Lecture 4: Investors are part of the problem Part II Jesse Reyes NBA 5590 Lecture 4: Investors are part of the problem Part II Jesse Reyes

LPs at the Poker table

Takes Two to Tango Lessons Learned Or Lessons Forgotten Takes Two to Tango Lessons Learned Or Lessons Forgotten? “LPs at the Poker Table” “if I don’t stop committing at some point, I’ll wind up with long-term bond returns” Major Pension Fund LP Circa 1994

Difference in Risk and Uncertainty? LPs at the Poker Table Difference in Risk and Uncertainty? Knight Risk – we don’t know outcome but we know underlying distribution (rolling dice) – outcome is unknown but we can predict some probability Uncertainty – we don’t know outcome, we don’t know underlying distribution (predicting terrorist attack or asteroid hitting the earth) Common use Risk – possibility of negative outcome Uncertainty – possiblitiy of something happening either good or bad

Is there a difference in investment, speculation, gambling? LPs at the Poker Table Is there a difference in investment, speculation, gambling? Investment manages losses as well as gains – r(maxi-min) – minimize volatility Speculation: high degree of risk with high potential returns – volatility of outcome is part of the game. Soros says Investment is speculation gone wrong? Gambling: Peter lynch says, “investing is gambling where you’ve tilted the odds in your favor” Venture investing – aren’t the odds stacked against you, -- maybe just like poker to make money, you leave it to the experts? Life insurance example – you are betting you are going to die in the next year, the insurance company says, I’ll take that bet because we know so much about people like you (the oddsmakers are not bookies but actuaries) that we don’t think you will die in the next year. As evidence, why is the ante so high or payoff so low if you try to get insurance at age 80 versus age 35? – Sure things, whether horse racing or football spreads have lower payouts.

Industry Forgot to Take Money off the Table Cash Management usually is most successful by Investing most at the beginning of an investment program Investing smaller amounts as prices increase which keeps cost basis down so that even a large increase in price doesn’t affect profit much But harvest some of the winnings Invest Less as prices increase

Industry Forgot to Take Money off the Table However the Lps during the venture boom (during 1990s) Invested relatively little at the beginning Then invested larger amounts as prices increased which increases the average cost A small price decrease brings the whole thing down Is buyout investing in the same position? Invested More as prices increase

Industry Forgot to Take Money off the Table Even worse… As distributions outpaced commitments LPs effectively rolled over distributions into new commitments Effectively – doubling down with every new roll of the dice

So what is next? Allocations to private equity will continue to be a vital part of the LP portfolio LPs will continue to make commitments Good investment managers will continue to be backed LPs will have a more short-term focus in evaluation LPs will be less forgiving of stumbles

So where are we an where are we going? Is the Industry getting too big? Average funds will find it hard to Raise money Hard for LPs to get into the best funds they want Industry Performance may scare off LPs no matter how long term focused they are– Buyouts and early stage are at extreme end of the private equity spectrum but have similar challenges – you have to know who to invest in Next stop – “looking over our shoulders”