“The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design”
F. A. Hayek
The Fatal Conceit
This year, nearly half of the world’s population will participate in the electoral process. Predictably, we are being cautioned about impending market fluctuations. However, we often overlook that most people already vote with their wallets every day. This unending and harmonious exchange between consumers and producers is arguably more impactful on society than most elections. But its quiet and conflict-free nature doesn't make the headlines. Thankfully, our portfolio companies continue to be favoured in this continuous consumer election, with a strong start to the year as their customer bases expand.
Investing, unlike politics, is a game where everyone can come out ahead. Warren Buffett once observed that he had turned a profit under every presidency since he began investing. Similarly, the S&P 500 index has risen during all presidencies since Truman, apart from two. The presidencies that have witnessed the greatest stock market gains are those of Democrats - Bill Clinton and Barack Obama.
Given the old boys’ race we are witnessing in this year’s US presidential election, it is also worth noting that the S&P 500 only fell 6% on the news of Eisenhower’s heart attack and a mere 3% following Kennedy's assassination. In both instances the market’s recovery to its prior levels was swift. These examples may feel cynical, but the stock market knows who is doing the heavy lifting in the economy, and that it is not the politicians.
Politicians have the power to plan, control and even destroy markets; everyone can name a handful of countries where this is obvious, from Venezuela through to Cuba and Congo to North Korea. It is easy to confuse this power to destruct with the power to create. Whilst politics may have the power to enable free enterprise, it can rarely create it. That job is almost exclusively under the purview of individual entrepreneurs. Acclaimed author George R. R. Martin contemplated these concepts extensively while writing 'Game of Thrones'. He likened the Targaryen dragons to the US nuclear deterrent. But did the control of such a formidable weapon yield any other advantages beyond having immense destructive capacity?
“Power is more subtle than that. You can have the power to destroy, but it doesn’t give you the power to reform, or improve, or build”
George R. R. Martin
Interview with Vulture
In this letter, we will spend some time discussing the power to destroy and create from the perspective of the, perhaps surprising, combination of politicians, parents and private equity managers.
“The overweening conceit which the greater part of men have of their abilities is an ancient evil remarked by the philosophers and moralists of all ages”
Adam Smith
The Wealth of Nations
Adam Smith was one of the first economists to call out the over-confidence with which most people make decisions. We all recognise this. Whether it be through talking about others being terrible drivers, or from all the New Year resolutions that are ditched around the time of writing this letter. The psychologists David Dunning and Justin Kruger had the dubious pleasure of naming this phenomenon the Dunning-Kruger effect. Their initial study focused on logical reasoning, English grammar… and sense of humour. David Dunning himself described his research subjects in a comical, but tragic way: “The first rule of the Dunning–Kruger club is you don't know you're a member of the Dunning–Kruger club”.
Obviously, we all are paid up, or at least visiting, members of this club, which is a source of disappointment and comedy as we balance life’s never-ending trail of high-expectations and failures. On the positive side, it is not impossible that the same hubris drives entrepreneurs and artists to take on the daunting task of creating. The dreamy, often ridiculously grand ideas and ambitions sparked in creative minds are perhaps the reason why creativity rarely is a collective effort. It is almost exclusively an individual sport. John Steinbeck described it well in his novel ‘East of Eden’: “The preciousness (of creativity) lies in the lonely mind of a man.”
Finding a way to support these vital bursts of creativity and not being a source of disruption or destruction are some of the most important priorities for people with power. Originally intended to inspire people to take control over themselves, Reinhold Niebuhr’s Serenity Prayer may serve as inspiration also for those with power over others: “God grant me the Serenity to accept the things I cannot change, Courage to change the things I can, and Wisdom to know the difference.”
“I think you all know that I’ve always felt the nine most terrifying words in the English language are: ‘I'm from the Government, and I'm here to help’”, Ronald Reagan at a news conference on August 12, 1986, where he also announced record state support for the farming sector.
Compared to most politicians, Ronald Reagan had a reasonably healthy relationship with his Dunning–Kruger club membership. Despite this, he was convinced that some of the country’s most important, albeit problematic, areas, such as the farming sector, needed his active ‘government help’.
It is easy to sympathise with his notion. When Reagan took office in 1981 the broader US farming industry represented some 20% of GDP. It was also reasonably efficient. Despite having only 0.03% of the world’s farmers, the US supplied 11% of all food consumed outside its borders. The US share of food exports was almost the size of OPEC’s share of the world oil exports. A simplified description of the US policy at the time was to trade cheap food for cheap energy.
