Wednesday, July 23, 2008

Recent Thoughts

Last week marks a significant milestone in the project I've been involved with since the beginning of the year; the Fund has finally completed its first closing! It has been an interesting learning experience, made more so as the scope comes in sharp contrast compared to my first posting on the Abu Dhabi project. In any case, it's a good time to reflect on some of the lessons I've learnt, and some of my thoughts arising from this experience. But first, a recap on what I actually did…

My Job in the Fund:

I see my role in the Fund being segregated into 3 primary tasks, namely financial modeling, fund marketing & documentation. While my previous role in GCC was also primarily on financial modeling, the focus this time round was quite different. Firstly, U.A.E. is a tax-free zone, which removes a major consideration in deriving the return. Secondly, the Abu Dhabi project was principally a residential one, whose investment horizon and cashflow profile is starkly different from the income-generating nature of the office, retail, serviced residence & hotel found in the integrated developments of a typical project in the Fund. It is quite fascinating to try to absorb the supply/demand, regulatory and other relevant market information of all these real estate types across the various cities (where the seed assets reside) while at the same time, attempt to pick up the basic economics of these various real estate types. What is the typical Net Leasable Area efficiency of a Grade A office, what is the typical net margin of a well-managed shopping mall, what kind of rental variations can one expect between the ground floor and the 5th floor of the mall and between anchor tenant and "small-time" tenant, how do serviced apartments make its money compared to hotels…a ton of "entry-level" questions like these that keep me engaged when attempting to nail down the assumptions in the model. Finally, after figuring how things might look at the asset level, the model also needs to consolidate the underlying assets to the Fund level, an entirely different ballgame which requires an understanding of how the fund structures would impact the cashflow going upstream to the Fund, how the management fee and carried interest are deducted, how the various exit scenarios might impact the Fund return etc. Overall, the modeling part has been a great learning exercise that appeals to my natural inclination to data-crunching (in fact, I think working out an Excel model is akin to writing a software program!).

While the financial modeling part of the job fits in well with my usual domain, the fund marketing (or specifically, the back-and-forth with the investors) and the legal documentation parts of the job lie squarely outside my comfort zone. Certainly, it helps that the boss is so conversant with her role so mostly I just try my best to observe and learn from the way she handles the investors' requests, the lawyers' comments, our overseas colleagues' feedbacks, the various consultants' advices etc. There're quite a number of moving parts in this project and I've gained a lot just by observing how she tied in the various (and sometime opposing) objectives/ideas from the different parties and steer everyone in the same direction. It's also our great fortune that the legal counsel we engaged possess such high level of work ethics and professionalism that we were able to complete the deal (somewhat) on time. I have to say, though, that I feel inadequate at times trying to catch up with the rest of the team as they jump from one document to the next, while I was still trying to figure out what is a company's "M&A". I am definitely, in the CEO's words, still "growing into the job". I suppose experience does play a big part here. (Incidentally, I asked my boss of her opinion on how many times does one have to go through a project like this to get a hang of legal documentation. Her reply? "Once." I was secretly hoping for an answer like "3 or 4", which is what it'd probably take me to feel confident enough to do what she's doing.)

Reading through the docs, drafts after drafts, was, as aptly as I can put it, a pain in the ass! Nevertheless, it was a great educational process for me, especially since this Fund is a (almost) fully invested fund; I was exposed to S&P agreements beyond the typical Fund docs like PPM. Gradually, I begin to interpret the rationale between each draft version, and develop, albeit far from mastering, some sense of how to sieve out the key commercial points from thousands of lines of legalistic jargon. One side effect from this exercise is that I now have a much higher respect for the law profession; it takes great discipline to digest line after line of convoluted sentences while maintaining the same mental rigor when analyzing every word (Indeed every word counts!...which is what I found out as we debated the use of "and" vs "or" for a few days in one of the clauses!).

