Fortune profiles Chris Flowers, one of the best-known private equity investors in financial services companies.
My working hypothesis, as I try to expand my manager selection skills from stockpickers to other platforms like real estate investing and private equity investing, is that these other platforms can and should also be viewed through the lens of value investing. Simply put, you evaluate a private equity fund manager the same way you evaluate a hedge fund manager: by trying to predict that individual's ability to generate superior risk-adjusted returns over time.
"Risk-adjusted," in the value investor's dictionary, simply means the combination of the probability of permanent (as opposed to quotational) capital loss and the magnitude of that loss when it occurs. In private equity, adjusting for risk in this way is especially important because private equity relies on leverage. In private equity investing in banks, it's even more important because banks themselves are highly leveraged businesses. Small mistakes in predicting the future by managers become big mistakes to limited partners.
A value investor creates superior risk-adjusted returns mainly by investing with a margin of safety. "Margin of safety" is often defined simply as a bargain price, and it's certainly true that the lower the price of an investment relative to its intrinsic value, the lower its risk according to our definition. I prefer the slightly more elaborate definition contained in Seth Klarman's aptly titled book Margin of Safety because it gets to the epistemological truth about why value investing works as well as it does:
Margin of Safety--investing at considerable discounts from underlying value, an individual provides himself or herself room for imprecision, bad luck, or analytical error (i.e., a "margin of safety") while avoiding sizable losses (my emphasis).
Value investing is ultimately a theory about the future, in particular the future of any given set of cash flows one chooses to predict. Value investors like Klarman see the future, almost intuitively, as subject to imprecision, bad luck, and analytical error, and seek to minimize the impact of this on their investment returns. They do this primarily by looking only for bargains, but also by making sure what they think is a bargain is actually a bargain--by investing only when they can predict the future of a given set of cash flows with relative certainty.
Protecting yourself and your investors from imprecision, bad luck, and analytical error, and making sure you invest only when you can reasonably predict the future--that is, ensuring you have a margin of safety--becomes especially important in private equity because of the leverage involved. Leverage does not change the probability of a given universe of outcomes so much as it magnifies the effect of those outcomes to equity holders. The more leverage, the greater the probability of a great outcome if things go well, but also the greater the likelihood of permanent capital loss is if they don't.
So figuring out whether your PE manager invests with a margin of safety is very very important. This Fortune profile only gives a glimpse of whether Flowers does it. It cites two examples of permanent capital loss, but also gives ample evidence that Flowers really knows his way around a bank. So I can't draw any firm conclusions. And I take no comfort from the fact that Warren Buffett is quoted as saying of Flowers "I think he's a smart guy." In the language of Wall Street, "I think he's a smart guy" is a way of saying something without revealing anything. Also, I'm familiar with the Warren Buffett style of personal testimonials, which he takes as seriously as haiku, and can say with confidence that when Warren Buffett wants to praise someone, he doesn't simply say "I think he's a smart guy." He says something like this:
Jim Kilts transformed Gillette. Before his arrival, the company was a study in self-deception. Great brands were being mishandled, operational and financial discipline was nonexistent, and fanciful promises to investors were standard practice. In record time, Jim excised these business pathogens. I've learned much from Jim. So, too, will readers of this book.
or this:
In this book, Adam Smith says I like baseball metaphors. He's right. So I will just describe this book as the equivalent of the performance of Don Larsen on October 8, 1956. For the uninitiated, that was the day he pitched the only perfect game in World Series history.
or this:
I knew Ben [Graham] as my teacher, my employer, and my friend. In each relationship--just as with all his students, employees and friends--there was an absolutely open-ended, no-scores-kept generosity of ideas, time, and spirit. If clarity of thinking was required, there was no better place to go. And if encouragement or counsel was needed, Ben was there.
Walter Lippman spoke of men who plant trees that other men will sit under. Ben Graham was such a man.
Because I can't draw any conclusions from the Fortune article, I'll instead close with two more general point about margin of safety in PE, especially famous PE investors with great reputations:
1) It's important to keep in mind that a famous PE investor enjoys a personal margin of safety that his L.P.s do not: If a given fund goes badly, he can always say "bad luck, who could have predicted these macro shocks" and go raise another fund, while if it goes well he'll become extremely rich, or extremely richer. So a given PE investment may pass the personal margin of safety test while failing to provide an adequate margin of safety to his investors.
2) The intuitive understanding of and desire for a margin of safety when investing are independent of a PE manager's pedigree, brainpower, contacts, fame, deal flow, skill at chess*, etc. If you possess all of the latter but lack the former, you may be more dangerous to your investors' long-term wealth than if you possess all of the former but none of the latter. If you put a gun to my head and forced me to say what Buffett meant by his faint praise of Flowers, I would speculate that he thinks of Flowers the same way he thinks of John Meriwether: "I think he's a smart guy, but . . . he doesn't invest with a margin of safety."
*As an aside, I hate it when skill at chess is presented as a metaphor or proxy for competence in general, especially when applied to investors. It is factually untrue. Chess masters and grandmasters have been studied to see if their skill at the game translates into skill at anything else, or IQ, or other measures of intelligence. Generally it does not: skill at chess implies only that you are skilled at chess. The most you could say is that skill at chess is a proxy for the ability to practice hard enough to get good at a mental exercise like chess. That aside, judging investors by their skill at chess, or bridge, or other games of skill, is like judging offensive linemen by their bench presses at the scouting combine.
Disclosure: Long Berkshire Hathaway.
Update: The Public Buffett Giveth, the Private Buffett Taketh Away. Check out page 2 of Rice MBA student John Reuwer's notes from his class trip to Omaha. If the link ever breaks, here is the money quote:
[For Bank of America] to pay anything for Merrill was silly. Everyone knew Merrill would be basically free one day. It's not smart to pay a premium when you don't have to. The Fairness Opinion from Chris Flowers was a joke. I want to write a Fairness Opinion about the Fairness Opinion.
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Posted by: Term Papers | January 13, 2010 at 05:23 AM