Adding to its economic importance, farming is deeply rooted in the heart of the American self-image. Jefferson called the farmers the country’s most valuable citizens. Emerson and Thoreau gave them and their struggles a romantic touch and embedded farming into the heart of the national character.
American farmers are also often used to illustrate the Dunning–Kruger effect, as they have the habit of using fixed cash fees to lease land to farm crops with the highest yield variation. Unsurprisingly, the sector has a unique ability to find itself in crisis. The 1980s were no exception. In a torrent of good intentions and grandiose rescue declarations, the Reagan administration rapidly tripled spending on federal farm programs from $3bn per annum in the period preceding his presidency to $10bn per annum during his first years in office.
A decade later, Congressional Quarterly could have quoted Reagan himself when summarising the results from this ‘help from the Government’: “Their common refrain is that the programs help those farmers who need it least, provide little or no help to the poorest farmers, make U.S. farm products uncompetitive in world markets and provide no lasting solution to the chronic problem of overproduction.”
If that is the verdict of the creative power of one of the most market-oriented governments in one of the freest global economies, how have other countries and politicians fared? You guessed it – not so well. At the same time as the US farming sector crumbled under state support, the whole Eastern European block collapsed under the weight of its centrally planned economy. Today, the state supported Chinese economy is stumbling for the same reason. But centrally planned economies are perhaps low hanging fruit to pick on, so let’s examine the score in more open liberal economies.
In 2022, following a couple of record-breaking years of government interference and policy making (sadly, not only the tech sector set new records during COVID-19) two Swedish professors, Karl Wennberg and Christian Sandström, concluded in their research book ‘Questioning the Entrepreneurial State’ (a response to the state enterprise glorifying book ‘The Entrepreneurial State’ by Mariana Mazzucato): “In many regards, this book is a warning: huge government schemes towards specific, noble outcomes have historically been plagued with failures. In sum, we argue that innovation policy needs to be inverted: instead of being specific and targeted, it needs to be broad and general, focusing on the general conditions for firms to operate.”
The author and historian (and friend of Sprints) Johan Norberg reached a similar conclusion in his latest book ‘The Capitalist Manifesto’: “Governments are bad at picking winners, but losers are good at picking governments.”
“It takes a village to raise a child”
African proverb
Like politicians, parents have been granted many destructive powers. In the movie ‘Ted’, Ted gives thanks to the terrible fathers of his many short-term girlfriends. The prisons in England have the same absent fathers to thank for three quarters of their inmates. Only a few lucky children with absent or disruptive parental relationships grow up to become extreme over-achievers. A mobile phone giant, a global internet retailer and a leading electric car manufacturer are some of these unexpected yet extraordinary outcomes.
The odds aren’t great though. No one would recommend deliberately trying to be an absent or terrible parent for the chance of winning the billionaire entrepreneur lottery. The chance of that happening is slim, and the chance of your children thanking you with love and a generous retirement grant is even slimmer.
Most parents are highly committed. Being a parent is as closely tied to most adults’ self-identity as farming is for the national identity. All the parenting books, newspaper articles, Instagram accounts, TV-shows and endless dinner conversations are examples of our ambition to be the best parents possible and turn our offspring into exemplary citizens. But other than not messing up, what can parents actually do to help their children succeed in life?
In his book ‘Blueprint: How DNA Makes Us Who We Are’, psychologist and geneticist Robert Plomin argues that parents have a much smaller impact than they think. The most important contribution parents give their children is their DNA, which according to Plomin determines ~50% of our children’s outcome as adults. The remaining 50% is a result of the environment that children are brought up in, but this category covers a wide variety of inputs, including parents, siblings, schools, friends, peers, neighbourhoods and sports without one being a major or stable enough contributor to be statistically measured. Similar results have been achieved in several recent academic studies.
Is all the work that parents do not even statistically measurable in how their children turn out as adults? On a good day Plomin would give all the work parents do a 10% attribution. But in his capacity as professor, he realistically thinks it is closer to 5%. In Plomin’s opinion parents should be administered the same medicine as politicians i.e. be given the mandate to provide ‘good general conditions’ - buy a house in a good neighbourhood, get the kids into good schools - and then stay politely on the side-lines.
As an ambitious parent this can be hard to hear. At a seminar organised by Intelligence Squared, Robert Plomin debated his findings with two ‘parenting friendly’ psychologists. The audience was a large group of people at an age suggesting that most of them could be parents. Before the debate started the audience was asked to vote yes or no to the motion ‘Parenting Doesn’t Matter (Or Not As Much As You Think)’. Unsurprisingly, 66% voted no. Only 17% thought parenting did not matter much with the remaining 17% uncertain.