Recent thoughts:

There're also a couple of concepts/ideas that arises from my experience with the Fund in one way or another. I still can't quite figure out what to make of most of them, nevertheless I'd like to share some of my thoughts here:

On Fund Management/Track Record/"Mismatch" Problem:

The Fund Management business, an important cornerstone of our business model, is an intriguing industry. The Economist's Special Report in Feb 08 on this peculiar business starts with the following:

"Imagine a business in which other people hand you their money to look after and pay you handsomely for doing so. Even better, your fees go up every year, even if you are hopeless at the job. It sounds perfect."

How we got to today's "universal" standard of "2%/20%" fee structure (for private equity funds) would make for an interesting finance history research paper. What seems clear to me, or anyone who bother working out the math, is that it will be quite difficult for a Fund Manager to lose money. The worst that could happen, is that he loses money for the clients (though it does not necessarily follow that he is a bad Fund Manager at that; in fact Nassim Taleb, author of Black Swan, would argue that some "bad" managers can outperform the market for years) and he is forced to switch career (in other words, no investors want to invest with him any more). Switching profession hardly seems like a big loss compared to the potentially disastrous losses that might have been suffered by the investors. On the other hand, if the market swings his way, or if the particular asset class he's managing suddenly become the hottest thing or if he's really a capable Fund Manager, the potential upside for him (and the relatively small team required to run a fund) is enormous because of the 20% incentive fee. Even if we discount this carried interest component, the 2% annual management fee is also a significant income if the Fund size, from which this 2% is applied, is substantial. Indeed I'd be interested and probably quite surprised to find a similar fee structure for service providers/consultants/managers in any other industry like IT, management consulting, property management etc. According to a Boston Consulting Group survey, the average profit margin for fund managers is a whopping 42%!

This is of course an overly-simplified scenario of the FM business. Fund Manager often has a stake in the Fund, and may include a high watermark in the incentive fee calculation etc, but this lopsided risk/return profile inherent in the fee structure leads to an interesting question, why has there not been an erosion of fund managers' profit margin with all the fierce competition among the managers?

The Economist report suggests that it's because Fund Manager don't compete on price, rather they battle with their so-called track record. Personally, I still can't accept that price is not a consideration for potential investors and if I have to guess, this 2%/20% arrangement will eventually be replaced with something much more palatable to investors when more firms compete on cost leadership (why this fee structure has sustained for even more than a few yrs still eludes me). On the other hand, I completely agree that track record is a major factor for investors (another way to look at it is that firms compete on differentiation, supposedly supported by their track record). In fact, the single most common question, besides those on corporate governance, we've had from investors during their due diligence is regarding our past track record.

I'm not sure if there's any authoritative study on the ability of past track record to predict future performance for private equity real estate funds, but it's a well-known fact that various extensive studies over different time horizons have indicated that there's no statistical correlation between past performance and future performance for mutual funds. However, the habit of investing based on past performance is still as prevalent as ever.

I think this illogical inclination to past track record is another manifestation of a much broader phenomenon, the human kind's innate need for certainty, and nothing is more certain than a number, something concrete, something quantifiable. It might seem a bit ironic for me to say this since I'm somewhat a self-confessed geek with a liking for data manipulation. But over the years, either from my research days in the lab, or more recently from messing around with financial models, data always fall short, for 2 main reasons, 1) it's never detail enough, 2) the data collected seldom lead to any meaningful correlation to the end result in the real world.

A while ago I came across this talk by Malcolm Gladwell at the 2008 New Yorker Conference where he illustrated this "mismatch" problem (2nd reason above) much better than I ever can. He pointed out how various standardized tests were used to sieve out potential future star athletes (either baseball or basketball) in the States and how utterly useless the tests are in predicting future success of the individual players. This is why I've always detested academic grades, and even more so the likes of SAT & aptitude tests which most major corporations require their potential to take these days; the scores have such a low correlation (Alas! Maybe even negative correlation!) to actual performance. (“Flynn Effect”, which states the rise of average IQ test scores over generations observed in most parts of the world, serves as another example of the “mismatch” problem.)

