Indiana Jones, Investor

Photo 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 . . .

Hey, Hotshot

Remember that epic “Get the Feeling” ad campaign that Sports Illustrated ran during the mid-1980s? I seem to recall some print advertisements and perhaps a television spot or two, but it’s the billboards that peppered Brooklyn during those summers that seared themselves into my memory.

Maybe it was the in-action pictures of larger than life heroes rendered at 14 by 48 foot scale? Or perhaps the provocative captions that asked questions most mortals would never be able to answer? One of my favorites accompanied a mid-swing picture of slugger Don Mattingly: “How Does It Feel To Turn a Slider Into a Souvenir? Get the Feeling. Sports Illustrated.” Then there was the one featuring base stealer extraordinaire Rickey Henderson in his classic “I’m about to run” pose: “How Does It Feel To Know You’re About To Break the Eighth Commandment? Get the Feeling.” Of course, that question was a bit less remote in a neighborhood where “thou shalt not steal” was considered more of a suggestion than a hard-and-fast rule.

But it was an over-head shot of some over-sized state college football stadium that captured my imagination. Splayed out across every inch of Astroturf were dozens upon dozens upon dozens of corn-fed Midwestern boys stretching before an early-season practice, all with one question on their mind: “will I make the squad?” The caption below asked, “How Does It Feel To Know You’re Just Another High School Hotshot?

And lately, when the day's FexEx drop is particularly bountiful and several more private placement memoranda are added to the pile already strewn about the sidetable in the office, I've wondered if that ad might work just as well for the private equity world.  After all, top quartile funds are as plentiful as fleet-footed recievers out of Ottumwa or Odessa.

Indeed, in 2011 a bumper crop of freshmen will be vying for a limited number of open roster spots.  What factors will seperate the starters from the bench-warmers from the water boys?  This year, simply being good won't be close to being good enough; my own two cents is that too few GPs think critically about what makes them and their strategy truly distinctive and defensble. 

So in honor of the new year — and the inevitable flood of funds expected to come to market in 2011 — I thought I'd focus the first few posts of the year on fundraising, offering over the coming weeks some going-to-market observations, tips, and maybe even best and worst practices. 

After all, there's little comfort in knowing that the number four quarterback at BCS-bound State U probably has the raw tools to play in the NFL if you actually happen to be that number four quarterback.  Maybe over the next several posts we can work through throwing mechanics and defense-reading a bit in hopes that the competition for the scarce roster spots will be more robust.

Strategy 101

Let's talk about strategy for a second. 

Now, strategy is a topic near to my heart since, you see, I was a young strategy consultant — one of the "Kids in the Conference Room" during the mid and late 1990s (that New Yorker article — linked here again in case you missed the link a dozen words back — offered some menacing portent for the subsequent "The Smartest Guys in the Room.")  Now, I wasn't one of the McKinsey cats, but I was at another of the "B's and M's" (the en vogue catch-all for the then-hip consulting firms.)  And indeed, that article struck just a bit too close to home, as it kept quoting clients talking about "snot-nosed 25-year olds" and I could take cold comfort from the fact that I was almost 27 at the time.

(It was a great experience, though, and one of the most valuable things I learned during those years was the Mike Porter definition of strategy: "strategy is an integrated set of choices that inform timely action."  You couldn't leave an offsite training confab without being able to recite the definition when asked. The lazy, petulant, or merely hung-over soon found that they could get away simply saying: "informed choice/timely action."  Four words and you were on your way . . . )

And so what?  Well, I'm writing about it because I'm amazed at how often companies confuse strategy and tactics.  Tactics are not strategy; tactics arise from strategy.  I'm seeing this muddling a lot of late.

But I don't want to get pedantic about it; I'm really bringing it up to amplify the concept that strategy is a set of choices.  And choices are about the things that you don't do, as well as about the things you do decide to do.  The problem is that deciding not to do things is hard and, in particular, deciding to take a decision to stop doing things that you're currently doing can be even harder.

As you'll recall, I wrote about focus a while back and it seems now that focus is a lot more critical as 2011 business plans are getting finalized and people are starting to get (maybe?) more optimistic about business conditions.  The temptation exists to start doing a lot of things that weren't being done during times of belt-tightening.  And I'm not saying to not to do those things, rather, I'm asking folks to think about doing things in the context of the inegrated set of choices they're making and how they inform timely action that has the Great End and Real Business of optimizing shareholders' (or stakeholders') success functions.   


