Relative Superiority: The Key to Win Against Bigger Opponents

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Every team should be able to answer the question, “Where do we have relative superiority?”

Retired four-star admiral and former Navy Seal William McRaven, author of Spec Ops: Case Studies in Special Operations Warfare Theory and Practice, explains the concept:

Simply stated, relative superiority is a condition that exists when an attacking force, generally smaller, gains a decisive advantage over a larger or well-defended enemy. The value of the concept of relative superiority lies in its ability to illustrate which positive forces influence the success of a mission and to show how the frictions of war affect the achievement of the goal.

In other words, it’s possible that a smaller force, by defying conventional wisdom, can organize and defeat an imposing, yet scattered opponent.

McRaven continues:

Large forces are more susceptible to the frictions of war. The principles of special operations work because they seek to reduce warfare to its simplest level and thereby limit the negative effects of chance, uncertainty, and the enemy’s will.

Although gaining relative superiority doesn’t guarantee success, it is necessary for success. If we can determine, prior to an operation, the best way to achieve relative superiority, then we can tailor special operations planning and preparation to improve our chances of victory.

Your team and resources may not be as big as your competitors, but your ability to concentrate, move fast, and adapt, is well within your control.

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What I Learned From Complications: A Surgeon’s Notes on an Imperfect Science

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In 2002, Atul Gawande wrote Complications: A Surgeon’s Note on an Imperfect Science.

It reveals what most doctors know, but will never admit: medicine is an imperfect, mistake-filled process, far from the idealized world doctors would like it to be.

Investing is no different. Like surgery, investing is imperfect, no matter how data-driven, hyperrational, and supersmart we are. Gawande explains how to handle the imperfections, the mistakes, the guesswork, and the uncertainty.

Gawande is a world-renowned surgeon and multiple time best-selling author. He’s published several books subsequently, including The Checklist Manifesto, Better: A Surgeon’s Notes on Performance, and Being Mortal.

Investors can learn a lot about investing from areas specifically outside of investing. Look, I’ve learned a lot from Buffett, but there’s only so much I can digest before it starts to sound the same.

Start learning outside the industry.

Here are the 8 lessons to learn from the book:

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Staying in the Middle: Responding When Markets Go Against You

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I remember being around a sell-side analyst many years ago at a conference dinner. One of his companies just missed earnings and was down 8% on the day. In my mind, no big deal. Companies miss earnings all the time. And I’ve seen way worse than down 8%. But damn, you would have thought the world for him was ending that day. Absolutely distraught that he didn’t see it coming. Maybe that stock was his best idea. Maybe he just put a bunch of clients in the name. I don’t know. But things going against you in investing happen all the time. Internalizing and personalizing losses will destroy your sanity.

Not everything works out. Not everything goes up. You do this long enough and you’ll have plenty of mistakes.

This doesn’t mean you need to like losing money. This doesn’t mean you celebrate losses. But it does mean accepting that investments going against you are part of investing.

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Making Conferences Great Again

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I normally enjoy investment conferences. But many investment conferences are in a race to the bottom. It’s become a commodity. The same topics are included because they’ve always been included. The same format is followed because it’s always been followed.

Conferences could be so much better for all parties involved. Organizers could build a sustainable model, managers could get quality leads, and allocators could get useful information and networking.

Lately, it seems like it’s all a short-term profitability maximization exercise – how can we get as many paying managers as possible, without regard to the quality of the event, the topics, or the participants itself.

I get there’s a profit-motive for the organizer and asset managers. That shouldn’t change. But how they go about it should.

The lack of thought and strategy that goes into some of these events is mind boggling.

Allocators can’t attend every event, and they’ll choose what works for THEM.

If you don’t get allocators, you don’t have an event.