Hence, one should not be surprised to find that I dislike the Singapore education system (at least at the time when I was in it, though I understand there're a lot of efforts to change it these days). I know I benefited much from this system, not because I'm extraordinarily intelligent, rather because I know how to score high in exams. (Sure, plenty with excellent academic records go on to do great things, but the reverse need not be true and I suspect there's much placebo effect at play here.) My younger brother, on the other hand, who by most measures is much more creative than me, struggled in school, because I guess there's no easy way to quantify and hence reward this wacky thing called creativity.

It might seem that I'm digressing, from Fund Management business to investors' reliance on track record, to the "mismatch" problem, but there is an important theme here, with critical implications for people who wish to quantify things to forecast the future, and that, by default, will include almost everyone in business. For instance how does one calculate an IRR for a project? That sounds easy enough, except to me, that figure is never complete without a corresponding distribution that takes into account the probability functions of all the inputs. Then again, calculations like these will most certainly be beyond the reach of most "normal" analysts, and in the end, the statistical confidence level may be so low that will render the figure "useless" in the practical sense. But does it mean we should revert to some sort of "gut feeling" or simplify things to just a few factors? Malcolm Gladwell seems to think so, as he espoused in his book "Blink". I don't think I can make any judgment on this yet, perhaps because I have not been around long enough to develop some sort of "gut feeling" related to doing business, but I suspect there are just some things in life which just can't be simplified to just a few factors.

On Measuring Financial Performance:

I finally took the CFA Level II exam in June. While it was quite a lot of sacrifice for me, and probably more so for my wife, it was definitely time well-spent. For highly technical skills like the ones that the CFA program covers, formal/structured education (vs me reading finance books randomly) is a very efficient way to build up my foundation. The topics covered are very broad, and although real estate investments only receive a short mention, it led me to start really seeing real estate as an asset class, a financial instrument for storage of wealth, for value creation as well as a means for speculation. The course also brings about an awareness of the intricate connection among all the various asset classes, be it equities, fixed income, commodities, real estate etc. Understanding how they interact with the overall global economy is crucial in coming up with any intelligent forecast and course of actions. This will certainly help me interpret the big picture and see where the company fit into the overall landscape. I am definitely still very much an amateur in this, but at least now, I know what I don't know (which is a lot better than not even knowing what I do not know).

Another revelation that I had while studying for the course is that any corporate ambitions defined merely by size, be it Asset size, Asset Under Management size or Profit size, are meaningless unless the target is viewed in relation to the capital used in reaching such expansions. The airlines, the telcos and a century ago, the railways were once the Googles of their era, promising rapid revenue growth. And yet, arguably even more investments had to be injected in order to realize these growths. In the end, it is really the ROIC, the ROE, the ROA that determines whether a business is creating value, or destroying some.

On asking "Why" & "Why not"/Institutional Imperatives/Innovation/Meaning:

A while ago I was asked by one of our IT colleagues to remove the Firefox browser from my laptop. When I asked him why, he replied "this is the company's policy". SOPs, policies, processes are good because it helps orientate collective behavior, serves as a cradle for organizational knowledge retention and improves efficiency. However, when these rules are so institutionalized that people stop questioning why we're following them in the first place, we'd end up like the fool who queue up after a long line simply because there's a long line of people waiting, without knowing what everyone's waiting for. In a similar light, Warren Buffett referred to it as one of the conditions of the "Institutional Imperatives", where "as if governed by Newton's First Law of Motion, an institution will resist any change in its current direction."

I guess asking "why" to someone who's been doing without questioning can be quite the cognitive dissonance and I suspect it can really get on people's nerves when you keep asking them on something which they've made up their mind that this is one aspect of their lives which they're not going to think too much about. I think that's a natural psychological adaptive behavior that people develop as we compartmentalize on what we choose to question on; some choose to ask more, some choose to just do it. For better or for worse, I know I fall into the "can't-stop-asking-why" end of the spectrum. More specifically, I like to ask "why not", and probably spend too much time each day just day-dreaming on "why-not" scenarios.

