious, vital and complementary.

And as any contemporary teenager or Simple Life aficionado knows, sometimes the hardest place to be is in between two frenemies.  Ever-shifting sands and constant demands for loyalty can be a recipe for headaches.  I'm positive there will be some screaming good deals out there, but I just hope that GPs have a keen eye for the inherent tension and potential conflict of owning both debt and equity during stressful times. 

Sure, low price can cure a lot of sins, but I fear that if things stay bumpy a bunch of people who bought a side dish of debt to go with their equity entree may find themselves in the middle of a furball melee.  Old man Moran's admonition echoes across the years: more often than not, it's the cat (the debt) that ends up sitting smugly in the tree while the dog (the equity) whimpers away to lick its wounds.  Either way, it's a fight no one wants any part of.