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Changing the Game

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

Changing the Game focuses 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.” 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 draw from academic research, studies of high achieving organizations, and our own experience with outlier investment managers. We examine the potential for outperformance in the investment sector, where markets often appear efficient until an inefficiency is unmasked. And we 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 third issue we discuss alignment, which is a critical aspect of all business relationships that we believe is often misunderstood. We discuss the surprises we’ve encountered through the years, and how alignment is a key to knowing when and how to rely on the work of others.

“I Love Other People’s Due Diligence.”

This flippant comment came from a reasonably famous investor we met a few years ago. He was describing an investment he was excited about. He hadn’t dug into the details but felt comfortable piggybacking off of the work of a private equity firm that was leading the deal.

As he explained his logic, it generally made sense. The lead firm was credible and running a thorough investment process. And from his vantage point as manager of a diverse global portfolio, the investor could compare the investment to a wide range of alternatives and see that the investment was priced attractively.

But potential misalignment among the investor group struck us as a red flag. The investor and the private equity firm were casual acquaintances with distinct investing styles. If the investment experienced some early problems, their differences with respect to time horizon, appetite to fund additional capital, and ability to understand company-specific problems could create tension or even paralyze the group. While invited to participate in the investment, we declined.

Our decision to pass notwithstanding, the investor’s comment about other people’s due diligence contained an important kernel of wisdom that comports with one of our core beliefs: In investing, as in much of life, the ability to properly rely on the work of others is a key to world-class performance. But getting it right is often a lot more complicated than it looks.

The Lessons

At East Rock, 15 years of forming partnerships with a wide variety of investment managers has taught us some valuable lessons about alignment. During this time, we have paid close attention to the motivations that drive the people around us, which has helped us understand the following:

  1. Incentives are easy to misjudge.
  2. Alignment behavior is often correlated with stage of career.
  3. Skin in the game matters—but not all skin in the game is created equal.
  4. Long-term aligned relationships can create superlative—and personally gratifying—results.

Incentives Are Easy to Misjudge

Before we discuss our own experience with incentives, a story. In 1998, two economists ran an experiment in Israel.

They were trying to get parents to pick up their children on time from Haifa’s day care centers. Haifa’s day care centers close at 4 pm, but parents were not penalized for showing up late. The economists directed six out of the ten participating centers to impose a fine for tardiness that, they hoped, would motivate delinquent parents to arrive on time. The experiment backfired. The number of parents who reported late to pick up their children more than doubled. It turned out that having to apologize to a day care worker exerted a more powerful hold on parents than money. Rather than reducing tardiness, the fine allowed parents to view late arrival as a legitimate option purchasable by money.1

At East Rock, we remember from many years ago an unfortunate surprise when incentives didn’t work as expected. In 2007, we committed capital to several private equity funds. It was planned at the time that the fund managers would deploy the capital over 4 to 5 years, i.e. between 2007 and 2012. As with most private equity funds, the managers were incentivized to deploy the capital fairly rapidly in order to begin earning carried interest on the funds’ investments. They were further incentivized to invest quickly because full deployment would allow them to move on to raise successor funds.

Despite these incentives, the problem with these funds did not turn out to be overly rapid deployment, but its opposite. The financial crisis that emerged in 2008 resulted in a period between 2009–2010 that offered some of the most attractive investment opportunities we at East Rock have ever seen. It should have been a prime moment for the private equity funds to deploy capital aggressively. But during this period only 35% of our private equity fund commitments were deployed. Why? It turned out that the funds had a number of investors who asked the managers to hold back. The investors were concerned about the liquidity and risk in their own portfolios and wanted the private equity managers to wait. The managers were under no obligation to do so, but they generally agreed. With the benefit of hindsight, we now know that this pressure, and the managers’ willingness to bend to it, resulted in a failure to take advantage of an unprecedented opportunity set.

Alignment Behavior is Often Correlated with Stage of Career

Each year we meet hundreds of investment managers. A striking pattern we see is how younger managers tend to be more focused than their more mature peers on alignment with their investors. Whether driven by the idealism of youth or a rational desire to create tight-knit investor relationships that can propel their careers, aligned behavior tends to be stronger among younger managers.

As with parents and daycare pick-ups, alignment between hedge fund managers and their investors can be hard to judge. At the launch of a new hedge fund, it is desirable for a manager to invest a substantial amount of personal capital in his/her own fund to share risk and reward with outside investors. However, as the fund succeeds, the manager typically accumulates a larger amount of personal capital and a valuable base of fee-paying outside capital. While nominally better aligned—the manager’s personal money often grows to represent a larger percentage of total fund assets—the manager has more to lose and may enter a new stage in which aggressiveness declines, often in contradiction to the goals of investors.

