The Investor's Consigliere

J. Christopher Flowers Profile

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. 

Buffett--I mean Gaines--on Valuation

To evaluate investors one must evaluate how they evaluate their investments.  One of the things I look for is what I call "elegance" in valuation.  It' s hard idea to define; you kind of know it when you see it.  Warren Buffett rarely discusses valuation, but when he does he almost always demonstrates this quality.

I guess what I mean by elegance is the ability to restate a problem (in the context of investing, the problem is most often "what is this asset worth?" or "is this asset undervalued?" or "what is the expected return of this asset?") in such a way that the solution presents itself with disarming clarity.  Think of the legendary story of a precocious German schoolchild daydreaming in class in the 18th century.  The dour schoolmaster commanded his students to sum all of the integers from 1 to 100, expecting the tedious calculation to occupy at least a half hour of his students' time.  Instead our precocious schoolchild, the youngest in the class, almost immediately blurted out the correct answer, making the dour schoolmaster even more dour.  The child was Carl Friedrich Gauss, who became one of the greatest mathematicians ever, and he solved the problem not by his ability to calculate 1 + 2 + 3 +. . .+ 100 faster than anyone else, but by recognizing immediately that the problem could be restated in a way that made the solution easy: the list of 100 integers could be grouped into 50 pairs, each of which sums to 101 (1+99, 2+98, 3+97, etc.), so the correct answer was simply 50 x 101 = 5050. 

There are many professional investors who can "sum the integers from 1 to 100" the hard way, by outworking everyone else or by using technology.  But the very best investors are almost invariably elegant in their thinking; they have the Gaussian ability to simplify problems so that the difficult process of evaluating an investment becomes much easier.

A recent example of elegance in valuation caught my eye.  It's maybe not up to the level of Gauss' trick but it is elegant nonetheless.  My friend and editor John Mihaljevic recently interviewed Brian Gaines of Springhouse Capital for his Portfolio Manager's Review publication, and posted an excerpt on his blog.  The excerpt included the following discussion of Netflix, a company whose traditionally high P/E ratio and new business model made it unpopular among value investors:

As for investing in Netflix, the important thing for us was we never paid for the growth. When we first invested, we were paying around 5-6x operating income if you backed out the growth portion of the subscriber acquisition costs and made a fair assessment of what it would cost to maintain the subscriber base. Basically, on a story where you had clear evidence in early entrance markets like San Francisco that the product was taking well, you were able to get the growth for free. This was a good example of where we thought we had excellent downside protection with more than 50% upside. We were able to invest very successfully in Netflix on two separate occasions when the market refused to give credit for growth. When the market was willing to give any credit for growth, which was happening at a rapid pace, we elected to exit.

What made this analysis elegant was Gaines' ability to restate the "is Netflix undervalued?" problem in a different way, by substituting business reality for accounting "reality."  According to GAAP, subscriber acquisition costs must be treated as an expense on the income statement (I vaguely remember this rule coming about in the mid 1990s and it caused AOL to trade way down).  For a growing enterprise that does a lot of marketing, this will depress GAAP earnings, the E in the traditional P/E ratio, which will in turn raise the P/E ratio beyond the reach of most value investors.  Gaines' insight was to treat subscriber acquisition costs not as an expense, but as mostly an investment in future growth, similar to a capital expenditure.  Only a portion of this expenditure, analagous to maintenance capex, was to be subtracted from the pro forma income statement, as it represented the cost of maintaining then-current volumes.  

Gaines' insight had the effect of significantly increasing the profitability of the non-growth portion of Netflix's business, which in turn lowered its operating P/E to a very value investor-friendly 5-6x.  Having determined that Netflix's product was performing well, having calculated that he wasn't paying anything for the company's future growth, and having assumed that its heavy investment in future growth would likely earn a good return (or else would dramatically be curtailed), Gaines turned a growth investor's speculation into a value investor's investment, with a significant margin of safety, and was well rewarded.  Elegant.

Some More Real Estate: The Danger of the Personal Guarantee

My real estate self-education project continues.  Again, I'm trying to see if I can apply value-oriented manager selection to real estate investing.  There will likely be a lot to do in real estate in the next few years, both in public and private markets.  Many new funds have been and will be formed to take advantage of all the bargains that are widely assumed will be available.  My suspicion is that many of those hoping to take advantage of the bargains will be the same people who "took advantage" of all the non-bargains in the last days of the boom by buying overpriced properties.  I want to stay away from those people.

Steve Roth of Vornado alluded to this in his 2008 letter to shareholders, under the heading "Price Does Matter":

It sounds trite, but buy low still works.  A good friend of mine and Mike's, who runs a large real estate opportunity fund, years ago made an observation which I still remember.  He said they analyzed every deal in every cycle and concluded that everything bought in the first half of a business cycle was profitable to super-profitable, while everything bought in the second half was a struggle or worse.