Private Equity Lessons from the Subway

So I've been riding the New York subways pretty frequently lately.  Between annual meetings, conferences, and the entrepreneurial scene, there's been a lot to do in The Big Apple this fall.  And every time I hop on the train, it takes me back to my childhood.  You see, a quarter-century ago I rode the subway to middle school.  Imagine that: a 12 year old with an overdeveloped sense of adventure and a transit pass that offered unlimited access to the lurid expanses of Metropolis!

(Let me take a moment to apologize to Mr. Criscuolo and my other afternoon-class teachers.  A fake bellyache and a hangdog look was all I needed to get permission from the school nurse to go home after lunch.  And as my time in middle school began to wane, I started scooting out about once a week in an effort to see the entire city, one subway stop at a time . . .)

But, despite my school-skipping, I actually did learn stuff on the subway, my very own classroom on rails.  And who knew I could apply those lessons to private equity and even investing more broadly?  Only recently have some of those lessons come into focus.  Let me run you through five scenarios and their associated learnings in what may be the first in a series of "Lessons From The Subway":

* * *

Scenario #1: Have you ever been barreling through a tunnel on the local train as an express pulls up alongside you between stops?  For several seconds, the two trains hurtle down the tracks together side-by-side before the local starts its inexorable deceleration into the next local station while the express pulls away, charging ahead to the next express stop.  For a moment, there's an intimacy with some of the passengers in the express train.  It's almost a voyeuristic feeling, like looking into someone's living room window; sometimes you even make eye contact with one of the passengers in the other train.  Do not give that person the finger or stick your tongue out or make menacing gestures.  There's a chance that they will get off at the next stop, wait for the local to pull in, and kick your behind.

Lesson: Life is a multi-period interaction.  What happens at one moment resonates into the next.  Even the most random encounters can presage subsequent ones.  Don't be a jerk and always have integrity.  Why soil the canvas?


Scenario #2:  Your train pulls into the station on one of those muggy summer days that seem all the hotter and more acrid below ground.  Car after car blurs by, stuffed with people; as the train starts to slow, one car is nearly empty.  But hold on a second; today's not your lucky day, the day you get a seat for the long ride.  Rather, the odds are that the air conditioning simply isn't working and that car is hotter and stuffier than August in Houston.

Lesson: There's information in crowds.  While one never wants to be a lemming, there can be limits to being a contrarian.  Sometimes, leaning against the gales can work, other times, it just gets you windburn and a face full of leaves and other wind-blown detritus.


Corollary / Scenario #2a:  Speaking of reasons why cars might be empty, sometimes there's an, ahem, stinky dude on a train car that clears out all the people.  Again, there's a reason that train car is empty and, odds are, that funky cat is going nowhere.

Lesson:  If something stinks, it's likely that the stink will linger, no matter how you try to rationalize away that hinkey feeling about, say, the GP that does't feel right or the story that doesn't quite hang together.  Trust your nose.


Scenario #3:  Don’t give the finger to a policeman. Ever.  Catch me sometime offline and I'll tell you a story . . .

Lesson:  The people who make and enforce the laws know and understand them far better than you do.  And even if they're wrong, they're right.  And they can make your day a lot more aggravating than you can imagine.  You get a lot further by smiling and saying "yes, sir" than you do by being petulant.  This may be a good thing for our industry to remember as the shadow of regulation lengthens across our sun-kissed land of private investments.


Scenario #4:  If someone starts talking to you on the train, it's likely that they're a looney toon, but there's a chance that they're lost or want to talk about something interesting.  Subway philosophers end up having a lot of things to say, some of which are worthwhile.  Once, though, I talked to old Brit about what to see on holiday and he gave me a 50p coin as a souvenir.  It was the coolest thing I'd ever seen.  Another time a kid told me about a pizzeria over on Ditmas Avenue that had a Space Invaders game that would give you 10 credits if you held the coin return while you put in your quarter.  Needless to say, I became the master of Space Invaders that spring.

Lesson:  Be generous with your time.  You have to be careful, but you never know what you might find out.


