Changing the Game

On the occasion of East Rock Capital approaching its 15th year of operation, we are initiating a series of writings on world-class performance, both inside and outside of investing.

Changing the Game will focus on areas of competition in which an innovative strategy or subtle edge allows one competitor to separate itself from its peers. David Swensen disrupted endowment fund management as an early adopter of private equity and hedge fund investing, which was a significant leap forward from the old stocks and bonds model. East Rock’s founding investor, the Miller family, built Lennar Corporation into the largest homebuilding company in the United States by controlling all aspects of the construction process and meeting all needs of the homebuyer. In baseball, the Tampa Bay Rays have made the playoffs 5 of the last 12 years with payrolls that are consistently among the league’s lowest. They have been called “more ‘Moneyball’ than the Moneyball A’s themselves.”1 The team’s owner, our client and informal advisor Stu Sternberg, has selected team executives who have successfully pushed data-driven strategies to new levels.

In this series, we will draw from academic research, studies of high achieving organizations, and our own experience with outlier investment managers. We will examine the potential for outperformance in the investment sector, where markets often appear efficient until an inefficiency is unmasked. And we will discuss our efforts to bring a higher standard to family investing by focusing on talent, sourcing, and alignment. The goal of this series is to create a collection of our learnings on what it takes to outperform.

In this first issue, we explore the surprising power of trust.

Trust is more powerful than most people think. In fact, new research in social science has found that the most successful people, organizations, and countries aren’t necessarily the ones with the highest IQ or the best resources. The winners in life frequently have built a large network based on mutual trust.

Some intriguing research demonstrates the power of trust at the level of national economies.

It turns out, there are enormous differences in how trusting people are in different countries. The World Values Survey has asked hundreds of thousands of people around the world a simple question: “Can most people be trusted?” In Norway, more than 70 percent of residents answer yes. In the Philippines, fewer than 5 percent do.2 And this simple metric — the percent of people who agree that others can be trusted — is highly correlated with how fast a country grows. As the percent of residents who believe others can be trusted increases by 10 percentage points, a country’s economic growth, on average, increases by 1% each year.3

Now, this correlation alone doesn’t tell us that trust causes economic growth. But economists are finding strong evidence that it does. Perhaps most convincing is what happens when a group of immigrants arrives from a high-trust country. Economists have found that such immigrants tend to bring with them their high levels of trust — and places with many immigrants from high-trust countries tend to have higher economic growth.

Economists have estimated that some countries with the lowest trust could have a GDP level five times higher if their residents had higher levels of trust in each other.4

It turns out, there are enormous differences in how trusting people are in different countries. The World Values Survey has asked hundreds of thousands of people around the world a simple question: “Can most people be trusted?” In Norway, more than 70 percent of residents answer yes. In the Philippines, fewer than 5 percent do.

Country by Country: Trust Versus GDP per Capita.

Shown is the share of people agreeing with the statement “Most people can be trusted.” For each country the latest available data is shown.

Source: Data from: World Values Survey Data, Longitudinal (2014) and Penn World Table. The chart has been re-rendered and simplified, with the highest and lowest values called out. Licensed under CC-BY-SA by the author Max Roser.

Estonia Kazakhstan Monteneg r o Belarus Thailand India Iraq Dominican Republic Indonesia Y emen Ky r gyzstan Russia Czech Republic Hungary Slovakia Israel Lithuania Slovenia Spain France V ietnam Poland Uruguay Azerbaijan Bulgaria Algeria Egypt A r gentina Albania Pakistan Ethiopia Bangladesh Ukraine Macedonia Serbia V enezuela Chile T urkey Brazil Philippines Colombia Ghana Ecuador Peru Lebanon Iran Mexico Armenia Geo r gia T anzania Zimbabwe Uganda Zambia Mo r occo Nigeria Burkina Faso Rwanda Mali Moldova Palestine Guatemala T unisia Jo r dan Malaysia Cyprus Romania T rinidad and T obago Latvia C r oatia Japan Canada Germany Hong Kong Saudi Arabia Switzerland Singapo r e Kuwait Norway Australia New Zealand China Finland Sweden Netherlands United States T aiwan Bahrain United Kingdom Italy 70% 60% 50% 40% 30% 20% 10% 0% $0 $10k $20k $30k $40k $50k $60k $70k

Why Trust Matters

Why is trust so valuable for getting large groups of people to perform better?