After listening to the for and against arguments for an hour, the audience was asked to vote again on the same motion. The parenting friendly majority had shrunk to 51% while the disbelievers in the importance of parenting had almost doubled to 29%. However, despite this swing in voting, it is likely that all the parents in the audience rushed home to make sure they had enough time to tell their kids to clean their rooms, finish their meals, brush their teeth, do their homework, prepare for the next day and dream of becoming doctors and lawyers. To make them feel extra powerful, all this good advice and intention was likely delivered with the usual bribes and threats.
Robert Plomin would think there is a better way: “I suggest parents relax and enjoy their relationships and that part of this enjoyment is watching your children become who they are genetically.”
“The only source of sustained competitive advantage is the ability to learn faster than your competitors”, Peter Drucker, management guru.
What has all of this got to do with investing? Investors share one important job with politicians and parents – don’t mess it up. The basic job of an investor is to stay out of jail and bankruptcy, apply good governance while also improve profitability and maintain a healthy capital structure. Over and above that, investors often struggle with the same serenity prayer as politicians and parents – what can and should they actually try to impact?
When the private equity sector took shape in the early 1980s, things were relatively simple. Valuation multiples were low and the lending markets generous, making financial engineering the easy answer to value creation. Buying profitable companies with debt, slashing cost to increase cash flow and using the cash to reduce debt was the standard modus operandi. However, the LBO crash in the early 1990s exposed its fragile financial structures. A study in 1993 showed that of 83 large LBOs completed between 1985 and 1989, more than half defaulted or entered chapter 11 proceedings. Simultaneously, the internet moved the epicentre of investing away from old cash cows to fast growing companies with weaker cash flow profiles.
Although disruptive in nature, these events may have been a blessing in disguise as they moved private equity managers’ focus to a larger and potentially more profitable opportunity in growth companies. This shift also alerted investors to the need and potential of value creation rather than financial engineering. Large operational teams, almost like a shadow government to a ruling one, were hired to support the portfolio companies’ various needs.
The results from this new phase have, on the surface, been quite good. Private equity has outperformed the public stock market in most years over the last decades. Adding to that, key return drivers such as revenue growth and margin expansion are things that an operational partner would surely raise in an annual performance evaluation. Combined with multiple expansion, these make up 60% of the sector’s returns since 2000. Leverage is still important but a distant second, making up 30-40%.
However, applying a Plomin-like cynical view to ‘value creation’, it could also be argued that private equity returns are merely the result of skilful capital allocation rather than operational support. According to research by J.P. Morgan, private equity is only a tenth of the size of the global public equity markets, allowing private managers to be highly selective in their portfolio construction.
The vague reporting from certain private equity firms also adds fuel to the sceptics’ argument. In its most recent annual report, one of the leading listed private equity firms mentioned value creation on almost one third of its 170 pages, including the first. But anyone interested in how many people are engaged in it or any quantification of results achieved from it would have to look elsewhere.
This vagueness doesn’t help to motivate further investment into more value creation work. If you are a shareholder in a listed private equity company - rather than a fund investor - you 'own' 100% of every dollar of fixed fees, but only a fraction of the 20% carried interest, i.e., the profit share of value created. For example, in a 33% profit sharing scenario, a fee dollar spent on value creation would have to yield 1/(0.2*0.33)=$15.2 in added value to break even. Assuming the firm’s target is to at least double the value of every dollar spent, rather than just break even, anyone employed in value creation would have to yield a return of 30x on their cost. In this case a shareholder would need to choose between receiving a dollar in dividend today or the possibility of receiving two dollars in some five years assuming someone has found something to do that yields 30x the cost of doing it.
With that in mind, it is tempting to suspect that the focus of most private equity managers will remain on capital accumulation, capital allocation and financial engineering, rather than ambitious value creation. Given the lack of data on the return on investment it is also reasonable to assume that, in listed private equity firms, dividends will grow faster than investment in value creation.
In spite of this, as a privately owned manager with a concentrated portfolio of assets, Sprints is a strong believer in active management and operational value-add. But not without a solid awareness of the Serenity Prayer, that reminds us to focus our efforts on those things where we have the highest chance of having an impact, such as good corporate governance, cost management and optimal capital structures.
Every investor knows that with the right team and incentives, ownership becomes simpler. Therefore, our pro-active value creation efforts are centred on recruitment and talent management, ensuring we always have the best candidates and set high standards for new team members. And, on the defensive side, our focus lies on strong tech platforms and cyber-security.
“Byrne is like the farmer who rolls an ostrich egg into the hen house and says, ‘Ladies, this is what the competition is doing.’”
Warren Buffett praises Jack Byrne, former Chairman and CEO of White Mountains Insurance Group.