A recent study of 2,345 hedge funds found evidence of this evolution. It concluded that more experienced hedge fund managers tend to be rewarded with more capital for weighting their portfolios in favor of popular investments.2 Once managers have built a positive reputation, they can often protect their capital base by simply doing what everybody else does.

Knowing this, it is not surprising that data on hedge fund performance is fairly conclusive that younger hedge funds do better. A Preqin study on performance between 2012 and 2019 showed the following:

New hedge funds beat older funds by 3.7 percent on a three-year annualized basis, and outperformed by 4.6 percent over five years. In fact, hedge funds early into their lifecycle beat more established funds in every year included in the study.3

1.

Incentives are easy to misjudge.

2.

Alignment behavior is often correlated with stage of career.

3.

Skin in the game matters—but not all skin in the game is created equal.

4.

Long-term aligned relationships can create superlative—and personally gratifying—results.

Our experience with private equity indicates that there is a similar phenomenon in private investing. A recent academic paper focused on understanding differences in private equity performance found that the individual leader of a given investment is about four times as important in explaining the outcome of the investment than the private equity firm where the leader works.4 Top performers at the best private equity firms often leave to start their own firms, and, based on our experience, their best performance occurs in the early years of their new firms.

Of course, there are a variety of factors that may explain the outperformance of younger managers. But 15 years on the front lines tells us that motivation plays a big role. New managers know that their path to success is to give investors what they want—high returns and careful avoidance of losses. Their earliest investments on their own must work. For many, this moment is the point of maximum alignment between investor and manager.

Skin in the Game Matters—But Not All Skin in the Game is Created Equal

To some extent, we agree with the traditional investor focus on “skin in the game.” The data supports it. In one study of mutual funds, more than 60% of managers did not invest their own money in their funds, but those that did outperformed by a high margin.5

This finding matches our experience at East Rock, which tells us that skin in the game is correlated with lower probability of loss on a particular private investment.

But the value of skin in the game is quite sensitive to factors that can be subtle and easy to miss. We recently conducted a review of underperforming private investments in East Rock’s history as part of our regular effort to learn from our mistakes. This exercise uncovered a pattern that was surprisingly impactful to our results. While our external partners have invested personal capital in nearly all of the 100+ private investments we’ve made in the last 15 years, there was an unusual element present in four of our six worst performing deals. The unusual twist in those four deals was that the external partners’ capital was invested 6 to 24 months before East Rock’s decision to invest.

Why should this lag matter? The simple answer is that it created a subtle misalignment in our upfront decision to invest. By the time we were conducting our due diligence, our partners’ motivations had changed. They were already invested and no longer searching for flaws in their investment thesis. Instead, they became cheerleaders for the opportunity and our participation in it.

Fortunately, we have found that skin in the game works quite well in a standard “no-lag” setup in which we and our partner conduct diligence side-by-side and commit to invest simultaneously. So long as we adhere closely to this approach, we have found it to be an exceptionally powerful way to collaborate with experts whose skills open up new areas of opportunity that we’d be unlikely to enter on our own.

* * *

While “no-lag” is an important element of aligned investing, we remain conscious of other ways in which not all skin in the game is created equal. Sometimes, non-monetary skin in the game can be an aligning force more powerful than money. For example, when managers walk away from high-paying, secure jobs to launch new funds without certainty of capital or resources, we find that this demonstration of confidence—this willingness to embrace the opportunity to take a risk on themselves—is an important indicator of future success.

Differences in age and prior success also means that the same amount of money inevitably has different value to different people. Typically, when investment managers describe their personal investment in a given transaction, they mention a specific number (“$5 million”) or a percentage of the deal (“I will put up 10% of the capital.”). But without knowing whether a manager’s $5 million investment represents 0.1% or 10% of their personal net worth, the picture is incomplete. We are surprised how rarely many investors dig deeply into key elements of their partners’ circumstances, like net worth, even though they would have a far better understanding of alignment if they did. The ability to ask for sensitive information tactfully and respectfully, and to build trust that leads to its disclosure, is a key part to really understanding skin in the game.

The Best Combination We Know: Skin in the Game + Long-Term Alignment

If incentives and skin the game are easy to misjudge, and alignment may wane with maturity and personal wealth, how do we stay aligned with partners for the long run?

There is a proverb that says, “You can’t have too many friends.” Similarly, there is a certain type of long-term partner you can’t have too many of. These are relationships built on trust, shared admiration, common values and, perhaps most importantly, an investment in the personal relationship that leads to true caring for each other’s success.

While hard to find, these partners buck the trends that make us generally favor younger managers. Over long periods of time, they tend to avoid excessive asset growth and stay obsessively focused with the quality of the investments they make and the returns they provide.

We conclude here with a story of how a 20-year relationship of this kind led to an opportunity for us to participate in what is perhaps the signature investment of some dear friends’ long and distinguished careers.