First, when people trust each other, they share valuable information instead of hoarding it. Studies have found that, when students trust each other, they perform better on standardized tests — perhaps because they help each other learn.5

Second, trust lowers transaction costs. People who trust each other spend less time on legal and research fees. A study of the auto industry reported that, when suppliers and automakers reported that they trusted each other, they spent 80% less on procurement costs, which included time haggling and contract fees.6

Third, trust allows people to take risks. When people trust others, they have confidence that, if they succeed, they will be fairly compensated. Trusting individuals also report a lower fear of failure, confident that they will get second chances.7 Indeed, trust in the people around you is a strong predictor of starting a business.8 The effect of trust on entrepreneurship is particularly strong among immigrants. A group of researchers found that, in predicting rates of entrepreneurship among immigrants, the levels of trust in a society was a more significant predictor than measures of the quality of a country’s governance, its levels of GDP, or globalization.9

Trust Networks: Bigger is Better

The size of a network of trust is crucial in creating significant positive outcomes. In some parts of the world, people can exhibit high levels of trust but reserve this trust for a select subset of people: namely, their immediate family members. And these places — where the network of trust doesn’t extend much beyond one’s house — struggle economically.

In a study of a large sample of countries, economists found that trust in family members alone does not create strong economic performance — and sometimes can lead to worse economic outcomes. It is only when people trust in a wide circle of people that an economy booms.

Most notably, the economies in places where only family members can be trusted tend to be dominated by small, family-owned firms. Places with large circles of trust tend to create large firms with multiple shareholders that drive innovation. Each one standard deviation increase in trust increases the share of GDP produced by large firms by 7 percentage points.10

Bigger companies tend to mean more growth. A McKinsey study of developing countries, for example, found that outperforming countries have about twice as many big companies per trillion dollars of GDP as other emerging economies. Why? Because large companies “bring productivity benefits by investing in assets, R&D, and job training at a higher rate than small and midsize enterprises (SMEs) — and they tend to pay higher wages.”11

Large trust networks have also been shown to be valuable in the field of venture capital. One study of 3,500 venture capital funds managed by 2,000 venture firms used a variety of measures to determine the strength of each firm’s ties to the rest of the venture capital community.12

The authors found that how connected a venture firm was to its peer firms was a significant predictor of how it performed. And this was true even after taking into account other predictors of fund success, such as how old the firm was and the success of its prior funds.

Share of people agreeing with the statement “Most people can be trusted,” 2014

The survey question was, “Generally speaking, would you say that most people can be trusted or that you need to be very careful in dealing with people.” Possible answers were, “Most people can be trusted,” “Don’t know,” and, “Can’t be too careful.”

Trust allows people to take risks. As the percent of residents who believe others can be trusted increases by 10 percentage points, a country’s economic growth, on average, increases by 1% each year.

Source: Data from: World Values Survey Data, Longitudinal (2014) License: CC-BY.

The authors concluded that a one standard deviation increase in network strength at the time of fund formation increased the internal rate of return of the fund by 2.5 percentage points.

How Trust Can be Built

So how can a network of trust be built? What causes people to trust each other?

To try to answer this question, Alberto Alesina and Eliana La Ferrara analyzed data from the General Social Survey. In particular, they studied some 7,000 answers from Americans to the question of whether other people can be trusted.13 They looked at what demographics and life experiences predict that people will agree that others can be trusted.

One factor stood out as dramatically increasing trust: having a great recent professional experience.

More generally, trust increases when people have been treated well.

One interesting factor did not predict trust one way or the other: living in the same place for a long period of time. You might have guessed that people who had long resided in the same community would have great trust for the people around them. You might have naturally suspected that people would build trust with those they have known for long periods of time.