So here’s my 12 ideas to make conferences better from the allocator perspective, which ultimately benefits all parties:

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ILPA's 2023 Members' Conference Takeaways

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I recently attended ILPA’s 2023 Members’ Conference. It’s an LP only event that has a number of great presentations and discussions on private markets. It’s always helpful to see how other LP’s are dealing with the numerous issues we face as private markets investors. It’s nice to have a conference where the content is built around practical issues and solutions, not managers promoting their strategies.

Below are my notes from various panels and discussions.

On Fund/Asset Valuation

  • LP’s are very skeptical on fund/portfolio company valuation. There was (and always has been) justification from the GP/accounting teams emphasizing the substantial rules, process, work, etc, of the audit process. But in my experience, there is 1) incredible variability and flexibility in valuation assumptions, and 2) GP’s know the companies much better than accountants and will craft a compelling narrative on why adjustments should shift in the desired direction. Are accountants really going to tell a GP they know the assumptions/value better than the GP? I doubt it. In my experience, auditors want to document their process and limit their liability, not push back against the GP.

  • Of course, GP’s will never deliberately ask for a specific valuation to maintain certain IRRs so fundraising is easier. But GP’s are great at telling stories about why the relevant comparable set needs to be “updated” to reflect what a great asset the investment is…

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Investment Committee Governance: The Forgotten Foundation of Investment Success

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Of all the contributors to investment success, the role of the investment committee is the most neglected.

It’s rarely the most exciting topic to discuss. It’s never as urgent or volatile as market-related issues. But it’s probably more critical to your investment process than the investment strategies themselves. It’s the foundation of your team’s success and a suboptimal committee will slowly degrade and destroy a quality investment team.

Investing is difficult. To compound those difficulties with a second-rate committee will guarantee mediocrity and underperformance.

Weak committees are easy to spot:

  • They will second guess sound, long-term strategies just when they are the most attractive

  • They will micromanage the investment team

  • They will focus on noise and randomness

  • They will overreact to short-term underperformance

  • They will enjoy the perks of committee membership, but not do the work

  • They will prioritize consensus, comfort, and conformity vs. active debate and disagreement

  • ·They will use their position to advance personal or political ambitions

  • ·They will fall asleep during meetings, as I’ve witnessed firsthand

Investment committee change is difficult. By design, committee turnover is structured to be slow and deliberate. Second, educating and shaping the thought process of a committee takes a long time. Opinions change slowly. In fact, it may take many years, meeting after meeting, of reinforcing the proper investment process before you see acceptance.

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Private Market Valuations and Volatility Laundering

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A recent Financial Times article, “Private Markets Don’t Launder Volatility, Honest,” defended private equity’s approach to fund valuation. The author claims managers are fair and balanced in their methodology and that GP marks are much more credible and reliable than public market prices.

As an LP in over 100+ funds, the reality of private asset valuations are much different than what GPs claim. 

Clifford Asness of AQR describes it perfectly when he calls these valuation games/abuses, “volatility laundering.”

Volatility laundering has two concerns.

First, private assets understate the true economic volatility of the assets since assets are valued less often and GP’s smooth/delay valuation changes, especially on the downside. Almost every time a manager insists that risk-adjusted returns are higher for private strategies, it’s almost always the case that true economic volatility is being substituted with accounting-based volatility, which understates the real underlying risks LPs face.

The 2nd concern is that GP’s arbitrarily use their discretion to overstate NAVs by marking assets up quickly in the good times but are slow to mark down during the bad times. This drives higher interim IRR’s (great for fundraising), less investor questions, and of course, more NAV-based fee income.

This article defends private equity’s practice, but in my experience, the reality of private markets valuation is much more tenuous and conflicted than the industry claims.

To be clear, it’s unfair to group all GPs together. Some are more transparent and forthcoming than others. However, the issue is pervasive enough that LP’s need to be aware when reviewing fund values.

Here’s my experience on the reality of private market valuations versus the what the author claims:

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One Simple Change to Fix Exit Interviews

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Exit interviews are useful. To understand why people are leaving, get direct feedback from those departing.

There’s just one problem - don’t wait until people leave to have these conversations.

