List of all Perth posts

Are the Financial Guys in Private Equity Failing Due To Over-Reliance On Financials?

I guess you’ve noticed all the comment and analysis about private equity doing worse than the S&P or at least not doing better? Seems that while PE has done much better than the S&P over a 10 year period, over the past 5 years they have been way behind.

But alternative investments are supposed to beat the pants off the old ways of doing things like investing in stocks. So even if PE does as well as the S&P, it essentially means it has lost the contest in which it claims to be a much better alternative. How can that be when PE employs the smartest economists, financiers and data junkies? And coupled with a no-holds-barred approach to under-performance that is often seen as brutal?

Private equity is about increasing the valuation of their holdings. To do that, PE pursues an unrelenting approach to improving the usual litany of financial metrics; EBITDA, ROI, ROE, EVA, you name it. In theory this should lead to outsize returns that should easily beat the S&P or for that matter any other index. So what’s the problem?

Here’s a hint. Look at the undisputed master of private equity, Warren Buffett. What’s his secret? Well, from his point of view, there isn’t one. He has broadcast it very widely. He looks for strong management! What does that mean? It means managers with the “right behaviors”.

What could right behaviors actually mean? Well Buffett doesn’t actually talk about that so much, probably because he relies on his amazing intuition. But we are starting to see what they are from the emerging disciplines of behavioral economics and behavioral finance.

These new disciplines focus on unconscious biases that result in systematic biases in management decisions that lead to them under-performing as managers. This has led to a new breed of PE managers who focus on behavior first, and value second. This new breed includes Richard Thaler, a professor of behavioral economics at the University of Chicago and coauthor of the bestseller “Nudge”. He’s also a principal in an asset management firm, which manages more than $2 billion by using insights from the study of investor behavior to identify “mispriced” stocks.

But there’s an ever newer approach, which is to focus on the behaviors of the CEOs and management teams of portfolio companies owned by PE firms. In this new approach, when you do due diligence on the firm, you look at the behaviors of the management teams first and their financials second.

And no, we are not talking about the hunch-driven guesses of PE portfolio managers which mostly don’t work out. We are talking about formal assessment instruments that measure the behaviors of management teams using behavioral finance-based instruments. The idea is to get past the idea that PE managers somehow know best and can take the behaviors of their portfolio firms as a given that they know and understand well because of their vast experience. The record shows unambiguously that these approaches mostly don’t work.

Here’s the rub. It’s clear that the financials produced by a company are symptoms of behavior. If you don’t understand the behavior, you can’t understand the financials. What’s more, they are lagging indicators of behavior. They show you the behaviors that occurred one or more years ago. If you really want to understand what is coming down the pike you have to understand management behaviors because they are leading indicators of the financials.

But that has been a problem for PE firms. The managers of these firms have been schooled in finance, not psychology, or behavioral finance. And until quite recently there haven’t been any formal ways to measure manager behaviors using assessment instruments based on a behavioral finance paradigm. While there have been attempts to use personality assessments to measure these behaviors, these just haven’t worked. That is because these were never designed to measure the financial impacts from different personalities.

But now there are assessments that can be used for management due diligence, like those from our very own Perth Leadership Institute. These allow you to look at the financial impacts of behavior and even to predict likely impacts on the income statement and common valuation metrics.

That’s going to be interesting. Is this something the PE guys really want, or is a scientific approach to behavioral valuation too threatening to the current PE business model? To wit, are PE managers going to feel that their basic people analysis skills are going to be questioned so that puts their portfolio choices into question?

If so, join the club. There isn’t a board in the world that hasn’t made terrible management choices of CEO and hasn’t lived to regret it. There’s no shame in PE admitting that they haven’t found the answer either.

So PE managers are really no different. But since they are promoting the idea that their alternative investment strategies are better than the traditional ones, the onus is on them to put up. About the only way I can see that happening is to go the behavioral route because the financial and quant route to PE has failed gloriously thus far.

That is, it hasn’t beaten the traditional approaches. And in order to get real street cred, it’s gotta blast them into oblivion.

It’s true, that the normal biographical information given to investors about CEOs and senior executives is pretty useless in terms of its behavioral value. The biographical information in proxy statements is normally almost totally useless in assessing likely performance of the executive.

Even worse, the biographical information is usually airbrushed, especially in the case of CEOs by public and investor relations firms that are hired for that very task. Often this information is a hagiography, not a real biography. That makes it even more important for PE firms to find alternative ways to evaluate biographical and behavioral information so that their management due diligence constitutes more than the usual token review.

You know the old saying attributed to Einstein? The definition of insanity is doing the same thing again and again and expecting a different result. Sounds like a perfect description of PE (also most hedge funds) to me.

It looks to me that the PE guys are guilty as charged. If they want to make a quantum jump in their returns, they are going to have to do things very differently. It seems to me the first thing they have to do is rely less on financial measures, which so far haven’t yielded the results they wanted. And the best candidate for a new set of metrics is behavioral. If they do that they have a fighting chance of breaking through.

If they don’t, it doesn’t look to me like PE has much of a future.

 

 

“Lean In” The Sequel: Are Women More Profitable th...
Eat Wheat To Become A Better Leader!

Related Posts

 

Comments

No comments made yet. Be the first to submit a comment
Already Registered? Login Here
Guest
Thursday, 21 September 2017

Subscribe Our Mailing List

Interest in leadership? Don't miss out our latest news!

Contact Us

Perth Leadership Institute

808 NW 13th Street, Gainesville, FL., US

  • Office: +001-(352)-333-3768

Connect with us

We're on Social Networks. Follow us & get in touch.
You are here: Home Perth Blog etedprince Are the Financial Guys in Private Equity Failing Due To Over-Reliance On Financials?