As discussed above, being a politician trying to overengineer the economy, a helicopter parent trying to design their offspring’s future or an active owner trying to create value over and above what the existing management teams are already doing seem to be Sisyphean workstreams with limited measurable results to show. But can doing nothing really be a better option?
The phrase ‘laissez-faire’ is said to have been coined by the French minister René Louis d’Argenson in the middle of the 18th century. He argued that, since the world had become civilised (“depuis que le monde est civilisé”), it no longer needed micromanaging authorities. Politicians today have the benefit of being able to look back at a couple of centuries of evidence demonstrating that he was onto something. Free, open and competitive economies outperform centralised, planned and controlled ones. Politicians have a safe bet on their hands, and that is to draw some fair lines around the market and watch from a distance. But sadly, this behaviour is rare as they are some of the most active members of the Dunning–Kruger club.
Parents, on the other hand, have much less data to rely on. According to the Merriam-Webster dictionary, the word parenting itself was first used in 1918 and it was not until the 1970s that it gained any broad popularity. Consequently, parenting is a young research discipline. Nonetheless, much recent research points in a similar direction, telling us that children do not turn out the way parents plan, but mainly strive to become like their peers. The famous American psychology researcher Judith Rich Harris calls this the ‘group socialisation theory’: “A child’s goal is not to become a successful adult no more than a prisoner’s goal is to become a successful guard. A child’s goal is to be a successful child. Thus, the influence of peers is stronger than the influence of adults.”
Following Judith Rich Harris’ and Robert Plomin’s advice, parents should act like good politicians and make sure to expose their children to the best and most inspiring environment and peers possible. They will teach themselves how to play and compete at that higher level.
The private equity sector has an even shorter history, which dates back to the 1980s. But looking more broadly, some of the world’s most successful investors have applied a similar laissez-faire investment management style. For instance, Warren Buffett follows this principle: “We buy to keep, but we don’t have, and don’t expect to have, operating people in our parent organization. All of the businesses we own are run autonomously to an extraordinary degree”.
The listed Swedish serial acquirer Indutrade uses a similar hands-off model with remarkable success. Without exploiting any synergies or doing any value-add work for the several hundred portfolio companies it owns, its share price has multiplied around 30x in only the last 15 years. The secret to success? Competition. Every quarter, Indutrade benchmarks all its portfolio companies on a number of KPIs. In a subtle, unspoken way, this sparks play and competition between the portfolio companies and inspires them to continuous improvement and innovation.
A hands-off, competitive approach seems to be superior to a controlled one when ‘things are civilised’. But what about the situations where intervention is warranted and we are certain of being right? Why is it a struggle to get our disciples to do what we want, even in those cases? Human behaviour expert Bri Williams has identified it as our need for autonomy that keeps us from doing the right thing when it is pointed out by someone else – especially a parent or a boss. This is why giving people freedom to pursue their happiness in their own way is more efficient, despite our own views on the right course of action. Competition and play seem to be the best ways to inspire great performance.
“Even the very wise cannot see all ends. My heart tells me that Gollum has some part to play in it, for good or evil, before this is over.”
J.R.R. Tolkien
The Lord of the Rings
If we can’t engineer or design our subjects or offspring, why do we still care so much? Perhaps the answer lies in a genetic, subconscious focus on our species’ long-term survival. A research paper published last year by the Royal Society for Biological Sciences suggests that parental care increases the life expectancy of individuals with mild harmful mutations, therefore keeping a broader gene pool alive.
Already in his book ‘The Descent of Man’ (1871) Charles Darwin similarly noted that species with a high survival rate “present many modifications of structure which are of no service to them at present, nor have been formerly.” These random dormant mutations that we keep alive with our care are perhaps what give us our crucial adaptability to change. By way of example, scientists at UC San Francisco have found that those who contracted COVID-19 without developing any symptoms were more than twice as likely to carry a specific gene variation. This is one of life’s magic complexities. Looking at some of humanity’s less flattering experiments in the 20th century, it is unlikely that we would have the wisdom to add dormant mutations with a weaker current survival rate, but a higher long-term adaptability potential, if we were to design the human DNA set-up ourselves.
So, despite the lack of gratitude in this letter, we are grateful for this strong, caring parenting gene and for all the hard work that parents do to protect their offspring and our species. Humanity’s care for the weak combined with our love for life and play have made us extraordinarily successful in a relatively short period of time. Instead of trying to design ourselves too narrowly or being over-controlling, we are likely better off as a vastly diverse society that is free to innovate and create the most unexpected things, while also being less fragile. That is a source of comfort and hope.
As always, thanks for your continued support.
Henrik and the Sprints team
London, 10th April 2024