Understand and discuss frustrations before people leave, not after they’ve made their decision.

These discussions don’t have to be formal. Nor does it have to be a high-pressure, high-stakes conversation.  Just ask people about their issues and what they would like changed, especially as it compares to outside opportunities.

It’s perplexing for leaders to wait until someone is walking out the door to learn. Learn while people are there. Make it a fluid, ongoing process. Exit interviews shouldn’t be a one-time thing but a continuous dialogue over a person’s career.

When employees feel like they must wait until they leave to voice issues, that’s a problem. Many employees and employers don’t want to talk about the obvious truth: people leave jobs. It’s not uncommon, so get over it. Don’t pretend it doesn’t exist.

Read more below…

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Organizations Advance One Retirement at a Time

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A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it.

                                                                                                                        -German Physicist Max Planck

 

As Planck states, it’s not the superiority of new ideas that replaces bad ideas. Instead, it’s when those people with outdated ideas are no longer around, which allows fresh ideas to flourish and take hold.

Organizations advance the same way. The best ideas don’t win because of logic, rationality, or evidenced-based merit. The best ideas win when the old guard is no longer in the way. For companies, that means change happens one retirement at a time.

I remember attending a Berkshire Hathaway annual meeting around 2010.

Someone asked Warren Buffett and Charlie Munger: “I’m at a company and I want to change the culture. How do I do it?

Warren or Charlie responded something to the effect of: “You don’t. You just leave. You’ll never change the culture.”

And that stuck with me. Thinking you can go in and just revamp a company’s culture is noble, but foolhardy. Changing a group’s mindset is impossible, as most people prefer consistency and predictability vs. changing deep-held belief.

Continue reading…

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The Best Way to Hire

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I recently came across the most powerful yet underappreciated hiring mindset.

In a 2014 Manual of Ideas interview, Seth Alexander, current CIO of MIT’s endowment, explains how they hire:

We do not try and hire someone every year or anything like that. Instead, we hire opportunistically. If two great people came along in the same week who would both be a great fit, we would hire them. We are always looking to hear from passionate investors about working here and really encourage people to reach out to us.

This seems obvious, but rarely practiced. Hire when you find great investors. Not when you need or have budgeted for them.

Organizations have it backwards. They hide behind self-imposed budget and planning processes. Only then after several rounds of approval and justification can they begin the search.

Here’s the problem: great candidates don’t just magically appear when your budget process is done. Or when the planning committee finally submits approval.

If you wait to hire until you have a need, then you begin a forced process of settling for people as the great people have already moved on. It’s ensured mediocrity.

Click on the title to continue reading…

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On Effort and Holiday Cards

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I’ve been flooded by electronic holiday cards wishing happy holidays and a prosperous 2023.

But the senders are forgetting one major thing. Effort matters. An electronic holiday card means nothing when it’s blasted out of a CRM with no human touch or effort. It’s the meaning and effort behind the message that matters. Not the message itself.

I’m not looking for facts. I’m not looking for information. I’m looking for someone who cares enough to craft a note to me personally, even if it’s just a few sentences. I’m looking for someone who took time out of their busy day. That time is costly, and therefore, it means a lot.

Here’s the bigger lesson: if you want to send something valuable, it needs to have some cost. That may be monetary or it may be time. But expending a cost shows you care.

It’s the same thing with rubber-stamped signatures – if you are a leader, sign the damn card/letter/note yourself. And yes, we can tell if your assistant signs it for you. If you are too busy for this simple act, what message does that send? No one’s asking for you to write a book, but just make it personal.

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Key Person Language and GP Removal

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People are the key variable in private markets investing, so when issues come up relating to the actions of the GP, it’s important to understand what options LP’s have. In addition, because the assets are private, there’s very little clarity and insight on what’s really going on inside the GP. Investors place a lot of trust in the GP, which is why they want to ensure they operate in a manner that is aligned with LP’s.

