Bloomberg article here.
You can learn a lot about an investor when he sues someone or gets sued. A lot is revealed through discovery and depositions and testimony. It will probably become a bigger part of money manager due diligence, at least in the world of private equity.
The other thing to examine, as the article mentions in passing, is the use of the lawsuit as a tactical or strategic instrument, as itself a type of investment. To pursue a civil lawsuit requires an outlay of money, time, effort, and reputation in the hope of achieving some monetary reward. A large corporate lawsuit can rival a good-sized PE acquisition in terms of the financial and human resources required. Each lawsuit has its own prospective risk-adjusted return which can be evaluated (some even do it professionally), and when a professional investor like Terra Firma sues someone, that lawsuit becomes another portfolio asset and a subject of due diligence.
I returned, and saw under the sun, that the race is not to the swift, nor the battle to the strong, neither yet bread to the wise, nor yet riches to men of understanding, nor yet favor to men of skill; but time and chance happeneth to them all. --Ecclestiastes 9:11
Nice guys finish last.--Leo Durocher
The NYT has a long and detailed case study of the Simmons Bedding Company, which was owned by a series of private equity companies in recent years. As a new student of the art and science of private equity manager selection, I read the piece with great relish.
The fundamental message of the article to someone in my position is that anyone evaluating a private equity fund must be able to disaggregate the returns of that fund, to isolate the various components that together form the "35% IRR" or whatever large number a fund uses to advertise its great success.
Not all of these components are created equal, and the private equity manager selector must judge which of these can ultimately be attributed to manager skill, which to luck, and which to simple greed that comes at a social cost. All three seem to have been on display in the Simmons saga.
Starting, like Dante, in private equity hell and moving heavenward, the practice of PE firms paying themselves management fees for running the companies they buy, or success fees for selling them, represents the least "worthy" form of private equity returns, the equivalent of a major stockholder/CEO of a company voting to give himself an enormous raise. I can't morally object to a PE firm, which is after all a fiduciary to its limited partners, engaging in this if it can get away with it, but this component of a PE fund's return should be given the least value when evaluating a PE manager.
(This wouldn't be an Investor's Consigliere post without a Buffett anecdote, so here it is: In 1996 Buffett sat on the board of Gillette when it purchased Duracell, the well-known battery maker. Kohlberg Kravis and Roberts, the buyout firm that owned 34% of Duracell at the time, demanded an "investment banking" fee of $20 million for its work on the deal, even though it was more properly the seller, not the banker (Morgan Stanley was). Now my adoration of Warren Buffett is second to no one's, but I think even he would confess that throughout his long career as a board member, he's been something of a . . . wimp, holding his tongue even when he wanted to object to certain practices. In this case, however, KKR's demand so offended him that even though he favored the merger, he abstained from voting on it as a form of silent protest. End of anecdote.)
The next level up, call it PE Purgatory, are all the practices that come under the general heading of replacing equity with debt, which include the dividend recapitalizations mentioned in the article as well as the initial underwriting of deals. George Orwell, who had a lot to say about capitalism and human nature, pointed out that when the powerful call something X, they're often trying to hide that fact that X is really the X's opposite. Warren Buffett, another student of capitalism and human nature, has written that "private equity" isn't about equity at all, but rather about its opposite: debt.
The common denominator in these types of transactions is that, in exchange for some present benefit for the private equity buyer/owner (either leverage for its equity or, in the case of a dividend recapitalization, cash up front), the burden of the company's future success or failure shifts from owners to debt holders. It's complicated for a manager selector to evaluate the "worthiness" of these transactions, as they can involve manager skill, luck, and pure greed, or some combination of the three. For instance, A PE manager that is able to finance a deal with low-interest PIK bonds at a time when such bonds have willing buyers can be
a) skillful, in the sense of protecting its equity from future cash flow problems in the business,
b) lucky, in the sense of being in the right place at the right time (e.g. NYC during a credit bubble), and/or
c) egregiously greedy, in the sense of having the chutzpah to sell something (as an insider) that it would never itself buy.
From the perspective of the manager selector, skill is always good. Lucky is good too, certainly better than unlucky, except for two problems: a) a PE fund that can only prosper when conditions are completely favorable won't outperform over the long term, and b) lucky people have a tendency to confuse their good luck with skill. Egregious greed is almost always bad, and not for moral reasons, which each investor must work out for itself. My objection to egregious greed is practical: it creates negative karma--not for the next life, but for the next deals. A PE fund that foists crappy debt on gullible bondholders once won't often get a chance to repeat the feat. A fund that borrows too much and must resort to mass layoffs to avoid bankruptcy will find its union pension fund LPs less than willing to invest in its next fund.
There is also a very subtle psychological downside to playing this game of replacing equity with debt, often in ever increasing proportions as in the case of Simmons. John Maynard Keynes famously described modern securities markets as
so to speak, a game of Snap, of Old Maid, of Musical Chairs--a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated.
Modern private equity can be looked at similarly, although in this case the Old Maid being passed around is the inevitable (and it is inevitable) losses that will afflict bondholders and equity holders when rosy business expectations that prevailed on the days securities were sold don't pan out. Many PE players have had great success at this game, but it occurs to me that those who play it may forget that if you choose to play, no matter how good you are one day it will be you holding the Old Maid at the end of the game, or you without a seat when the music stops. In that sense then, to even play the game is to lose it sometimes.
Finally, we come to Private Equity Paradise, the noblest and most worthy components of PE returns, and the purest measures of manager skill. They are the ability to buy assets at bargain prices, and the ability to effect real and lasting operational improvements in the companies purchased. A manager selector fortunate enough to invest in a fund that derives most of its returns from these components will feel as Dante did when he saw Beatrice, either for the first time (take it away, Ridley Scott) or when they reunited in heaven (take it away, Signore Alighieri). Ultimately, nothing justifies the existence of the PE industry (and the fees it charges), either for its investors or as a social institution, but these two factors.
Having rambled at length on this subject, I must confess that I've never known of any PE fund that has tried to disaggregate the components of its returns like this. If someone reading this works in the industry and has seen it done, please let me know. Nor do I think it would be possible for someone from the outside looking in to attempt such a disaggregation with any precision. Therefore, I suppose, we as manager selectors must console ourselves with the various qualitative efforts we can make to penetrate the essence of a given fund's returns.
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.
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.
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.
Some color into the world of private equity manager selection, from the great Jonathan Keehner of Bloomberg.
Via the WSJ.
The NYT profiles Leon Black's Apollo Group.
Having just reread the article I ask myself: If I were a PE fund investor and either had an investment in an Apollo Group fund or was considering one, would this article help me evaluate my investment? My answer is: not really. And yet how much more and better information do actual LPs get than what's in the article? I'd be interested to hear from those who know.
It goes back to the ultimate question for the money manager selector, and the ultimate subject of this blog: how can you evaluate the decisionmaking ability of the manager given the imperfect information you have, and given that you can't do his work yourself for him?