The transaction was an investment in a massive land redevelopment called BSE Processing.6 The BSE land site had been the location of industrial manufacturing activities within a dense urban area for more than 100 years before an accident caused the operator to enter bankruptcy.

The leader of the BSE investment was Perimeter Real Estate Capital, which agreed to purchase the BSE site after an extended bankruptcy auction process. Perimeter saw an opportunity to demolish the industrial complex and repurpose the site as a next generation hub for logistics, industrial warehousing, and life sciences. The project would result in the elimination of the largest stationary source of local pollution within the local city limits.

The site’s large size makes it a potential home to approximately 15 million square feet of construction in a single campus—a unique opportunity in an urban location.

We consider our group’s purchase price of approximately $250mm to be low, even taking into account environmental cleanup costs, because of the strong anticipated demand for the space we expect to build.

But assessing the cost of environmental cleanup is not our specialty at East Rock. We have experience with environmental risk assessment, but it takes unique expertise and large amounts of time to evaluate and carry out the BSE cleanup.

Fortunately, Perimeter has substantial experience investing in similar situations.

Perimeter was founded in 2010. At the time, East Rock was able to play a catalyzing role in the formation of company by introducing the Perimeter co-founders to a wealthy family that was interested in real estate investing as a strategy. The family anchored the launch of Perimeter, which went on to develop a strong investing track record, including in projects requiring environmental cleanup.

A wide variety of experiences through the years have brought this group closer together. We have shared personal time at weddings, birthdays, and a bris. We’ve gathered to wrestle with the world’s political and social problems and promote solutions. We’ve supported each other through the stress of the financial crisis and worked to add value to each other in our respective core areas.

With respect to BSE, it helps that our financial alignment is exceptional. The sponsor group has committed approximately $125mm of personal capital side-by-side and concurrent with $125mm provided by Perimeter’s fund and co-investors, including East Rock. That money represents quite a lot of incentive to check, and re-check, every environmental report, cleanup contract, insurance policy, and much more.

But we gain more comfort from the caring we all have about each other’s success.

In choosing when and how to trust and rely on others, BSE sets a high standard. It is a long-term project that, when completed, will be better for the environment, the community, and the local economy. And we get to do it with long-term friends as they utilize unique capabilities to execute something differentiated and visionary.

Alignment of this quality does not come quickly or easily. It results from many years, even decades, of dedication to building a circle of relationships with world-class investors who are personally motivated to bring value to each other and succeed together.

About the Images

Man-made stacks of rocks, known as cairns, have been used since prehistoric times to mark resources or burial sites, provide defense, or serve as a focal point in religious ceremonies. Today, cairns are used throughout the world to mark hiking trails, landmarks, survey points, or add a natural artistic element to indoor or outdoor environments. Vastly ranging in style, size, and construction techniques, cairns can include carefully balanced rock sculptures, loosely piled rocks, megalithic cairns, and even ancient mausoleums—a true testament to enduring alignment.

Photography credits, from top:

iStock.com/tbd.

iStock.com/Leonsbox.

iStock.com/ecuadorplanet.

iStock.com/Anita Nicholson.

Katvic/Shutterstock.com.

Legal Information and Disclosures

This newsletter is for discussion purposes only. This newsletter does not constitute, and should not be construed as, an offer of advisory services, securities or other financial instruments, a solicitation of an offer to buy any security or other financial instrument, or a recommendation to buy, hold or sell a security or other financial instrument in any jurisdiction. The provision of information in this newsletter does not constitute the rendering of investment, consulting, legal, accounting, tax, or other advice.

Specific examples of investments described herein have been provided for illustrative purposes only and should not be considered a recommendation to buy or sell an interest in such investment or a similar investment. Such examples of specific investments have been presented at a high level and do not contain all information pertinent to the investment decision. Certain market and economic events having a positive impact on the performance of the investments may not repeat themselves. The investments identified and described represent a small number of the overall investments purchased, sold, or recommended by East Rock Capital, LLC (“East Rock”) and should not be interpreted as indicative of the overall performance of East Rock’s portfolio of investments. The reader should not assume that any investment identified herein was or will be profitable. Wherever there is the potential for profit there is also the potential for loss. Past performance is not indicative of future results and investments may lose value.

Certain information contained herein is based on or derived from information provided by independent third-party sources. While all of the information presented in this newsletter is believed to be accurate, East Rock makes no express warranty as to the completeness or accuracy of the information appearing in this newsletter. The information presented in this newsletter reflects East Rock’s and the authors’ current views as of the date of this newsletter. As facts and circumstances change, East Rock’s and the authors’ views may change as well. East Rock has no duty or obligation to update the information contained herein. Certain information contained herein, constitute “forward-looking statements” and are based upon certain assumptions. Forward-looking statements can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events or results may differ materially from those reflected or contemplated in such forward-looking statements.

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