Three Books about Capital Allocation (Part Three)

The third book on capital allocation to be reviewed is The Counting House by Gary Sernovitz.  As with Ana Marshall’s The Climb to Investment Excellence, it concerns the work of a chief investment officer on behalf of an institutional asset owner.  And like The Rebel Allocator by Jacob Taylor, it deals with allocation ideas in a fictional setting, which allows for an exposition of the main character’s inner life.

The protagonist

Throughout the book, the protagonist is referred to only as “the CIO.”  He oversees the $6 billion endowment of a university — not an Ivy, but “frustratingly close to the super-elite,” albeit geographically off the beaten path.

The CIO had a great track record at a family foundation, where the performance during the financial crisis got him noticed and led to his job at the endowment.  The hot streak continued there (“the three glorious years and the article in the Times”), although performance has been slumping over the last couple of years and everything seems hard:

The thought, the one metastasizing through every midnight when the numbers were bad:  that I am not a genius investor, that I’m not even a good investor, that I have only been lucky when good, and that if I am not a good investor, what am I, what am I, what am I — and what happens (to the pay, the purpose, the status) when They find out?

In meetings, his sarcasm lands differently than it has before.  He is becoming impatient with everything and everyone, quick to leave interactions either mentally or physically.  A year before, his wife had asked him, “Why are you doing this job if it’s no longer fun?”  Now it seems the only fun is making impertinent comments to others.

The game

The CIO is cynical about the investment business and the trappings (and traps) that come along with how the game is played.  He says that Wall Street’s greatest product is “lectures on the way the world really works” and its greatest talent is “to throw way too much money at any idea and make the returns go away.”  Its oldest rule?  “When you do well, you’re a genius.  When they do well, they’re lucky.”  It is, more than anything, “colossal bullshit,” wrapped in an “allocation-of-capital faux-purpose.”

From “the hero worship in Finance Bro Culture” to “the returns to be captured by intermediaries to intermediaries to intermediaries” to managers “temporarily performing but still able to conjure wealth to fly in private jets over kids in neighborhoods doomed by opioids and gangs and trauma and dreadful schools,” the CIO looks at the industry with a jaundiced eye:

The money, they will tell you, “doesn’t really matter,” even if everyone is scheming and clawing for a larger piece of the pie.

Would he want his daughter to follow in his footsteps?

There is no part of my imagined future for her in which she spends her days thinking of money as her mission, as her measurement, as her profession — I don’t know — as her identity.

Scorecards

A number of times in the book, the CIO either mentions to others or ruminates about the $264 million that the endowment is expected to provide to support the school.  That figure, which will escalate in future years, is an absolute yardstick by which the CIO is measuring himself.

But there are relative benchmarks too, especially how the endowment — the twentieth largest in the country — fares against the nineteen bigger ones.  Will it be “middling” (twelfth of twenty) again this year?

All involved (at the school and at those other endowments) try to figure out how they might stack up when the numbers come out.  When they do (“The Journal included the compulsory paragraph about the sub-Top Twenty Freak of the Year,” which this time was Reed College), the CIO can’t figure out “how he could be six points behind Duke.”  (He had already heard that Harvard had “another dumpster fire.”)

The CIO is also searching for his inner scorecard (a topic of the last posting) as he juggles meetings and calls with the president of the school, trustees, his team, and the parade of asset managers selling their wares.

Managers

The book is set up in chapters with the titles indicating the date and form of those various encounters, many of which capture exchanges with asset managers, as the team tries to sort the wheat from the chaff:

There is an endless supply of asset management firms desperate to get some of this endowment to manage.  Some of them are hustlers, some of them are creeps, all of them, deep in their hearts, believe it’s their divine right to become billionaires.

The CIO has seen it all and increasingly vents to the managers about the sameness he witnesses, as in this response to a presentation by a lower-middle market private credit manager:

Almost sixty incoming pitches from direct lending firms like yourself.  Sixty firms screaming at us, “Pick me, pick me, I’m incredibly unique.”

Among the strategies the managers present are Asian long-only public equity, mineral rights acquisition, industrial real estate, cannabis sector venture, buyout, emerging markets credit, and quantitative equities.  Of the managers of a GP stakes fund, the CIO asks:

Do you find this hard?  This divining the Truth of Individual Manager Performance Persistence.  Because that’s the same thing we are trying to do.  And we find it hard.

The pumping of numbers in advance of fundraising.  The “peacocking.”  The narratives!  (“Did these words and shapes and boxes mean a system?” — “Everyone talks about experience and processes. . . . Everyone has a market niche that others don’t fully understand.”)

When the CIO tells a manager he’s looking for firms that can translate their ideas into performance over long periods, the manager responds, “We do.”  But the CIO corrects the tense and cites reality, “You did, and maybe you will.”

In order to fill the portfolio, “One is required to have faith in human beings.”  But it is so hard to muster that faith when there is a paucity of “honest human communication” in these get-togethers.

The endowment model

“Do you think this works anymore?” Ben Wirbin (a Goldman Sachs investment banker and the “first among equals” on the investment committee) asked the CIO at one point, meaning the endowment model.  If not, “We got to find something that does work.”

Heresy.