But this is not necessarily the case. Long-standing acquaintances only build trust if they have acted in ways that make you trust them. Just as easily, long-standing ties can destroy one’s trust.

Familiarity doesn’t breed trust, in other words. Trustworthiness does.

If people are more trusting when they have been treated well, this suggests that you can build a network of trust by treating other people well.

Indeed, a laboratory experiment by James H. Fowler and Nicholas A. Christakis showed the power of literally one person acting trustworthy.14

They randomly assigned strangers into groups of four to repeatedly play a public goods game. In such a game, players decide how much of their own money to contribute to a shared pile. If everybody contributes money to this pile, everybody will end up better off. Fowler and Christakis found that, if a single generous person is randomly assigned to a group, all the other players begin contributing more. In sum, when one person enters a group and treats others well, others start to work together to build and share a larger pie.

Trust spreads.

How Trust Helps East Rock

Several years ago, JTS Investment Group15 had nearly locked up what they viewed as the deal of a lifetime. A major international bank under pressure to raise capital was willing to sell a loan package to them at 38 cents on the dollar. There were 30 loans and they were collateralized by high quality commercial real estate in major cities in the United States. JTS had calculated the package was likely to pay off at nearly twice the purchase price.

But JTS faced a remaining hurdle. The deal size was $300 million and they did not have that full amount available. To complete the deal, they needed to raise capital quickly and quietly.

JTS considered the situation so sensitive that they named the potential acquisition “Project Skunkworks.” They feared that, if others heard about the deal and understood the value of the real estate, they would try to grab the deal for themselves.

Who should they call? We’ll come back to that in a bit.

* * *

Sometimes, an investment manager will locate an opportunity that is pretty close to a sure win. Even world-class managers might find such an opportunity only two or three times in their entire careers. It is for this reason that a large trust network of talented investment managers is so valuable. Since 2006, we have strived to position East Rock to rarely miss a “Project Skunkworks” situation. Instead of two or three of these opportunities in a career, we believe our network has the potential to provide two or three per year.

While we have developed some creative ways to build and strengthen our network, the fundamental approach is quite simple. We meet lots of managers, approximately 400 last year. We help them — with introductions, career advice, assisting with new hires, and any other way we can think of. We host events and small gatherings and try to get to know people outside the context of business as usual. And we focus intensely on acting in a trustworthy manner, always, and identifying others who do the same.

When conducting references on a potential new partner, we listen for statements that are strong indicators of trust — statements that we hope and believe others would say about us. Examples of these statements include:


“I would do a deal with them on a handshake.”


“I know they’ll do the right thing when no one is looking.”


“They listened to what I was trying to accomplish and they helped me get there.”


“They would rather lose their own money than someone else’s.”

How does our large network of trust help us achieve our goal of protecting capital and growing it faster?

Here are two clear benefits.

First, people trust us with sensitive information about people. Sometimes, this information is critical in telling us who to partner with. Other times, it is critical in telling us who to avoid.

Second, mutual trust is the glue that allows East Rock to partner with talented investors outside of the rigid context of traditional private equity funds.

A positive experience with Tim White, founder of Dunes Point Capital, is an example of both benefits.

When we met Tim, he was a veteran of three high quality private equity firms and was starting a new investment firm. There was a lot about Tim that was intriguing: he had a strong prior track record; a demonstrated skill at improving company operations to yield investment returns; and a commitment to risk his own capital side-by-side with his investors’ money.

But to determine whether Tim was really someone we should partner with, we turned to our network.

We have a close relationship with the former CEO of a major Wall Street firm who was close with Tim’s former boss. We asked the former CEO if he would place a call and get the real story.

The next day, he reported back: “I don’t know who this Tim White guy is, but based on what I just heard, whatever you are doing with him, I want in.” Later, Tim’s former boss, whom we had not met previously, told us directly that Tim was the only person he’d trust to manage all of his assets and his children’s assets if he ever retired and “went to the beach.”

