Tennis Lessons for Alternative Investors
“There are moments in a match when the ball hits the top of the net, and for a split second, it can either go forward or fall back. With a little luck, it goes forward, and you win. Or maybe it doesn’t, and you lose.”
What does the current era of professional tennis have to teach us about the state of venture capital (VC) and private equity (PE)?
It turns out there are some illuminating parallels.
The Big Three and VC
Three exceptional players have dominated the elite men’s tennis ranks for a long time.
Of the last 12 Grand Slams — the ne plus ultra of tennis tournaments — Rafael Nadal has won five singles crowns, Novak Djokovic four, and Roger Federer three. The last time someone from outside this trio captured a Grand Slam? When Stan Wawrinka won the 2016 US Open.
In the last 10 years, the Big Three has won 82.5% of all men’s singles Grand Slams and two-thirds of all Tour Masters 1000 tournaments. Only fine-tuned adaptability and talent can explain such dominance.
Venture capital is a lot like men’s tennis. Its expertise is difficult to earn and hard to replicate. Only fund managers based in Silicon Valley or Boston’s biotech cluster, for example, can build the local entrepreneur networks that can best access prime deal flow.
Success depends on a few key variables, a strong understanding of the power law and the abstract art of pattern recognition, among them. The power law implies that portfolios should be constructed around a select group of a VC firm’s most likely winners, which goes against conventional wisdom of always keeping a portfolio well diversified.
Venture capitalists operate in an extreme environment where the unusual and unpredictable are commonplace, where disruption is frequent and deep. In fact, these conditions are what authentic VC fund managers seek to exploit.
The skills needed to navigate this terrain are different from those taught in business schools or applied by management consultants. Venture capital aims to produce exceptional value by embracing fundamental principles like the aforementioned power law, Gordon Moore’s law about processing capability, or Ray Kurzweil’s law of accelerating returns. Very few market participants truly grasp how these concepts define their trade.
Identifying what will make, say, a software developer successful requires decades of trial and error across hundreds of start-up bets. There is no substitute for experience. Some of the Valley’s VC standard-bearers were founded in the 1970s. Others are run or co-managed by grey-haired serial entrepreneurs who have honed their pattern-recognition credentials and know how to assess and nurture start-ups.
As a result, the top VCs have consistently outperformed their peers over the past 40 years. Among the thousands of VCs worldwide, only a select few deserve to be called talented. In statistical terms, VC returns follow a skewed distribution (as do all power laws), with a tiny cohort of outperformers operating among a vast population of also-rans.
Just as any tennis gambler would have done well to bet the Big Three over the last 10 years, investors should only commit their capital to the VC equivalents of Nadal, Djokovic, and Federer and ignore the rest of the pack.
To be sure, success does not last forever and even superstar VCs have to retire eventually. Which makes succession planning a serious matter.
And it would be foolish to totally ignore the influence of luck. Some novice or run-of-the-mill fund managers may temporarily deliver decent results or even score the occasional unicorn.
But when the current bull market blows up, the Wawrinkas of VC will most certainly lack staying power.
Normalized Returns and Women’s Tennis
Private equity, on the other hand, is a different beast altogether. But like the VC space, it too has a revealing analogy in the world of professional tennis.
In the last three years, 10 women have won 1 or more of the 12 Grand Slam singles events. Although Serena Williams has bagged 12 titles and reached the finals in another 7, 18 other players have captured at least 1 of the 40 “majors” held over the past decade.
Beside Williams, the elite of women’s tennis has no consistent top tier. Few among us could put a face on names like Garbiñe Muguruza, Li Na, Flavia Pennetta, and Marion Bartoli, even though they have all hoisted at least one Grand Slam trophy in the past 10 years. Between 2009 and 2018, the three most successful female players won only one-third of all Premier tournaments, the sport’s second most prestigious series.
The feeling that the women’s tour is up for grabs may help explain why former world No. 1 Kim Clijsters, who hung up her racket seven years ago and last won a Grand Slam tournament in 2011, recently announced her wish to come out of retirement.
Likewise, private equity is made up of a variety of competitors with comparable aptitudes. But it is a somewhat forgiving environment. With so much money to be made from commissions alone, PE executives have no incentive to retire. Who would walk away from such secure sinecures?
What is clear is that PE has no Williams equivalent (i.e., no consistently outperforming outlier), but it does have a big, open field. Any buyout professional can “create” value by slicing headcount, outsourcing non-core activities, negotiating preferential terms with lenders, and incorporating holding companies in tax havens.
Because buyout transactions in PE are over-intermediated, occurring mostly via auction, the best way to secure them is to simply outbid everybody else. That does not require any special talent beyond having deeper pockets than the competition.
Thus, performance in PE tends to be randomly distributed: A large proportion of fund managers delivers middle-of-the-road returns, a few significantly outperform, and a similar number fail.
But a second and more consequential point is that, unlike the top VC firms, most standout private equity fund managers eventually revert to the mean: According to research by MIT Sloan Professor Antoinette Schoar, about 10% deliver a first-quartile performance from one fund to the next. We can neither tell whether persistence in investment returns is due to chance or talent, nor can we isolate the source of value creation between the two.
Sloane Stephens won the US Open in 2017, Naomi Osaka triumphed the following year, and Bianca Andreescu prevailed earlier this month. Few would have predicted!
Against random outcomes, punters have to spread their bets across various potential winners. Given its weak persistence in returns, private equity requires the same approach.
When picking among unpredictable performers whose past results count for little, we are best served by assigning capital to multiple experienced participants. And crossing our fingers.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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