If the way it works is this stark, ideally you want to invest with someone who

a) Knows exactly when the first half of the cycle is about to become the second half
b) Does his buying only during the first half, and
c) Does his selling (and his golfing, fishing, traveling, etc.) during the second half.

An unattainable ideal, but that's why the margin of safety was invented.

Margin of safety is especially important in real estate because almost all real estate is bought with leverage, often a lot of it.  In real estate investing, skill at building the right side of your balance sheet is as important as skill at building your buildings.  Because leverage magnifies returns both on the upside and the downside, and because of the idea expressed in the Steve Roth quote above, the stakes are very high when it comes to evaluating a real estate investor's use of financing.  It's often said that the secret to getting rich as a real estate developer is to use Other People's Money.  Don't forget the corollary: the secret to getting rich investing with a real estate developer is to remember that Other People's Money to him is Your Money to you.

Wednesday's Wall Street Journal featured a long article about the Cababie family, one of Mexico's most successful real estate developers (who I'm sure trace their routes to the Jewish quarter of Aleppo, Syria, which isn't so Jewish anymore, if you know what I mean.  It sometimes seems that if you fled from Aleppo to Latin America there was something wrong with you if you did not become extremely rich).  To finance their move into US real estate, the Cababies crossed an investing Rubicon by issuing personal guarantees on two major real estate deals, a huge condominium project in downtown Miami and a portfolio of 56 office buildings in Southern California.

A personal guarantee is just that--an individual or family personally guarantees to repay a loan if it cannot be paid back otherwise.   The WSJ elaborates:

Personal guarantees can cause problems for real-estate developers because they give creditors enormous power to go after all of their assets in the case of a default. During the real-estate collapse of the early 1990s, personal guarantees helped create huge financial problems for Donald Trump and took down scores of others, including William Zeckendorf Jr. Easy money during the last boom enabled most real-estate borrowers to stay clear of such guarantees, but a few, like New York developer Harry Macklowe, used them and have been forced to sell properties to pay them off.

To a value-oriented manager selector like me, an investor who issues personal guarantees, even if it backstops money you yourself are investing, is a red flag.  Not automatically bad, but something to take a close look at.  Manager selection requires you to create a kind of psychological profile of the investing temperament of the person to whom you're giving your money.  A personal guarantee on the right side of an person's own individual balance sheet can be revealing.  If it's guaranteeing the 250th enormous condominium project built in downtown Miami (not even on the beach!) in the last few years, then it's very revealing.  The combination of boom-time psychology, optimism, and testosterone that leads someone to expose their own money to that kind of risk must make you suspicious about what they are exposing your money to. 

The same principle applies to REITs or other real estate corporations, and even corporations as a whole.  The mix of recourse vs. non-recourse debt, as well as cross-guarantees and cross-default provisions, must be evaluated carefully, as it is a key factor in the shareholder's margin of safety equation.  Warren Buffett, who has been a closet genius at using leverage his entire career, pulled back the curtain a little in his 2005 letter to shareholders, in the section called "Debt and Risk."  Read the whole thing, but the guiding principles are that the more debt you take on, the more secure the income stream (not asset value) to service it must be, and significant debt must always be non-recourse to the rest of the enterprise.  John Malone, who has been an out-of-the-closet genius at using leverage his entire career, has used the nautical metaphor of the compartments of a ship's hull, separated by bulkheads--if the hull is breached in one compartment, it may flood with water, but the bulkheads prevent water from penetrating the other compartments, which could take down the entire ship.  Even during TCI's most heavily leveraged days, Malone was always careful to use as much non-recourse debt as possible, so if water flooded one "compartment" (i.e. an individual cable system could not service its debt) it would not threaten the entire ship (TCI and its shareholders as a whole).

 

Debt is Not (Always) a Four-Letter Word

A story in Tuesday's FT quoted heavily from a letter sent by PE firm TPG to its investors:

Last month's letter, obtained by the Financial Times, made the case that the leveraged buy-out was "an investment structure which is useful at some times during the cycle but not at other times".

"When debt is mispriced and inexpensive, as was the case before 2008, it makes sense to replace equity with debt, hence the abundance of LBOs," the letter said. "[Now] it makes sense to replace debt with equity, -leading to restructurings and recapitalisations."

Once upon a time I was young and a total Buffett-worshipper, and being a Buffett-worshipper to me meant YOU DON'T BORROW MONEY EVER.  Like a a true Capricorn, however, I've loosened up with age and now look differently at investors who use debt.  I now realize that there is debt and there is debt, and evaluting how an investor uses it, both qualitatively and quantitatively, is an important part of manager selection.

