Tyranny of the Relativists

There’s a great riff in John McWhorter’s book, The Power of Babel: A Natural History of Language that describes how expressive force in language diminishes over time. His poster child is the word “terrible” which once meant “causing dread or fear or terror,” but now is used as a mild negative modifier (e.g., “I’m such a terrible putter that my wife got me personalized golf balls that say, ‘three putt.’ ”)Similarly, the language of business is littered with expressions slouched from overuse: phrases like “best of breed” went from insightful to hackneyed over the course of mere years.

Of course, private equity has its very own once-powerful phrase that’s meandered to meaninglessness: Top Quartile. Now we all know how Top Quartile got to be the gold standard: a couple of cool graphs in the Book of David (Swensen) some McKinsey studies, an endorsement by an influential pension fund or two and Top Quartile was the place to be.

Everyone wanted to be in the Top Quartile, and, soon enough, most people were – if you accepted their pro forma returns based on aggressive multiples of EBBS (earnings before, ahem, bad stuff) or included estimates of what an acquirer might pay for a start-up once it had perfected its swell product and revenues had started their inevitable ramp.

The problem with that kind of thinking is that it obscured the true aim of private equity: return enhancement (relative to the opportunity cost of equity capital, i.e., some appropriate public benchmark). Success was no longer about getting adequately compensated for taking incremental risks; it was now about beating the next guy (or more specifically, the next three guys).

And that’s the paradox, of course, of any peer-group measure: when new entrants deploy capital, their extra dollars will likely depress returns across the spectrum – since the marginal dollar tends to set the price of assets – but the cohort of “winners” (with victory defined as being Top Quartile) grows. The club gets less elite as people enter from the bottom.

Of course, measuring private performance against a public benchmark can be pretty tricky and is fraught with tough questions like: what’s the appropriate evaluation horizon, how do you equalize for appraisal effects, and should you beta-adjust, to name a few. As a result, it’s tempting to fall back on an easy measure like peer group rank.

A while back, I started asking VCs what they thought the top quartile breakpoint for venture over coming vintage years might be assuming reasonably “normal” public market conditions. In my informal and unscientific survey, more than half of those I asked guessed that the top quartile line would be at or below zero. Surely, some firms will do fantastically well, but if the VCs I sampled are right, it will be really amazing that dozens and dozens and dozens of firms that tinker in one of the riskiest corners of the financial world will be able to call themselves successful even though they will have lagged the public market – not to mention cash – by many hundreds of basis points. What’s more amazing is that merely by surviving, these firms will earn billions of dollars in fees in aggregate and the folks who funded them will dance a jig for having done a great job.

It’s enough to remind one of an old story: two campers are awakened by the sounds of a bear sniffing at their tent. While one of the campers starts panicking, the other calmly starts putting on his sneakers. “Why are you putting on your shoes? There’s no way you can outrun that bear,” whispers the first camper. “I don’t need to outrun the bear,” replies the second camper, “I just need to outrun you.”

That kind of thinking may work for relativists, but the important return-enhancing role that PE plays in institutional portfolios demands that we instead ask: for all the extra risk and illiquidity we incur, if you can’t outrun the bears (and the bulls) why bother?

Chris Douvos’ blog is www.superLP.com