Skin In The Game

I am paid to evaluate investment managers for a living. In doing so I’ve come to believe you aren’t really qualified to sit in judgement of money managers without going through the exercise yourself. When you underwrite a name yourself and have to watch it sell off 20% on a quarterly earnings miss and make the add/trim/sell decision and feel the hit to your own net worth you develop a new and healthy appreciation for investment processes.

You then begin to cultivate two other important qualities: empathy and enhanced BS detection.

Empathy is important because investing is an activity where things can go against you for a long time, and for no particularly good reason. If you are going to hire and fire managers based solely on statistical performance reviews and rankings versus peers you will end up chasing your tail. When you can look at the world through the eyes of the people you are evaluating you realize the right decision is usually to be patient.

Enhanced BS detection is important for obvious reasons. However, people are worse at BS detection than you might think. Investment managers tend not to be complete idiots. In fact they have a habit of dazzling you with their brilliance. Everything always sounds great on paper and in pitch meetings. And yet out in the wild things have a habit of going horribly awry.

Listening to real estate people talk, for example, you would think everyone who has every done a real estate deal has earned a 30% compound annual return with no risk. Yet, real estate investments go to zero all the time.

This doesn’t happen because the real estate itself ends up worthless. It happens because you’re levered maybe 4x into the deal and there is a delay in the project or a hiccup in occupancy and, oops! the debt ahead of you in the cap structure is about to mature. So some enterprising soul comes in with a slug of equity and dilutes you to the point where you’re unlikely to make any money. Or she demands a massive preferred return, with the same result.

Anyway, after getting hosed on a couple “can’t miss” opportunities you wise up. You begin to appreciate just how unfair the universe can be in dishing out random dollops of catastrophic loss. Risk management becomes a bit more intuitive. You are more humble about your ideas, your intelligence and your fallibility.

You don’t get that from reviewing manager peer group rankings.

You get it from risking (and, occasionally, incinerating) real dollars of your own net worth.

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