There are no brave old people in finance. Because if you’re brave, you mostly get destroyed in your 30s and 40s. If you make it to your 50s and 60s and you’re still prospering, you have a very good sense of how to avoid problems and when to be conservative or aggressive with your investments.
This is such a good quote from Steve Schwarzman via Dan Primack.
Having just come through a massive risk-on investing period in Silicon Valley, an era where seemingly nothing but reward has been discussed (irrespective of investment entry point in a company’s life cycle) it is a nice reminder that reward AND risk management matters. Some risky bets might not fall you today, especially in private equity where feedback loops are long, but I can tell you from observing investment firms come, go, and stick around, over time, risk is a killer to a fund manager’s career and investors’ capital.
The funny part, though, is that risk is a nebulous concept; it can appear in many forms. Operational risks are usually easier to spot. In their most severe form, operational risks can be existential. Existential risks require intense focus to ideally avoid, but if required, to manage and mitigate. Sometimes, operational risks are less severe; it’s more a matter of identification and mitigation. If mitigated properly, while real, moderate risks can be inconsequential.
Still, other times, a company’s overall operations may appear low risk, but this is when risk pops up not in operations but valuation (price risk). This risk can be much harder to identify and mitigate to the untrained eye, and let’s be honest, even the trained eye when using a consensus-driven mindset. If a company is priced to perfection, one slip in execution or even just consensus expectations, can lead to an incessant downward spiral in equity value. (Witness Twitter’s IPO valuation relative to expectations and the downward spiral since.)
No matter the source of risk, its results are on full display in one statistic: A fund manager’s loss ratio. Below is a summary of loss ratios for each private equity investment strategy according to Cambridge Associates, which Cambridge defines as:
The percentage of capital in deals realized below cost, net of any recovered proceeds, over total invested capital.
As shown in the graph above, when it comes to risk (loss ratios), venture capital investors are the extreme. They generally ignore downside risk, instead seeking “high risk, massive reward” outcomes. Early-stage VC funds can have 40%+ loss ratios, and still, fund-level returns can be fantastic. Investing in this fashion requires seemingly crazy conviction to achieve the massive wins required to overcome high loss ratios.
Buyouts investors manage losses by focusing on high-quality businesses with recurring revenues that can be purchased cheaply. You also often see a dividend recap to get the buyout investor’s cost basis back, playing for upside with the house’s money. Debt levels are another risk/return lever, with many buyout managers seeking max leverage to boost IRRs in exchange for increased risk.
With growth equity, similar to venture, the focus is heavily on the upside. However, unlike venture, where VCs invest in congruent deal structures at the Series A stage of a company’s life, growth equity is more nuanced. Companies end up in this market with wildly different capital structures, lifespans, founder involvement, preferred stock terms, valuations, and funding levels (some bootstrapped, others massively venture funded). Furthermore, growth equity investing is often a look down, then up, investment exercise. Investors are constantly asking themselves, “How can I avoid losing a dollar, while capturing exposure to the upside?” As a result of these numerous factors, growth equity investors use an array of valuation and structuring tactics to tailor risk to potential rewards.
Thus, unless you’re an early-stage venture investor where it’s only about reward, as Steve Schwarzman points out, you better have a good reward AND risk management strategy if you want to have a long run in the money management business.