Sometimes, I envy public market investors; occasionally I think, “wouldn’t it be nifty to actually see your investment theses play out in less time than a presidential term or two?” But then I remind myself how cool it is to watch portfolio companies flourish and strive and struggle and dream. It’s like watching your nieces and nephews – the ones you see only about once a quarter – grow and mature. And all that waiting and watching pays off. Doesn’t it?
I’ve been asking that question a lot lately. After all, on Day One of LP School we’re taught that there is compensation for patience. Illiquidity is one of the key risk premia we collect (right?). At Old Ivy, we always said, “fifteen percent compounded forever is a lot of money…”
But I worry that some in the PE world seek illiquidity solely for illiquidity’s sake. Or even more cynically, I occasionally fear that there are some who hide investments gone sideways behind a veil of prudent patience. So, let me ask heretically: what if all of the talk of long term horizon is misguided? What if the compensation for holding an investment to the out-years is inadequate relative to the risk?
Let me double-click on that for a moment: nowadays most buyout shops tout their Hundred Day Plans. Think: Metrics! Dashboards! Flash reports! SWAT teams! (Or are those SWOT teams?) Some firms have upped the ante and talk about working to kick off The Plan even before they close on deals (how proactive!). And all of this stuff is music to LPs’s ears, giving the impression of catalytic ownership. Now we know why we’re paying these guys the big bucks: it’s because they do . . . stuff (and they do it fast!). And, sure enough, skilled owners can help businesses achieve real value inflection points. Some even have grand plans for strategic repositioning that will take many years and a half dozen or more add-ons to come to fruition.
But here’s a question: how long should one hold a company to capture value? Come in, rock your 100-day plan, catalyze a bunch of change, stabilize the company, get eight quarters of growth under your belt, and hope for a good exit market in years three or four. Easy. (Of course, easy can be very, very hard.)
But think about it another way: if there’s a value creation curve for the typical company, I’d imagine it’s very steep in the early years, with a flattening in the out-years. There might be an inflection point or two beyond the initial surge, but the rate of change almost certainly slows as time passes. Meanwhile, business is moving ever quicker – just talk to a biz dev team using The Cloud to fast-cycle product testing and launch, or a manufacturing group using lean production – and execution challenges are unending. One could even posit that owning companies in the out-years is more risky than anyone expected; there might even be a case to be made that risk-adjusted returns go down in the out-years. Maybe that’s why so many LPs grouse that their portfolios are full of over-ripe companies.
Perhaps there’s a way to think rigorously about which of the ripe fruits to harvest and which need some more vine time: I know of at least one group that methodically re-underwrites their portfolio every six months and asks, “what is the distribution of the prospective returns for each of our portfolio companies?” Implicit in the exercise is a belief that at any moment, you’re either a buyer or a seller. Those companies that exceed a certain hurdle rate stay; those that don’t go out for sale.
Now don’t get me wrong: I’m not saying that folks should sell prematurely or sub-optimize exits. Instead, I’m talking about a meticulous re-underwriting process that asks hard questions about prospective return, risk, uncertainty, and liquidity horizon. Of course, GPs are generally incentivized to let their winners run, even as rate of return slouches (as long as the multiple contribution is positive). LPs, on the other hand, want their money back yesterday. These divergent views express the tension inherent in unknowables: what does the future hold? What are the opportunity costs? For the GPs? For the LPs? Is it worse to sell too early – or run the risk of holding on too long?
And whenever I ponder these kinds of questions, my mind wanders back to one of my mentors, a dyspeptic Frenchman who seemed to be forever enshrouded in fogs of Gauloises and cynicism. Once, after he’d helped me finish a thorny financial model, I asked him what he thought. “Bof,” he replied with a shrug, “after year three, life is all terminal value anyhow. The important thing is to make sure you get those three years right and the terminal value will take care of itself. The first steps are often more important than the last.”