An Investor's Prayer
Grant me the courage to mitigate the risks that are mitigable
The serenity to accept appropriate compensation for those that aren't
And the wisdom to know the difference
Dispatches from the Disruption, Part 2
Here's the second half of last week's post:
Now, let's get back to one of my favorite topics: disregard for convention. A wise man once told me that most investors follow a set of rules that typically make them middle-of-road, B-level investors, but in breaking their rules they can become either A-level investors (rarely), or (more frequently) C-minus investors. And indeed, I've always been a bit insouciantly petulant about rules, but as far as guidelines go, but I've got to give James Montier from GMO a tip of the cap for The Seven Immutable Rules of Investing:
1. Always insist on a margin of safety
2. This time is never different
3. Be patient and wait for the fat pitch
4. Be contrarian
5. Risk is the permanent loss of capital, never a number
6. Be leery of leverage
7. Never invest in something you don't understand
And, generally, those are pretty darn good rules. The value investor in me swoons. But the Californian in me wonders if these rules are little more than a wind-break against the perennial gales of creative destruction? In this zip code, after all, those rules are more honored in the breach than in the observance. And surely, if investors had followed those rules exclusively all along, we'd still be communicating via horse-mounted couriers as we farmed the Appalachian Watershed with oxen, oppressed by the inexorable tyranny of the seasons and the immutable fright of nightfall. Instead, we live, work, and play in ways that are scarcely recognizable to our parents and would've been unimaginable to our forebears. Much of that progress was financed by the investors who broke their rules; some made mints while most didn't.
Now, I don't mean to critique value-oriented investing, as assets need an anchor around which to contextualize their valuation. But if the last century, with its optimists triumphant, suggested anything to us, maybe it's that the value of businesses isn't really the discounted value of their dividends? Perhaps businesses are better thought of as portfolios of options, some of which are very long-dated and way out-of-the-money. And maybe the central wonder of the American economy, with California as its exemplar, is that it offers the best framework for capturing the random forward lurch of progress? After all, the US economy, more so than that of any other nation, seems geared around exercising profitable options while letting unprofitable ones expire, often (and hopefully) cheaply. This asymmetry is getting even more acute as value chains continue to fragment and the cost of hatching and nurturing an idea continues to drop. The resulting left- and right-tail opportunities may be hard to differentiate from each other, but those who are unafraid of being wrong and alone will give themselves the electric opportunity of being right and alone.
I love working on a street thick with start-ups and it's been fun to watch these companies strive and stumble and pivot and grow. I love visiting them when engineers are piled up on top of each other in a too-cramped space; its a visceral and sensory experience when a startup finds its cadence. The old east coast value investor in me wonders aloud, "who would invest in this stuff? It's bananas! These guys are violating at least four of The Seven Rules!"
But the west coast Chris hears an echo of Steinbeck's description of Cannery Row: "[Silicon Valley] in California is a poem, a stink, a grating noise, a quality of light, a tone, a habit, a nostalgia, a dream."
Dispatches from the Disruption, Part 1
[Apologies for the self-indulgent post, back to investment soapboxing next time!]
Three years ago, I moved to California to open a new office in Palo Alto for my firm. (You'll notice I never name my outfit in the blog; that's not because I'm trying to be coy or an attention-hog. Rather, I've always tried to keep the blog "personal" so as not to run afoul of some regulatory trap for the unwary and embroil my employer in undeserved controversy.)
Anyhow, I'd already been spending 80 days a year on the west coast, meeting with entrepreneurs and investment managers, so it just made sense to make the leap. When a then-six year-old Miss LP started matter-of-factly calling me "Weekend Dad," I knew it was time to gather up the brood and light out for the territories to follow in the footsteps of pioneers, gold rushers, dust bowlers, and dot com-mers. At the time, I told our CEO that when our lease was up in three years time, either we'd need a lot more space because we'd been able to plant a potent seed in a fertile landscape, or we'd need no space at all, because the experiment hadn't succeeded.
Turns out that the truth lies somewhere in between, boring as that sounds. California may forever be a sunny and ample land, but for a dynamic investment firm with a global, multi-asset class perspective, other coasts and climes beckon and geographic footprints need to be reassessed from time to time. And in our reassessment as the lease-end approached, we decided to close the office . . . and I decided to stay out here and, sadly, part ways with my firm in doing so.
And here’s another boredom-inducing tidbit: there's no drama or backstory to tell. My firm tried to lure me back East; I thought about it, talked to the family, gazed for a while at a nearby grove of redwoods imperial — as a son of Whitman's Brooklyn, I'm endlessly captivated by the stalwart trees of the West — and politely declined.
I've had a blast working for my company; they're good people pursuing an important mission. It's been a great seven years, but the allure of California is just too strong; I've been mesmerized by this magical place, and I don't think I'll ever leave.