Those twenty endowments (and multitudes of other asset owners) have copied the David Swensen playbook.  Once adopted, modes of thinking cement themselves, but the CIO is more than willing to question orthodoxy, even when he realizes he’s a captive of it.  In a meeting with a manager, he references “the Chief Investment God of Yale and Father to Us All,” explaining that:

Because of Swensen, if I tried to go 20 percent into old-fashioned fixed income — corporate bonds, not these new, snazzy private credit funds loaning money directly — all the CIOs at the CIO Summer Jamboree would call me Fixed Income Fatty or Bond Boy Barry.

(Later, he says traditional fixed income is “the cassette tape of endowment finance.”)

At a meeting of his investment team, the CIO asks, “Do we think our asset allocation should be set by what David Swensen and Some People Who Used to Work for David Swensen do?”

In that phone conversation with Wirbin, he references “the Heroic CIO Era in endowment management’s late decadent period,” with “layers of interns, associates, VPs, managing directors, with huge offices far from campus”:

And the newest trend is that once you do a physical makeover, you do a personnel makeover.  Out with the sheepy allocators of capital to GPs, in with new types who see themselves as peers of the GPs, smarter than GPs, playing them off each other, seizing special economics and deal flow.  Co-investments everywhere.

Is that the next step for the school, the prerequisite for true group membership going forward?

At one point, a private equity manager complains to the CIO about having to present to junior people at some of those endowments “who think investing is running a highlighter through Pioneering Portfolio Management.”  Has it all gone too far?

The mystery man

Michael Hermann graduated from the school.  If press accounts are right, he’s worth $11 billion.  Labeled the Most Mysterious Man on Wall Street for his investing prowess, he has never given a dime to his alma mater.

Not that they haven’t asked.  And thought at times that maybe they should just give him all or part of the endowment to manage.

The longest chapter, the penultimate one in the book, recounts the CIO’s visit with Hermann, after much urging by others at the school.  Upon arriving, he observes that Hermann’s office is, like those of the school’s investment team, “below its means.”

After the CIO sits down, Hermann doesn’t say anything for several minutes, focusing instead on his Bloomberg, so the CIO tries to start the conversation.  In return, Hermann asks, “What do you do?”

“Most of us operate in normal science in the Swensen Era,” the CIO says, boiling it down to deciding on an asset mix and a risk posture, then allocating capital to external managers.

Hermann responds, “And you think that makes sense?”

“That’s the question, I guess,” the CIO says.  After the CIO offers vague comments about his manager selection practices, Hermann asks, “Do you think that’s a unique advantage?”

When trying to further explain the allocation process, the CIO offers, “Toddlers know that manager performance distribution within asset classes is so wide that outperformance is about picking the best managers.”

To which Hermann replies, “And this is something you can do?”

The Most Mysterious Man repeatedly leaves the conversation (such as it is) to pay attention to his Bloomberg, occasionally asking questions or making comments, as the CIO becomes more and more uncomfortable.  For Hermann, everything is about reducing distractions, and the CIO in his office is clearly one of them.

When he does open up a bit, Hermann proves to be even more cynical than the CIO.  He says (three different times), “The only problem with the investment management business is the investment management business,” thinking it a place where the actual craft of investing gets lost:

When I started working, it annoyed me that the Street’s so-called competition was also around unproductive end goals and personal status.  It annoyed me how people like Ben Wirbin stop when they find a short cut, an AUM trick, or a salary arbitrage.  It annoyed me how people failed upwards.  And, yes, it annoyed me that a lazy mediocrity could get a bigger bonus than I did from two trades in the casino.  And so I put a program in place to not be annoyed.

He bemoans the “entropy of talent as asset managers scale;” how “personal career ambitions are a cancer on performance;” pervasive agency issues; “incentives that distort the pursuit of their fundamental goals;” political decision making within organizations; and how “certain [investment] positions, in certain peer groups, signal intelligence,” resulting in choices made for the wrong reasons.

It is, he thinks, “most often a career in which the data proves that Trader, Banker, Analyst, or Investor X is unnecessary, replaceable, and/or counterproductive.”

Hermann doesn’t hold back regarding the boldfaced names in the investment business either, considering their avocations — art, politics, trophy properties, being a public intellectual, buying sports teams — are signs that they feel that they need to be interesting.  And, by extension, that they think that being a good investor is not interesting.

That’s not Hermann’s philosophy.  He believes that “the costs of being distracted are subtracted from the benefits of deploying a talent undistracted.”  Everything flows from that.

The CIO, of course, wants to hear about how he manages money.  Eventually Hermann offers a little insight:  eliminating agency problems, preserving “offensive liquidity and an equity bias at the same time,” and finding the difficult-to-predict ways that markets are inefficient at any time.  Plus extreme focus.  As he says, “Reading Buffett and Munger would have gotten you an approximation of the most useful parts.”

Important questions

Based upon this posting, you might suspect that the author is an outside agitator trying to question the dark arts of those at the heart of modern finance, but in his day job Gary Sernovitz works at a private equity firm.  His industry knowledge makes this a great read.

Sernovitz captures the asset owner milieu — the people, the pressures, the expectations, the norms, the managers, the stakeholders — and uses references to products and firms and investment leading lights in ways that feel true to life rather than cut-and-pasted from publications.

His story surfaces important questions for those of us that want to see the industry improve:

~ What aspects of current practice need to be reformed?

~ Which rituals, models, and narratives are performative distractions that inhibit rather than abet effective and efficient capital allocation?

~ And, for us as individuals, what do we do when our inner scorecard is at odds with the norms and activities of the industry?  Leave?  Bide our time and reap the rewards?  Or try to change things for the better?

 

The series index for “Three Books about Capital Allocation” is here.