Scenario #5:  Every mass transit system seems to have a few stops that are central nexuses (nexi?) of the tangle of lines that ferry people to the disrparate and far-flung reaches of their city.  At these stops the trains disgorge their contents and refil with cats connecting to elsewhere.  Jay Street – Borough Hall in Brooklyn was the one that occupied my imagination (where exactly does that exotic A train go?  Why do people write songs about it?) but 42nd Street/Grand Central and Fulton Street/Broadway-Nassau were other such network nodes, full of hurly-burly.  Here's the thing: if you're leaning against the door and not paying attention as the train arrives at one of these stations, you're likely to get pushed out.  And getting back in to your train can be as challenging as swimming upstream with the salmon. 

Lesson: Don't block the exits!  Sometimes, people need to get off the train.  There may indeed be better connection options for them (like West 4th Street,) but sometimes people need a bird in the hand instead of two in the bush.  This is a big concern right now, as I worry that GPs may be suboptimizing exits, but if there's an A train waiting at Jay Street, it probably makes sense to hop off the F train and change, because you never know if you'll wait in vain at West 4th for a delayed A train that never comes . . .



Speak Like the Locals

[Originally written as the guest column for the PEHub Wire, Sept 22, 2010]

In Brooklyn, Old O’Malley would tell us boys about being a Flatbush kid in the Marines in 1942.  He often laughed about meeting hundreds of guys from around America who didn't seem to speak any English.  "Fugghedabouit!  Dose guys all spoke Texan!"

And, indeed, such a language divergence plagues private equity today.  After all, our performance touchstones – quartiles – emphasize the relative in an increasingly absolute world; we’re speaking one dialect and the asset allocators another.  Interestingly, relative metrics gained sway because of the dis-integration of portfolios.  Armed with copies of Pioneering Portfolio Management, asset allocators knew they wanted PE, but they found it challenging to integrate the asset class – with its illiquidity, irregular cashflows, and stale prices – into portfolio analytics.  As a result, this thrilling, but naughty asset became a part of the portfolio, while apart from it in many ways.

Having been a source of illiquid heartache during the downturn, private equity entered its post-heroic phase and many investment committees are contemplating how to re-integrate PE into their portfolios so they can think holistically again; as a result, crises of confidence abound with respect to taking on new commitments.  And perhaps the most serious problem right now is that people around the asset allocation table all speak different languages. 

In fact, a Monday meeting at an endowment or plan sponsor can be like a European Parliament meeting: there's the cat that covers VC, he's speaking a sun-drenched, passionate language analogous to Italian ("sprazzo di sole" has the same hopeful cadence as "cashflow breakeven.")  The real estate manager speaks the frenetic Merseyside Scouse of a BBC sportscaster who's seen too much hooliganism.  Meanwhile, the public market folks speak a frugal Dutch, as they haggle over single basis points in manager fees.  The hedge fund team speaks a precise, formal language that is the finance equivalent of German (too much time thinking about Sortino Ratio can give you weltschmerz, no?)

In such an environment, crowing about top quartile performance, or telling stories about “impact companies” can fall on deaf ears, particularly with the liquid asset constituents of the portfolio still resent that their portfolios were used as ATMs for increasingly frequent PE capital calls between 2004 and 2008.

So how can a GP raising a fund speak in terms that resonate across the portfolio?  First, I think we all in PE need to be more thoughtful in articulating our return expectations while taking an honest accounting of risks.  Focus not just on rear-view performance – which should properly be considered a lagging indicator, not a leading one – but also on implicit assumptions: why are your returns achievable?  In what environments will the fund outperform?  Underperform?    

Said another way, asset allocators live in worlds of probability distributions, observed risks, and well-established performance calculation; they measure and predict performance.  By failing to give thought to their metrics, we are perceived as soft and non-rigorous.  They speak the language of efficiency while we tout inefficiency; they’re from Mars and we’re from Venus.

Remember, PE is a return enhancing asset, one that must be considered in the context of the opportunity cost of equity capital; for asset allocators that cost includes the drag from the cash they have to keep at the ready for PE capital calls. 

To that end, it can be helpful to give people a sense for expectations of capital calls and distributions, with a particular eye toward what one’s doing to accelerate cashflows.  Today, liquidity is prized and it seems most folks are trying to shorten the duration of their portfolios.  Asset allocators worry about facing negative PE cashflows ad infinitum; any visibility into when cash might come back is critical.  After all, there’s nothing like returns to silence critics.  A little “moolah in the coolah” goes a long way toward answering the question on everyone’s lips when it comes to PE: “why bother?”