I don't really know what did it: the weather is the easy throw-away answer, but maybe I've been beguiled by the succession of start-ups that I've hosted here in the office? Or it could be the open architecture of relationships out here. People seem to network for sport, and, if you're at all credible, you're a phone call or two away from anyone. Perhaps I've been enchanted by my neighbor who walks his home-built robot each morning, or that Miss LP asked me to clean out the garage because she wants to invent something in there? But, ultimately, it's the energy and intensity of the people here. Everyone seems to be Working on Something Disruptive. And it's not just the entrepreneurs, it's the investors, too. There's a disregard for convention that seems to define the Very Idea of California; we're not only struggling over the size of the slices of the pie, but we're also trying to figure out how to make the pie bigger. Hector St John de Crevecoeur could've scarcely imagined California when he wrote Letters from an American Farmer in 1782, but his words seem to presage all the Golden State would offer: "Here individuals of all races are melted into a new race of man, whose labors and posterity will one day cause great changes in the world. Americans are the western pilgrims."
The inquiring reader asks: "what's next?" Here's the best answer your humble narrator can offer: I'm not sure yet. I've got a bunch of plates spinning, some of which could be really interesting, and I'm spending time with as many smart people from as many different walks of life as I can get plugged into. The blank sheet of paper beckons and Walt Whitman's words echo: "I, now thirty-[nine] years old in perfect health begin / Hoping to cease not till death."
Indiana Jones, Investor
Sorry I haven’t posted in a while; it’s been a hectic stretch. And I also have to admit that I’ve been watching a lot of Indiana Jones movies with LittleLP lately. Every now and again, I’ll wonder if I should be doing something productive like scribbling down a blog post or paying some bills — but the moment I see that fedora, I’m frozen in place like one of Indy’s antagonists in the presence of some ancient and mystical idol. And I’ve long thought that the best of the bunch is The Last Crusade, but only recently did I realize that the last scene of that movie offers a metaphor for the craft of investing. Stick with me on this for a moment:
As you’ll recall, the movie reaches its climax when the good guys catch up to the baddies in the Canyon of the Crescent Moon, where the Holy Grail has been hidden for centuries. Seekers of the Grail must pass three challenges of worthiness. Bodies littering the floor of the temple attest to the high cost of failing these tests, so it’s fortunate that Indy’s dad, Professor Jones, Sr., has dedicated his life to The Search and chronicled his findings. After watching the movie for what seemed like the 16th time, I finally realized that the tests are like an investor's roadmap.
Challenge #1: The Breath of God — Only the penitent man shall pass. As he tiptoes among a jumble of beheaded precursors, Indy realizes that a penitent humbles himself before God, and he drops to his knees just as a spinning blade whirrs by at neck level.
This challenge is a warning that bad things can befall overconfident people. A mentor of mine once told me that a great analyst has no ego; one must be wary of confirmation bias and remember that big ideas often come from unexpected places. With each passing day, he concluded, you’ll realize that you know less and less, for there is no business as constantly humbling as investments.
Challenge #2: The Word of God — Only in the footsteps of God will he proceed. Having just survived a close shave, Indy now casts his gaze on a floor-tile grid of random letters. Pretty quickly, he realizes that this clue instructs him to hopscotch across the letters, stepping only on the ones that spell, “Jehovah.” But, he momentarily forgets that the Latinate spelling is “Iehovah” and he nearly falls to his doom as he steps on a “J” instead of an "I" and the ground gives way. (Indiana Jones aficionados will recall that his father made young Indy chew garlic when he made an error in Latin or Greek.)
I’ve been thinking that this challenge is a metaphor for the diligence process: you’ve got to ask the right questions and call upon your experience and skills to get the answers. Agility, wit (in both senses), patience, and confidence will serve you well as you traverse uncertain terrain.
Challenge # 3: The Path of God — Only in the leap from the lion's head will he prove his worth. Indy now finds himself facing a chasm separating him from the entrance to the Grail room. The protectors of the Grail, had, however, created an optical illusion by disguising the bridge such that the surface blended with the rockscape surrounding it. Indy inhales deeply as he steps out onto the ersatz gulf, only to find a bridge of faith below his feet.
Indeed, sometimes investors just need to take a breath and step into the abyss, knowing that their preparation was sound. After all, risk isn't a dirty word; investing is about optimizing discomfort, and we spend our lives seeking appropriate compensation for the risks that we do take (at least those that can’t be mitigated). If you never take the leap, the Grail will forever be out of your reach.
Having met the challenges, Indy now finds himself in the Chamber of the Grail, where he is met by an ageless knight and a room full of putative Grails. “Choose wisely,” admonishes the old knight just as the antagonist, the turncoat Walter Donovan, enters the room. Donovan grabs a bejeweled chalice, “a cup worthy of the King of Kings,” he says, drinks deeply, and perishes in a gruesome way. He chose poorly. Indy then searches for the Cup of a Carpenter, finds a modest vessel, fills it with holy water, and drinks. “You have chosen . . . wisely,” says the knight.
Now maybe I’m reading into this too much, but I saw this scene as an admonition against rashly investing in the new, new thing. Investors love shiny new pennies, but often, it’s the tried and true staples, arrived at deliberately, not snatched in haste, that offer the best outcomes.
