From 1994 until the end of 2000, the private equity market was glorious. Its floodgates broke under the rush of new capital. Newly minted general partners, new partnerships and new fee schedules snowballed. Private equity was irresistible.
What a difference a downturn makes. Once “far-sighted” general partners now look feebleminded. The venture capital component of the private equity market has collapsed, and from the depths of its debris investors are only now digging themselves out. As they survey the debris of irrational exuberance, face fearful general partners and confront a constipated private equity market lacking both new capital and exit opportunities, they wonder if it’s time to abandon private equity altogether.
The limited partner’s answer is found at the end of a disciplined and explicitly defined process. This process of constructing and reviewing an investment program can help the astute limited partner find opportunities in both down and up markets. This process can determine whether continuing a private investment program, restructuring it or shutting it down is the limited partner’s best option. This process has three steps. While simple in definition, it is both coherent and comprehensive in application. Those who don’t practice it, those who leapt into the market without forethought or insight when the market was hot, will tumble out of the market poorer but none the wiser.
While there are many variants, the process can be summarized as follows:
Precisely define your program purpose and exactly how to measure achieving it.
Separate purpose, which exists only in context to the limited partner, from means (private investing), which has no inherent context to the limited partner.
Ensure that your private investment program (means) is the sole or best way to achieve purpose.
Define Your Purpose
The first step in program construction or review is to explicitly determine, define or refine your program’s purpose. A formal statement of purpose describes three components: the limited partner’s current condition, the limited partner’s unmet need and the measurable difference between them. Condition and need must be accurately and precisely established to determine which means can be used to take the limited partner from current condition to a future condition where the need is met.
The universe of current conditions and unmet needs addressed by a statement of purpose can be infinite in variety. A constraint, however, is that the change between each current condition and need must be assessable, substantive and quantifiable. To be measurable, the change between current condition and unmet need must have the attributes of magnitude, quantity and duration. Magnitude means that change can be individually measured against the limited partner’s current or future condition. Importantly, magnitude creates context by relating change to qualities of the limited partner: current condition and need. Quantity ensures that the difference between current condition and unmet need is calculable by characteristics other than time. Duration provides for evaluation by time.
The universe of unmet needs addressed by a statement of purpose can be infinite in variety: Pension plans need to address future liabilities, endowments and foundations need to realize charter goals by making grants, and corporations may need to acquire new products, services, technologies and/or clients. In each case, the limited partner’s current condition includes an unmet need.
Put It Into Context
Placing need in context to the limited partner creates the capability for determining the value and risk of satisfying that unmet need. In this case, value is a measure of an action’s worth, its probability and utility for achieving that unmet need in whole or in part. Risk is the cost of that action’s failure. Risk and value are measures used by the limited partner to determine if satisfying the unmet need and going from current condition to a future condition is worthwhile. As with magnitude and need, value and risk are defined in context to the limited partner.
Investing is a means of addressing unmet need. However, need and the limited partner’s consequent future condition cannot be accomplished directly through an investment program. An investment program can only provide a portfolio of outcomes that must be placed in context by the limited partner and valued by their utility within that context. A limited partner’s unmet need and future condition cannot be encompassed within an investment program because those things exist outside of an investment program.
The investment process is inherently generic, without context to the investor. As such, investment metrics cannot substitute for future condition. For example, the chief investment officer (CIO) of a pension plan cites the “need” to obtain 22% internal rate of return (IRR), or 650 basis points over the Standard & Poor’s 500, from his or her private investment program. This metric has no context to the investor, no value or risk and consequently does not represent a need or condition. However, if the CIO identified an unfunded liability whose consequences could range from destitute pensioners to a federal takeover of the pension plan, then magnitude, context, value and risk are assessable and this represents a limited partner need. Regardless of their specificity or complexity, ROE, IRR, multiples of investment or any other investment metric cannot, in isolation, measure need or condition.
Determine the Best Approach
An investment program should be considered when it is the best or sole means of facilitating unmet need or future condition. To determine “best” requires that the limited partner compare and contrast possible investing outcomes to the outcomes of alternative means. These outcomes must be valued by their utility in facilitating unmet need. The risks of failure, direct as well as indirect, must also be considered. Direct failure is when the desired individual outcome is not achieved. Indirect failure is when the desired outcome is achieved but proves to have a different value than presupposed.
The limited partner must determine if investing, either publicly or privately, is an appropriate means to fulfill unmet need. Importantly, need and the means to facilitate it must be appropriately matched. For example, if the unmet need is an outcome from a single event, like rolling two dice to get a “7,” the means used to facilitate it must be singular and indivisible. If the change between current and future condition is incremental, obtainable through fractional gains, then incremental means may be used to facilitate it.