While this could be a distraction from "real" work and perhaps even at risk of irritating someone else, I would argue that the never-stop-asking-why mentality is crucial for any organization (like ours) that aspires to be a "lasting" institution. There're plenty of examples of corporate tragedies when company keep marching on blindly. The most recent (and quite dramatic at that due to its bad timing) illustration was when ex-Citigroup boss Chuck Prince told reporters right before the current credit crunch starts unfolding that "as long as the music is playing, you've got to get up and dance." Of course, the other side of the coin is the risk of rocking the boat when things are going along just fine.

In the end, this boils down to a delicate act of grooming a culture of asking questions, of generating innovative ideas while maintaining efficiency in the current focus of the organization. At this point I think we can take a cue from one of the world's most innovative companies, Google. Most people know that Google has this scheme where employees are given 20% of their work time to devote to something they're passionate about. This probably sounds like a luxury to most companies. So how does Google turn these into useful services? Eric Schmidt, the CEO, gave this answer "You can do whatever you want as long as you track it." So there goes; they just try it out, measure it, and decide whether to continue with it, if not, move on to the next idea. (Another idea factory, though highly controversial, is Intellectual Ventures (IV), started by ex-Microsoft CTO Nathan Myhrvold. IV does nothing but dream of new inventions and have so far filed hundreds of patents across more than 30 different fields from their regular brainstorming sessions)

In reflection, do we, as an organization, have this culture of constant innovation, of asking "why" and "why not"? Have we considered experimenting with pre-fabricated homes (which Toyota Homes & China Vanke have been working on for a while, probably due to its quality control and fast construction time)? If no, why not? Have we considered venturing into boutique hotels (which economically speaking might work quite like a serviced residence and potentially serve as a testing ground for innovative architectural & environmental tech innovation due to its relatively small scale)? If no, why not? How about something closer to heart: have we considered, on a regular basis, why our group's business model might work in the past and will still work in the future?

To some, these questions might seem too far-fetched from their current position in the organization; after all, how will a low-level executive have the insights or experience to ask something as strategic as the group's overall business plan? Yet, in my opinion, it does not matter whether a person has the capacity currently to fully comprehend the rationale, but the point is to never stop asking why. Someone may respond: why bother asking when chances are that one may not have sufficient "knowledge" to ask the "appropriate" questions (and worse still, risk looking foolish in the process)?

The over-arching reason, one that is much more important than a pursuit of a disciplined way of creativity (which I've been advocating in the earlier paragraphs), is that asking "Why" gives rise to meaning! And meaning, when it is one that the individual can relate to, gives rise to passion! This is the key reason why I can't stop asking why. It is because I want to find meaning in my work, which in turn will (hopefully though never for certain if I can't agree with this meaning) translate to passion for my work. I believe this is why our CEO keeps sending out those weekend emails. I suppose he's trying to convey what gives him meaning in his work, and in turn influence us to see meaning in our work as well. I know how it felt to find meaning in my work. There were exactly 2 occasions in the past where I found such passion in what I was doing and they were unforgettable experiences. I am still hopeful I can find that a 3rd time here. That is, ultimately, why I have to keep asking "why".

Disclaimer: A lot of what I wrote on my thoughts are really what they are, just thoughts. I do not pretend to have the expertise to suggest a solution (though I constantly try to arrive at one) to some of my own questions if I currently don't have one. It may sound like I'm just whining and I agree it can seem that way. But I have this desire to share with you what I'm thinking, and if you can think of a good solution to my hypothetical questions then that's great! If not, a great conversation leading from this will be, in itself, a great reward for me.

Some relevant links (if you’re interested):

Malcolm Gladwell’s talk at New Yorker Conference 2008

Economist’s Special Report on the Fund Management industry

Gladwell’s article on Intellectual Ventures

Eric Schmidt’s interview on BusinessWeek

Warren Buffett on Institutional Imperative

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