There’s a great riff in John McWhorter’s book, The Power of Babel: A Natural History of
Language, that describes how expressive force in language diminishes over
time. His poster child is the word
“terrible” which once meant “causing dread or fear or terror,” but now is used
as a mild negative modifier (e.g.,
“I’m such a terrible putter that my wife got me personalized golf balls that
say, ‘three putt.’ ”)
Similarly, the language of business is littered with
expressions that slouched from overuse: phrases like “best of breed” went from
insightful to hackneyed over the course of mere years.
Of course, private equity has its very own once-powerful phrase that’s
meandered to meaninglessness: Top Quartile.
Now we all know how Top Quartile got to be the gold standard: a couple
of cool graphs in the Book of David some McKinsey studies, an
endorsement by an influential pension fund or two and Top Quartile was the
place to be.
Everyone wanted to be in the Top Quartile, and, soon enough,
most people were – if you accepted their pro forma returns based on aggressive
multiples of EBBS (earnings before, ahem, bad stuff) or included estimates of
what an acquirer might pay for a start-up once it had perfected its swell
product and revenues had started their inevitable ramp.
The problem with that kind of thinking is that it obscured
the true aim of private equity: return enhancement (relative to the opportunity
cost of equity capital, i.e., some
appropriate public benchmark). Success
was no longer about getting adequately compensated for taking incremental
risks; it was now about beating the next guy (or more specifically, the next
three guys).
And that’s the paradox, of course, of any peer-group
measure: when new entrants deploy capital, their extra dollars will likely
depress returns across the spectrum – since the marginal dollar tends to set
the price of assets – but the cohort of “winners” (with victory defined as
being Top Quartile) grows. The club gets
less elite as people enter from the bottom.
Of course, measuring private performance against a public
benchmark can be pretty tricky and is fraught with tough questions like: what’s
the appropriate evaluation horizon, how do you equalize for appraisal effects,
should you beta-adjust? to name a few.
As a result, it’s tempting to fall back on an easy measure like peer
group rank.
A while back, I started asking VCs what they thought the top
quartile breakpoint for venture over coming vintage years might be assuming
reasonably “normal” public market conditions.
In my informal and unscientific survey, more than half of those I asked
guessed that the top quartile line would be at or below zero. Surely, some firms will do fantastically
well, but if the VCs I sampled are right, it will be really amazing that dozens
and dozens and dozens of firms that tinker in one of the riskiest corners of
the financial world will be able to call themselves successful even though they
will have lagged the public market – not to mention cash – by many hundreds of
basis points. What’s more amazing is
that merely by surviving, these firms will earn billions of dollars in fees in
aggregate and the folks who funded them will dance a jig for having done a
great job.
It’s enough to remind one of an old story: two campers are
awakened by the sounds of a bear sniffing at their tent. While one of the campers starts panicking,
the other calmly starts putting on his sneakers. “Why are you putting on your shoes? There’s no way you can outrun that bear,”
whispers the first camper. “I don’t need
to outrun the bear,” replies the second camper, “I just need to outrun you.”
That kind of thinking may work for relativists, but the
important return-enhancing role that PE plays in institutional portfolios
demands that we instead ask: for all the extra risk and illiquidity we incur,
if you can’t outrun the bears (and the bulls) why bother?
Super LP 