Excited by the strong reference, we proposed to Tim a unique partnership. We would lead a group of investors to commit to a series of Dunes Point deals by providing $5 for every $1 invested personally by Tim, subject to certain conditions. The mutual benefits were clear. We would get access to deals identified and executed by an “A” talent, with great alignment. Tim would get access to user-friendly and flexible capital.

But Tim had concerns and needed to be convinced. He did extensive reference checks on us before agreeing to go forward. This process took time but created a strong foundation for our partnership.

The mutual trust we developed with Dunes Point, and the structural flexibility it permitted, gave our partnership some unique advantages. We were able to acquire a portfolio of industrial businesses owned by an ESOP (Employee Stock Ownership Plan) subject to onerous rules that traditional private equity firms were not able to navigate. Tim’s unique ability to convey trust and portray his firm as a tight-knit group of family investors helped him acquire, at an attractive price, a building products company from two feuding families whose board had been deadlocked for many years. And our partnership dealt optimally with an under-performing investment in a supplier of datacenter equipment, which allowed us to recover the majority of our original investment.

With Dunes Point we built a portfolio we are proud of and believe is on track for a successful result. Recently, Tim and his team engineered a favorable partial sale of our building products company just as COVID-19 was beginning to hit. In executing this complex transaction, Dunes Point showed us, once again, their unique talent — talent we could not have connected to without a large network of trust.

* * *

Returning To Project Skunkworks

To further demonstrate the power of a large trust network, we turn back to “Project Skunkworks.”

JTS needed a partner they could trust on multiple levels to complete the Skunkworks investment. First, all information needed to be kept confidential. Second, the prospective partner needed to be trusted to work quickly towards a commitment and surface issues immediately. Third, if the partner committed to providing the remaining capital, there needed to be 100% certainty of following through to closing or the deal would be lost for lack of funds.

We were the perfect partner for them, but we had not worked with JTS before. Would we find each other? Fortunately, our large network meant that we had a number of relationships in common with people throughout the JTS organization. In fact, we were one degree of separation away from the two co-founders, the head of investor relations, and most of the JTS real estate team. So, it was not a coincidence when a JTS investor re-introduced our two firms in the context of Skunkworks.

Because of our common relationships, it was easy for JTS to confirm our track record as a trustworthy partner in similar situations. And from our first in-person meeting, it was clear to JTS that we had a large trust network within commercial real estate that would allow us to research the opportunity quickly and discreetly.

We got to work right away.

Often, good deals earn investors more than money, and Skunkworks was one such deal. It offered a great opportunity to reconnect with one of the most talented hotel investors we have ever met, Jonathan Wang. Early in Jonathan’s career, when he would take business trips, he would stay in a different hotel within each city each night. It helped him create a vast network of hotel property managers and made him a walking encyclopedia of hotels. Jonathan is also the type of giving individual who will help without needing to know exactly why. This allowed us to maintain confidentiality while getting a very strong sense of the real estate value behind Skunkworks. When we called him for help, all we had to do was mention a submarket (e.g. LA — Burbank area) and he could list the properties in the area, what he thought of them, who managed them, and what they were likely worth per room.

As an important aside, the experience with Jonathan confirmed our strong interest in partnering with him. When he later decided to start his own firm EOS Investors, he gave us the privilege of being his primary backer. It is one of our most valued investing relationships today.

Based on the insights we gained from Jonathan and other advisors in our network, it was clear that Skunkworks wasn’t too-good-to-be-true. We realized quickly that we wanted to lead the outside investors and make Skunkworks one of our largest investments to that date. JTS, based on the rapid development of mutual trust over a few short weeks, agreed to our request to lead. Together, we closed the transaction.

As we look back on Skunkworks, it reminds us that spreading trust through our network offers about as high a return as any other action we can take. After closing, the loans began paying off ahead of schedule and the overall result exceeded our expectations. It was a great deal, made possible by the power of trust.

Issue #2 Preview

What do world-class artists, tech companies, and investment firms have in common? They search through a huge number of ideas to find a few big winners.

In our next issue, we will explore how quantity of output and opportunities leads to quality.