The best investors work both sides of the balance sheet, they're in the spread business.  A dollar earned from the right side spends the same as a dollar earned from the right.  Any stream of cash flows, whether going in or coming out the door, can be cheap, and value investors buy things cheap.  If you can buy cheap AND maintain a margin of safety, you're well on your way.  So you can scold the Masters of the Universe for what they did in the last few years, but many of them were smart: they recognized a cheap liability and "bought" it, and some of them did so with a margin of safety too. 

Once I deprogrammed myself from the no-debt-ever cult, I began to see more clearly that Buffett has never been as strict with himself as his aphorisms imply.  His primal urge to use Other People's Money is as strong as the most venal subprime packager, he's just done it more intelligently and always with a margin of safety.  Not just insurance float, but also borrowing against utility earnings and to finance mobile home purchases, issuing debt for unspecified later use, even its derivatives bets.  Take a look at the right side of Berkshire's balance sheet today--it's loaded with debt.

It's not just Buffett either.  Baupost has drifted away from public market bets towards things like real estate, using non-recourse debt when the numbers make sense.  Charlie Munger's first fortune came from a heavily leverage real estate development--again, non-recourse.  John Malone has waged a decades-long war against the IRS, using levered cash flow growth, backed by what were essentially government-enforced monopolies, to shield earnings.  Much of David Swensen's outperformance in the last decade comes from large allocations to real estate and PE funds, both of which took advantage of cheap debt. 

It begs the question:  Where are the debt arbitrages of today and tomorrow?  If you're a creditworthy individual, and if you're worried about inflation to boot, now may be a great time to purchase a house in much of the country--the government is helping you out.  I've in the past wondered whether Japan is the next great PE opportunity, as super-low borrowing costs on liabilities are starting to coincide with lower PE ratios (higher earnings yields) on assets.  The same may be true for residential real estate too: according to the Economist, the price-to-rent ratio is lower in Japan than in any other OECD country.  That implies higher cap rates, which in combination with lower borrowing costs means a fertile ground for dealmakers in the next few years. 

So I'm keeping my eye on who is best using the liability side of the balance sheet.

Disclosure: Long Berkshire Hathaway.

Castle Hall Alternatives White Paper: The New Standard of Operational Due Diligence

Read it here.  An excerpt:

One of the lessons of the recent crisis is that managers who unduly impatient and unhelpful in 2006 and 2007 were, quite consistently, those firms who appeared to protect themselves ahead of their investors at the end of 2008.

The Muscle End of Manager Selection

Leo Kolivakis publishes a great blog called Pension Pulse, and recently wrote a long post about the brewing scandal involving alternative managers and the placement agents they hire to secure public pension fund capital.

It seems a middleman's work is never done:  Feeder funds like Fairfield Greenwich charged investors exorbitant fees for "access" to Madoff; while placement agents like Searle & Co. did it the other way, charging funds like Quadrangle exorbitant fees for "access" to pension fund investors.  I await the logical next step:  the revelation that one firm played both sides.

A Hedge Fund Manager Values His Earning Power as well as his Tangible Common Equity

Reading Warren Buffett on the importance of earning power over tangible common equity when valuing a bank got me thinking about, of all things, how hedge fund managers think about taxes, something I've touched on in the past. 

American family offices that invest in hedge funds care about taxes in a way that other institutional hedge fund investors--pensions, endowments, offshore money--do not.  In the course of their due diligence, these family offices will typically ask a prospective manager how he thinks about taxes, that is, how does he go about trying to maximize his limited partners' after-tax returns rather than pre-tax-returns.

The typical answer from the manager is something like this:  "Of course I think about post-tax returns a great deal, because my entire net worth is invested in the fund and I'm a taxable investor, so I invest the fund with my own tax situation in mind.  Our interests are closely aligned."

This answer makes sense, but it's also an example of Nabokov's doughnut truth: it's the truth, the whole truth, but with a hole in the truth (thank you Seth Roberts).  Here's why:

A hedge fund manager actually has two net worths.  The first is the "tangible net worth" represented by his interests in the fund of which he's a general partner.  On a look-through basis, these interests correspond to actual stocks, bonds, derivatives, etc. that can be traded and valued presently.

The second net worth, sort of a shadow net worth, is the manager's earning power, the capitalized present value of the income to be earned from managing other people's money.  This depends on the future returns of the fund AND on the amount of capital to be raised in the future.  The latter matters more because it's much easier to double the size of a hedge fund by taking on outside money than by earning 100% returns on existing capital.  Most of the outside money invested in hedge funds is non-taxable, so a hedge fund manager can maximize his second net worth more easily by behaving in such a way as to increase the amount of non-taxable money managed, which makes minimizing taxes a lesser priority.