LP’s need to ensure that the key principals remain at the fund and focused on the strategy. If this does not occur, or there are issues with the GP, then LP’s should understand what options they have, including suspending the investment period or removal of the GP, if necessary.

These are my collected notes over several years of private markets investing. Each LP should think about what is important to their firm and make sure the fund agreements reflect those priorities. These are principles and concepts to think about and discuss, not explicit legal advice.

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Arguing to Win vs. Arguing to Understand

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Most people are worried about looking good rather than making the right decision. This is one reason teams struggle to have vigorous, yet healthy debates.

One of the greatest communication superpowers is the ability to argue forcefully and honestly, while still showing respect and admiration for the other side. This is rare. It’s not a natural occurrence. Most people are either too aggressive and harsh or too passive and soft. There’s a balance you need to find.  

That balance comes down to “Arguing to Understand” rather than “Arguing to Win.”

Understanding this difference enables honest disagreement while still enhancing relationships.

It’s a shift in perspective that allows teams to debate forcefully yet calmly versus arguing with unrestrained emotion and ego.

Everyone likes to feed their egos. Any discussion, whether between 2 people or 20, gives us the chance to boost our ego by showing how smart we are. Wise decisions are not made by showing off. Instead, they are made after honest, deliberate, and disagreeable discussions. The only way to do that is to stop worrying about how smart you look and start worrying about how much you can learn.

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Subscription Lines and Other Fund Lending facilities

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The following are my notes collected over several years of working with subscription lines within alternative assets. While not always the most critical issue, understanding sub lines and other lending facilities can help improve LP fund governance, performance reporting, and enable the LP to ask better questions during due diligence and throughout the fund life.

Overview

• Subscription lines are not a new phenomenon in private markets as they’ve been used for decades. They allow managers to borrow to fund bridge financings and then eventually call the capital from limited partners

• The ability to delay calling capital enhances the manager’s flexibility to execute deals and shortens the J-curve, enhancing the fund’s Internal Rate of Return (IRR), particularly early in a fund’s life, and therefore its competitiveness on a quartile basis

• Funds use credit lines to boost Net IRR's and accelerate carried interest, particularly in funds with European style waterfalls

• From an LP perspective, the use of these lines helps smooth cash flows and eases the administrative burden of responding to capital calls.

• Improves capital call logistics – small investment outlays more conveniently aggregated

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Accuracy Not Confidence

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Confidence and hubris are abundant in the investment world, especially in bull markets. Everyone claims to know where the market is going, what the Fed will or should do, and what the next great idea is. Just ask, and you’ll have plenty of people talking about their can’t-miss ideas.

Confidence is infectious. We all want to know what the market is going to do. We all want to know when the next big crash is coming. We hate uncertainty. So anyone that can remove that uncertainty has our attention.

But it’s not confidence that we want. It’s accuracy. Accuracy in the sense of actually making investment decisions that succeed long term.

Confidence is about predicting success. Accuracy is actually delivering it. That’s a big difference.

Confidence doesn’t improve accuracy; it only appears too. Confidence has no bearing on whether a decision is good or bad. Decision quality depends on your diligence, research, understanding, and timing.

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Identity Investing

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Identities create comfort and order in a messy world. Identity politics is the best example. Political affiliations shortcut thinking. As soon as we realize an idea is Republican or Democrat, our mind is made up without even evaluating the idea itself.

No need to consider the merits.

No need to examine the nuances.

No need to learn from the other side.

Just let the identity decide for you.

This happens in the investment world too. Investors form identities which hinder the ability to learn from opposing views. We are suckers for identities because it saves us time and energy. And it fuels our ego when we hear nothing but things we already agree with. But it also creates defensive rigidity, mindless groupthink, and destroys the ability to adapt. For example,

· Bullish investors dismiss all bears as doomsayers

· Bearish investors dismiss all bulls as naïve optimists

· Value investors dismiss all growth stocks as expensive/unsustainable

· Growth investors dismiss all value stocks as falling knives

· Fundamental investors dismiss quants as opaque black boxes

· Bottom-up investors scoff at the futility of a macro investor’s economic views

· Active investors dismiss passive investing as lazy and boring

· Passive investors dismiss active strategies as paying high fees for underperformance

· Public market investors dismiss alternative investors paying 2 and 20

· And on and on…

It’s easy to dismiss strategies that conflict with our identity. Why spend time on other strategies when our strategy is superior?

