Sunday, July 27, 2014

Lessons from the Masters of PE and VC for Mere Mortals

I've just finished Robert Finkel's "The Masters of Private Equity and Venture Capital", and thought it merited some quick thoughts. First off, it's an easy read that I recommend, and a good introduction for those not immersed in the worlds of PE and VC. The roster of characters interviewed will probably interest even those who know PE and VC well, with stalwarts like Joe Rice, Warren Hellman, John Canning, William Draper and Franklin "Pitch" Johnson making appearances. Some of the anecdotes are amazing, such as Canning breezily relating how banks like First Chicago used their PE arms to smooth earnings. This practice became harder with the advent of mark-to-market, leading to the spin-off of future titans like Madison Dearborn. Some of the less-known stories are just as interesting. Steven Lazarus describes the creation of ARCH Venture Partners, designed to commercialize and monetize research from the University of Chicago. This seems a natural outgrowth of research, but it had never crossed my mind that such entities existed. While I was left a little disappointed with the chapter on Jeffrey Walker, his work bringing a PE approach to the Millennium Villages will interest those who have followed the debate over Jeffrey Sachs' ambitious project (particularly if you have heard these EconTalk podcasts with Nina Munk and Jeff Sachs.)

No book on PE or VC would be complete with a reference to Georges Doriot, widely considered the founding father of these two fields. In his introduction, Finkel quotes Doriot: "The study of a company is not the study of a dead body. It is not similar to an autopsy. It is the study of things and relationships. It is the study of something very much alive which falls or breaks up unless constantly pushed ahead or improved. It is the study of men and men's work, of their hopes and aspirations. The study of the tools and methods they selected and built. It is the study of conceptions and creations - imagination - hopes and disillusions." 

I thought Doriot's quote was an important one. Finkel's book, presumably meant for a popular audience, steers clear of arcane descriptions of valuation and financing. Yet this also reflects that financial wizardry is not the only ingredient for success in these businesses, or any branch of investing, for that matter. The venerable Pitch Johnson recounts his transition from the steel industry to VC, and counsels, "A person picks up a lot of lessons over time, and the person who pays attention, even in places as seemingly dissimilar as steel mills and biotech labs, has a good chance of backing the right people, with the right ideas, in the right markets." Being an "intellectual magpie", as my former English teacher would describe it, is exceptionally beneficial in the business of investing. Finkel concurs, pointing out that "Many of the major sources of competitive advantage for the private-investment asset class are qualitative in nature: picking the right companies, mentoring their managements, measuring their performance, and driving them toward success... Moving from deal to a successful long-term investment requires patience, a human touch, strategic insight, and ultimately a keen assessment of a company's market value and potential." 

Another crucial element the book describes in PE, in particular, is operational excellence (and I mean genuine insight, not just having someone who did an internship at consulting firm once). David Swensen, who allocates billions to PE as head of Yale's phenomenally successful endowment, has very cutting words for most PE fund managers, describing them essentially as investment bankers with mid-life crises. He derides most PE funds as providing commoditized financing, and insists on only investing in those that can provide operational guidance to portfolio companies. Speaking about Russian PE, Patricia Cloherty reflects,"Private property is a new concept, so negotiations focus exhaustively on price with a wholly inadequate emphasis on the strategic development of the company." It seems to me that western PE firms who lack operational expertise will similarly be relegated to bidding for companies with insufficient interest from firms who can offer both operational and financial expertise. The results for LPs are unlikely to be satisfactory.

Much like the hedge fund industry, PE and VC seem to have become more professionalized, and perhaps less lucrative for LPs. As Pitch Johnson observes, "After the dot-come crash of 2000, when the venture market came back, it came back in a different form than previously. It became a big money management business." Carl Thoma explains just how difficult the game has become: "Information flows a lot faster than it once did, and there are about five times as many firms out there competing for deals compared to when we started out." He goes on to say, "It's just a different game, and the old investment process no longer works as effectively." 

Given the exceptional suite of skills needed to be a top-tier PE or VC manager, and the increasingly competitive arena, it is therefore doubtful that most limited partners are getting what they pay for. Investment talent is scarce, and requires organizational frameworks that can nurture it. I am fairly skeptical that most "alternative assets" will prove worthwhile for limited partners - but I'm sure that many mediocre intermediaries will do fine off of management and incentive fees.

I'll end with some customary speculation. There has been a lot of interesting discussion among monetary policy commentators about whether today's central bankers are exceptionally averse to inflation given their coming of age in the mid to late 70s. I was intrigued by Patricia Cloherty's horrified observation that "In the early 1990s many young business people in Russia told me that they learned much of what they knew about business by watching films such as Wall Street with Michael Douglas." It struck me that someone who had "come of age" in the world of finance in 1987, when Wall Street came out, would have been about 45 in 2007 as various unseemly business practices in the world of finance became visible. One can only hope that this cohort of fairly senior people was not overly influenced by Gordon Gekko. It's an unfortunate indictment of a certain type of character drawn to finance that both Oliver Stone and Michael Lewis intended Wall Street and Liar's Poker to be cautionary tales about the noxious greed in the industry, but were both ultimately dismayed that their stories were instead seen as exemplars for ambitious young people. 

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