An ambitious hedge fund manager, confident in his ability to generate future returns and desiring to make a lot of money personally, keeps a close eye on his shadow net worth, although he seldom discusses it in public.  So should you, and in particular you should look for managers ethical enough to constrain their ambition in the interests of serving their investors.  The ideal money manager is someone who is very rich, the result of a successful track record over time, but much less rich than he could be. 

An unambitious hedge fund manager may behave differently but to my knowledge there is no such thing.  If I ever meet one I'll report back to you. 

 

Buffett on Evaluating People: Reference Checks vs. Behavior

Warren Buffett may be the most well-connected businessman around.  In the past, some have argued that it's this quality that enables his great success, even more than his own intelligence and judgement.  His investment results are better, this rather sinister argument goes, because his information is better.

From the same Fortune interview, here's Buffett on how he evaluates John Stumpf, CEO of Wells Fargo:

Well, John [Stumpf] is in charge. Dick is a terrific help to John. I play bridge with John on the Internet. He plays under the name of HTUR. His wife's name is Ruth. My bridge partner, who I probably play bridge with four times a week, developed online banking for Wells. A woman named Sharon Osberg. And she's worked with those people. And she told me about John Stumpf ten years ago. I've had some insight through her on these people. But the real insight you get about a banker is how they bank. You've got to see what they do and what they don't do. Their speeches don't make any difference. It's what they do and what they don't do. And what Wells didn't do is what defines their greatness [my emphasis].

I apply this logic to the world of money manager selection.  Manager selectors spend a lot of time on reference checks, talking to people they know who also know the manager they're trying to evaluate, just as Buffett talked to Sharon Osberg about John Stumpf.  Manager selectors, myself especially, also spend a lot of time evaluating investors communications: their investor letters, speeches, interviews, etc.

All of these things are important, especially in a world like mine in which the lack of information about people is the singular feature.  But it's important to realize that in the final analysis, reference checks and manager communications matter less than direct observation and interpretation of a money manager's behavior.  The real insight you get about an investor is how they invest.

Disclosure: Long Berkshire Hathaway

William Ackman Has a Cold: Profiles in Bloomberg and Portfolio

Read them here and here.

Ackman fascinates me.  No other hedge fund manager challenges the skills of the manager selector more than he does.  He's smart and well-pedigreed and very philanthropic, a hedge fund celebrity, extremely persuasive in both written and spoken communications, closely aligned with value investing, can point to an excellent track record, is backed by some of the best in the business*, and is very rich.  And yet his first investment vehicle, Gotham Partners, was forced to close amid a lawsuit and massive redemption requests, while his latest, formed solely to invest in Target, at one point was down 90%.

If you'd invested with Ackman's various vehicles proportionately to what each vehicle represented as a portion of Ackman's total outside funds under management, I wonder what your total return would have been over time?

*In June 2007 Leucadia National Corporation invested $200 million in Ackman's Target vehicle, representing 10% of the LP interests.  Leucadia marked this investment at $36.7 million as of 12/31/08.  The following is an excerpt from Leucadia's 2008 annual letter to shareholders:

Over the past several years we have invested our excess cash with various outside managers with a view towards receiving a good return and hoping to uncover investment opportunities.  We were disappointed with the results.  The returns were not good and we did not uncover investment opportunties.**  With few exceptions, our fund investments were not immune to the market upheaval experienced in 2008, but the overall return since inception was minus .5%.  It could have been worse.  For the most part, we do not intend to continue this activity.

**I'm always interested in examples of great investors, which Leucadia certainly is, who have proved to be poor investors in investors.  From what I can tell, George Soros is another one.  It leads me to believe that while there is a large amount of overlap between the two skill sets, there are also differences.  I hope to explore this further in a future post.

 

Art of the Interview, Part 2: Malcolm Gladwell Edition

I came across this New Yorker article from 2000.  See especially part 4 about structured interviewing.

The more I do it and speak to other practitioners, the more I realize that the singular feature of money manager selection is the lack of information available to the selector with which to make judgments about people.  There is no SEC in this game, no entity that forces a money manager to make the disclosures deemed necessary for investors, the way public corporations are forced to. 

The face-to-face private interview is one of the best ways to gather what limited information we can, but as Gladwell shows, an interview is fraught with the potential for many types of miscognition.  So you have to learn how to interview well.

This applies also to hedge fund managers themselves.  Many very successful investors are notoriously poor "investors" in human capital--simply put, they hire poorly and suffer high turnover as a result.