Investing is an incremental process made up of discrete inputs (investments), discrete process decisions (buy, hold or sell) and measurable outcomes (win, lose or draw). Additionally, an incremental process like investing must have quantity and duration attributes that are divisible, capable of being separated into constituent parts. In rolling dice, there is one indivisible event, the roll, with one indivisible outcome, either you get a “7” or you don’t. Similarly, a single investment and its outcome may be indivisible and occur instantaneously. Investing, however, is the process of making more than one investment at more than one time. Like constructing a limited partnership portfolio, it cannot be instantaneous, and it must have measurable, divisible duration. In summary, if the change between current and future condition for the limited partner is incremental, with divisible quantity and duration, then investing may be appropriate.
Each investment program created under a statement of purpose should address a single need and have a single strategic goal. Multiple goals inevitably conflict. For example, investing to promote a social issue and investing to promote an economic outcome are different needs. An investment’s value, its probability and utility for incrementally fulfilling a need cannot be maximized for two different needs at the same time. Failing to choose between needs creates a program that does not maximize the value of its investment or portfolio outcomes. As such, it cannot be the best means to facilitate a limited partner’s unmet need.
If the need and goal is singular, all investments made and all investment outcomes obtained lead to the same conclusion. This makes the investment program comprehensive. The advantage of a comprehensive investment program over a series of unrelated individual investments is efficiency. The limited partner can directly and indirectly use every type of outcome (win, lose or draw) to advance a single need. To be comprehensive, every investment in the program and portfolio must have a clear relationship to the limited partner’s unmet need.
If there are different end goals, there must be different intermediate goals. If there are different intermediate goals, there must be different investment goals. If end goals are different and independent, none of the intermediate or investment goals have to relate to each other. This precludes the coherent use of investment outcomes.
The inverse situation occurs when there is a singular need or goal. Not only do all intermediate and investment goals lead to the same end goal, but also all intermediate and investment goals relate to each other. At a minimum, all goals are related through the limited partner’s unmet need. The ability to use all outcomes coherently, in logical relation to each other, provides the limited partner with two advantages. If multiple investments are made to achieve a singular need, then the failure of any one outcome can be overcome by other outcomes. Additionally, multiple successes may increase the overall probability of fulfilling the unmet need.
In summary, for an investment program to be the best means of facilitating unmet need, that need must be incrementally obtainable. The change between the limited partner’s current and future condition must possess the attributes of divisible quantity, divisible duration and magnitude. The investment program should address a single unmet need. The investment program must be both comprehensive and coherent.
Keep Your Eye on the Ball
Private investing presents unique challenges. In between capital or liquidity events, a private investment’s value is subjective. Consequently, a private investing program must be able to advance toward its unmet need in the absence of objective information. Without this ability, the private investment program may lose both direction and velocity and may falter. Additionally, investing in the private market through limited partnerships adds a layer of complexity. It decouples the limited partner’s decision to invest, from the general partner’s decision to deploy capital into portfolio companies. Capital may not be completely deployed into portfolio companies for several months or years after the limited partner’s investment decision. As a consequence, the limited partner faces strong frictional forces (see Figure 1).
To create strong countervailing forces, a limited partner’s private investment program must have the qualities outlined in Figure 2.
There are an infinite variety of unmet future needs and, accordingly, an infinite variety of reasons for creating a private investment program. These reasons generally fall into one of two broad categories: financial or operational. Financial reasons run the spectrum from economy of force investing to speculation. Operational reasons center on acquisition: acquisition of (1) technologies, (2) products or services or (3) markets, channels or clients.
Putting Theory To Work
Financial reasons typically drive the formation of private investment programs for pensions, endowments and foundations. For example, a pension plan CIO considers the plan’s liabilities 15 years out. Against these, he projects the business cycle, subsequently generated revenue and contributions from the plan sponsor. Identifying a possible mismatch between long-term liabilities and assets, he initiates a high-growth strategy via private investment, setting aside 5% of current plan assets for this strategy.
The CIO’s statement of purpose would cite the current condition of the plan: assets, investment mix, risk and return assumptions. The unmet need is the unfunded liability. The measurable change is the increased growth required to meet that shortfall without jeopardizing the plan’s ability to meet its short-term liabilities. The consequences of this unfunded liability range from destitute pensioners to a government take-over of the plan. All of these possibilities help to define risk and value in context to the pension plan and outside of the investment program.
The CIO’s high-growth strategy is known as economy-of-force investing, which is the use of small, non-critical resources to produce big results. In investing generally, and with this CIO specifically, it is a high-risk, high-return strategy driven by a compelling need.
Many financial investors create economy-of-force investing programs by accident. This is a common oversight when the limited partner looks at the investment program in isolation-without context, condition or need. For example, establishing a private investment program in order to get a 22% IRR is valueless. The private investment program only has value because it facilitates an otherwise unmet need defined in context to the investor. Another reason for accidental economy-of-force investing is that the language used to describe a financial organization’s daily operations and the language used to define condition, need and context is financial. This identical lexicon tends to blur the distinction between the operations of investing and the unmet need it is facilitating. Additionally, when the pressure of financial obligation is gradual and distant, the visibility and immediacy of failure’s costs becomes equally diminished.