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Organizational Scar Tissue: Stop Creating Rules for Every Problem

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When things go wrong, companies implement rules to solve them.

· Employees booking overly expensive hotels? – Devise multi-level pricing matrices (with different versions based on location and/or employee seniority) that must be followed

· Someone overpay for computer hardware? – Require multiple approvals for mousepads, keyboards, and webcams

· Booking expensive flights? Mandate the cheapest economy flights, require receipts, and a copy of your boarding pass to ensure the flight was taken

· And of course, make sure you submit a copy of your conference badge or agenda, because we need to make sure you attended what you said you were going to attend

These policies are common reactions to employee abuses and honest mistakes.

And it seems reasonable – identify the abuse and create a rule.

This works in the short term but creates a drag on a company’s long-term success. It drives a culture of compliance and rule following, prioritizing adherence vs. doing what’s best for the company. Rules take away freedom and autonomy. On the field judgment is replaced with behind the desk directives. Rules can’t adapt quickly to the real world. Creating endless exceptions just expands already monstrous rulebooks, adding confusion and frustration to employees who are looking to get things done.

All of this because a select few people took advantage of the system.

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Checklists Gone Wrong

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Checklists are simple yet powerful tools. A wide array of industries have succeeded with checklists. Pilots use them to improve flight safety. Hospitals use them to improve patient care. Nuclear power plants use them to ensure safe operations.

Atul Gawande, famed surgeon and New York Times best-selling author, wrote the book on checklists – The Checklist Manifesto. It’s an insightful, practical look at how organizations use checklists to succeed in pressure-filled environments.

Checklist implementation is very popular. Organizations enthusiastically publicize how checklists have counteracted human and organizational flaws.

But like most good things, checklists have been misconstrued and distorted to become a headache, not a help, to an organization.

Organizations require mindless checklist completion instead of using them as a tool to improve understanding. It’s not the finishing of a checklist that drives value. It’s the thinking that occurs along the way that otherwise would not have happened. Checklists have become another mandated task to get out of the way. After all, bureaucratic organizations love nothing more than adding additional documentation and compliance tasks.

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Stop Trying to Achieve Consensus

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Many investment firms strive to achieve consensus group decisions. The desire to have unanimous agreement is understandable. There’s a certain comfort level when everyone agrees.

But seeking consensus is a mistake, even though it feels right.

Investment markets are too uncertain and unpredictable to expect unanimous agreement. The goal is not comfortability. The goal is to make the right decision. And that means getting every idea out on the table, debating and disagreeing, and then making a probability-based decision, knowing that 100% certainty is unachievable.

Disagreement is a necessary condition because no one knows the investment future. Opinions and ideas will differ.

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Enough with Credentials

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Like most professions, the investment industry is obsessed with credentials. It’s rare that a month goes by without another announcement of a new designation to add behind your name.

Investors have lost focus on what matters. Results matter. Good decisions matter. Long-term performance matters.

Credentials do not.

I’m sure I appear hypocritical given I’ve completed several credentials (CFA, CAIA, CPA, etc). But in my experience, it’s the rigor and thoughtfulness behind a decision that delivers value, not the credentials. We conflate credentials with competence because it’s an easy shortcut. But it’s a mistake and its incentivizing investors and their organizations to look good (more letters behind their name) rather than be good (deliver outperformance).

Can these programs have value? Absolutely. There’s useful information learned in these programs. But the question is, how do you judge who can apply that knowledge in the real world? It’s not by looking at credentials. It’s the application of knowledge that matters. And to judge that, you need to do something different.

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