I also recalled my days at Old Ivy’s endowment. With each investment, we felt the burden of being a bell-cow. We were proud that we did good, thorough work, but were sometimes surprised at how hastily people followed us in our investments, much like Donovan follows closely on the heels of Indy's pioneering footsteps. Of course, I was always quick to tell people that they were chasing our second-best ideas, since we kept our best ones close to the vest for as long as we could since those funds rarely had enough capacity to sate our entire appetite, not to mention the appetites of all of our friends.
It's true that the courageous investor must follow an adventuresome path in search of outsized returns. After all, the benefit of being right and alone with some frequency can generate outsized overall returns, but blazing a pioneering trail comes at the risk of being wrong and alone, as well. And for those of us who focus on long-dated asset classes, we, unfortunately, don't get the benefit of a knight that nods approvingly as we write investment memos. Only in the fullness of time will we know whether we chose wisely . . .
Cindy Crawford in a Bar
So Cindy Crawford walks into a bar and a swarm of dudes approach her, brandishing their best pick-up lines: "Was your father a thief? Was your uncle a robber? Well if not, who stole the sparkle from the stars and put it in your eyes?" or, "My, what a beautiful mole you have" and even, "Well, aren't you MILF-y tonight?"
Sounds like the beginning of a joke, no? Well, actually, welcome to my life! Well, not just my life, but actually the life of any LP . . . after all, being the cat with the checkbook can make you the most attractive girl in the bar. And being the hottie of the honky-tonk comes with a cost: an endless stream of pick-up attempts.
And the lines we hear from GPs can be remarkable for their homogeneity. In fact, when I hear a buyout fund talk about Proprietary Dealflow or Operating Partners, or a healthcare fund talk about the Aging Population or the Patent Expiration Timebomb, I can't help but think that I've heard this story several (hundred) times before. In fact, I've got a visual reminder in the form of my oppressive inbox of just how many times I've heard some such story. Here's a sampling:
As you can see, the leftmost column contains the folders I've created for funds that have sent me information since I started at my current employer in mid-2004. In this view, you can see about 30 of the 452 VC firms with whom I've corresponded. I have a similar LBO/growth capital folder that contains another 377 firms and an international folder that contains stuff from about 275 additional fund managers. Add in the 75 managers that are in my "active" bucket (running the gamut from the latest GP over whom I'm breathless to the oldest, most tired fund that 's in run-off mode) and that's close to 1200 funds from San Francisco to Stockholm to Shanghai. Throw in my tenure at Old Ivy and I probably saw another 300 incremental funds over and above those 1200. And compared to some other folks on the LP side, that tally of 1500 seems like a rookie's breakfast.
Speaking of Old Ivy, when I was just starting out as an apprentice in the craft of PE investing I asked an Old Timer in the office about the early days of institutional investments in PE — I mean, this guy was my Hubble Space Telescope back to the cottage industry-era of the PE universe. And one thing that he said stuck with me all these years: "in those days, we kind of figured out what kinds of strategies we wanted to back, looked around at the four of five managers who were doing those kinds of things and then invested in about half of them." Remarkable . . . when I think about my "funnel" today, the line we used in my Old Ivy days seems to ring ever more true with each passing day: "It's harder to get into our portfolio than it is to get into our college."
And I believe that all the competition has to be challenging for overall returns. Or maybe, paradoxically, overall returns won't suffer as tradecraft generally improves, but instead the dispersion of those returns tightens as the industry professionalizes and best practices are copied and losers fade away and become exemplars of survivorship bias. In that vein, I'm reminded of a great Stephen Jay Gould article I read about 25 years ago in which he talks about the maturation of an endeavor (in that case baseball) and the disappearance of outcomes that are several standard deviations (positive or negative) off the mean:
"Variation in batting averages must decrease as improving play eliminates the rough edges that great players could exploit, and as average performance moves toward the limits of human possibility … Declining variation arises as a general property of systems that stabilize and improve while maintaining constant rules of performance through time. The extinction of .400 hitting is, paradoxically, a mark of increasingly better play."
What if that's true? What if the fabled dispersion of top-to-bottom quartile returns starts to narrow, (like the pennant-shaped graphs exhibited by many styles of investing that show wide dispersions in the early, pioneering, wild west years on the left side and narrower spreads in more recent years)?
Well, one implication may be that the "better execution" story (i.e. "we're good at this") becomes commoditized while the "we're doing something different" story becomes even more compelling. After all, do I need an n-th mid market buyout fund with operating partners and a geographic focus? Or the m-th early stage Sand Hill Road firm? Maybe, maybe not. That's just post-heroic private equity and there's indeed a place for that in a portfolio as a return enhancer. But I fear that those types of firms in the aggregate are slouching toward an paradigm of little more than what the public market guys would call enhanced-indexing.
But what about someone who's doing something innovative in style? Structure? Terms? That might add some spice to the portfolio. That's where the true octane (on a risk-adjusted basis) might lie. It's definitely the higher volatility play, both in potential returns (for the LP) and in fundraising success (for the GP,) but to do something outstanding takes audacity. And indeed, private equity should be all about audacity. After all, heroic investing lives at the intersection of courage and conviction.
Super LP 