Foundations and, to a lesser degree, endowments indulge in accidental economy-of-force investing because they don’t endure the immediacy or degree of near-term liabilities as do other financial investors.
Beware of Subtleties
Unlike the pension plan whose goal is to pay pensioners, foundations pose a unique challenge in creating a statement of purpose because their unmet need is external. For example, a grant-making foundation is established to fund cancer research. If the foundation’s private investment staff misses its 10-year goal of 22% IRR by half a percent, the loss seems minimal. However, if that 0.5% could have funded a research effort that discovered a cure for cancer, then the value lost by that 0.5% shortfall would be enormous. The value of that cancer cure and the cost of its failure exist outside the foundation and its finances. For the foundation’s investment program to work, the research effort’s value, its probability and utility for achieving the foundation’s unmet need must be weighed against the cost of its failure, including the internal resources used to fund it. The need for an explicit statement of purpose at foundations is greater than other financial organizations because the unmet need, its value and risk are external to the organization.
The steps that a grant-making foundation must take are no different than any other financial investor. Define current condition, future need and the change between the two. Explain why a private investment program is the best or sole means of facilitating purpose. The challenge is that the components of purpose (current condition, unmet need and the measurable change between them) are external. For instance, the cancer research foundation may have a variety of cancer cure related goals stated in its charter. Instead of hiring scientists, building labs and pursuing those goals internally, the foundation funds external efforts. For the foundation to develop and maintain a program to fund those outside efforts, it must conform to the standards of program construction. Each outside effort must present a singular, irreducible goal of measurable quantity, duration and magnitude. Their value and the consequences of their failure must be directly and measurably attributable to the resources that fund them.
A foundation’s charter provides the context which links outside efforts to internal resources. The charter presents a list or description of unmet needs whose fulfillment represents the foundation’s basis for existence. While a charter’s description of future need is typically broad and directly unattainable, it is the executive staff’s job to create an array of singular goals of measurable quantity, duration and magnitude that encompass the change required by the charter’s unmet needs. Any private investment program must be attributed to and justified by the goals crafted from the charter’s unmet needs.
For example, suppose the cancer research foundation’s charter cites reduction of cancer-related deaths as its strategic goal, with cancer detection as its specific focus. To develop a statement of purpose for this focus, the grant-making staff members might precisely establish the current condition of detection science and commercially available technology. They define the unmet need as development and commercialization of new methods for cervical cancer detection allowing diagnosis at least 20% earlier than currently available. For measurable quantity, they develop a model of the development process with sequential, testable specifications. For duration, they determine a time line that represents an accelerated innovation cycle compared with the rate of normal innovation in cancer detection science. In coordination with the investment staff, they determine a “successful” commercialization and how to measure it.
The executive staff members sum up the positive effects of fulfilling this unmet need. They determine its magnitude by measuring those effects against the strategic goal of reducing cancer-related deaths. This effort’s value is its probability and utility for achieving some measurable portion of the foundation’s strategic goal. Its risk is the effect that failure would have on achieving the strategic goal. The foundation’s charter sets the goal and provides the context. This context links outside value to the internal resources, intellectual and financial, used to facilitate the goal.
Given magnitude, value and risk, measurable quantity and duration, the investment staff and the grant-making staff need to jointly determine the best means for facilitating this effort. There are many avenues available, such as grants for pure and applied research, investment in public companies, direct private investment in a company focused on this goal and indirect private investment in companies focused on this goal through limited partnership investing. To determine the best approach, the staff must compare and contrast the possible outcomes from each means considered. The best means or combination of means offers the highest utility and probability of facilitating unmet need.
In addition to this particular effort, the investment staff may operate with a portfolio of prior programs and constraints. A constraint might be that each new program cannot jeopardize the funding for existing initiatives. Additionally, the foundation may have goals for annual grant making, asset growth and operating expenses. The investment staff must consider its entire portfolio of programs, goals and constraints when deciding how to facilitate the foundation’s unmet needs.
Whether you’re working in a pension plan, corporation, endowment or foundation, an explicitly defined purpose with context, value, risk, magnitude, measurable quantity and duration can provide a clear and compelling rationale that allows you to operate effectively in objective and subjective investing environments. A coherent and comprehensive investment program prevents wasted resources, maximizes the value of investments and increases the probability of success in meeting unmet needs.
Deploying millions of dollars into a unique and expensive market, limited partners risk more than money. They risk their existence. Without explicit purpose, limited partners may dissipate enormous financial and intellectual assets. Without accurate or precise purpose, they lack a measurable, incremental path towards success, and without success, limited partners risk survival.
David Katz is president of Katco, a strategic consultancy for institutional investors in the private markets. The San Francisco based consultancy assists investors with program and portfolio construction, restructuring and performance measurement. Mr. Katz may be contacted at DKatz@KatcoInc.com.