Letter to a friend who may start a new investment platform
A friend of mine who is thinking about starting a new hedge fund recently asked for my advice. I wrote him this letter. While this friend is thinking of starting a hedge fund, I think many of the questions are relevant to starting any new platform.
I know you’ve been thinking about starting your own vehicle for a long time. At the start of each of the last several years, after your bonus check has cleared, you’ve debated whether to take the plunge. In advance of our lunch next week, I’ve tried to distill the patterns my partners at East Rock and I have observed in other new initiatives into a series of seven questions for you to ask yourself as you hold the possibility of launching your own platform live in your mind.
1) Are you ready to fully own the ambiguity of a new initiative?
2) Is your spouse fully on board?
3) How will you accelerate the process of building trust with new partners?
4) How will you protect the climate within your skull?
5) How are you going to source enough good ideas?
6) What are you compulsive about? Is it possible to put that at the center of the platform’s activity?
7) Are you really focusing on what you’re going to value over the long term?
Are you ready to fully own the ambiguity of a new initiative?
Start-ups of any kind are awash in ambiguity. It’s the founder’s responsibility to hold that ambiguity for everyone, which is often a lonely job. As you move from “refining reality” in your old job to “asserting reality” as you create something from nothing, you will inevitably encounter the cognitive dissonance borne of having to act as though everything is going to come together when there’s obviously a real chance, for reasons outside your control, it may not. It’s like the zen joke: the bad news is you’re falling through the air, nothing to hang onto, the good news is there’s no ground. I recommend watching Oscar Isaac’s portrayal of a heating-oil entrepreneur in the movie A Most Violent Year, which makes vivid the extended agony of an entrepreneur bearing the burden of ambiguity and risk for his employees and his family.
This initial process can be easier for sales people, who are used to asserting reality through storytelling, than for those who, like you, have spent their careers investing. Investors often rely on innate skepticism to see the reality of an investment opportunity clearly. Being able to always see the downside in a situation is slightly easier when you’re an analyst, but when you’re the leader of a new enterprise, it’s important to transmit the message to your internal and external partners that while failure is of course possible, you’re going to do everything you can to will the new initiative to success. So you have to practice asserting reality in advance.
Is your spouse fully on board?
An angel investor recently told me that he now only backs people whose spouses are completely supportive of the venture because he noticed a disproportionate number of failures involved founders with spouses who had not signed up for the venture implicitly or explicitly. That fits my sample of start-up hedge funds too. A start-up requires so much time that if your spouse is resentful or not fully on board, it affects the likelihood of a venture’s success. It’s also easier to hold a lot of ambiguity if your home and basic spending needs are taken care of for a while. If they’re not, your spouse may be bearing significant risk and less available to help psychologically with the risks at the office. It can even lead to divorce as risks compound and you get into a negative feedback loop.
I think it’s best to treat your spouse as a partner and plan out this era of your lives together, setting markers where you’re going to check in on the tempo and possibly adjust it. Every marriage has its own financial dynamics; depending on yours, I’d consider giving your spouse some appropriate percentage of your stake in the new enterprise, to make explicit how you value the support and that the venture is something you’re doing together. That way they can help you hold the ambiguity when you’re thinking about work on Saturday morning.
How will you accelerate the process of building trust with new partners?
In a perfect world, your next door neighbor from growing up is extremely wealthy, knows your parents, and saw your career develop over the course of twenty years, so she already trusts your competence and character. On your fundraising roadshow you’re going to be meeting lots of people who don’t know you. Your job is to try to accelerate the process of building trust with them.
I think of as each of us having built up an intangible asset over the previous chapters of our lives, a distributed reservoir of credibility that is held in trust by your friends, mentors, and former colleagues. Your task is now to convert that intangible asset into a tangible asset by having those trusted friends and colleagues, or people who speak to them, wire cash into your investment partnership. There are some allocators who are skilled at assessing your credibility through interviews with you and references with all the people familiar with your prior body of work. Others are clumsier in this process of assessing your credibility, so you have to help them do it (while not forcing your friends to do fifty one hour references each!).
One hang-up many analytical analysts launching a fund have is that they feel sales-y and do not like promoting themselves. Try thinking about marketing as telling people an interesting story about the way you see reality, which could be helpful to your audience whether or not they invest. Yuval Hariri has a great framing of us all as a primate species that is good at telling stories. He notes that wearing a suit to a meeting is one signal we send to each other that we’re telling the same story about business and money. It’s interesting to think about how to signal you’re signed up for a certain version of the story — making money together — but then also coming up with your own new plot twist.
A Baupost alumni noted to me that when someone once said to him that he admired how they didn’t have to market themselves, he responded that on the contrary he felt that they marketed to their LPs every day — through update calls, lectures and letters about how much cash they were going to hold or about how value investors often invest early and lose money. This piece on fundraising by First Round Review for entrepreneurs raising venture capital is quite good and surprisingly applicable. This advice is particularly on point:
The reality — and difficulty — with fundraising advice is that it’s not all created equal. There are two approaches: one for the top 10% of startups and one for the other 90%…for the vast majority of early-stage companies, raising capital is a slower, relationship-building exercise. It may not be a competitive process, so your goal should be to get one or two partners to fall in love with what you’re doing. Running an aggressive, get-every-meeting-lined-up approach won’t work as well for the 90% as it will for the top 10% of startups.
All this time and effort creating mutual trust builds an intangible asset for your firm that down the road may become a tangible asset. In 2008, I was very struck by the way Baupost effortlessly converted twenty years of relentlessly and deliberately building trust and credibility with their limited partners into raising $2BN of fresh cash in Q4 of 2008. I think most people, if given the opportunity to buy some equity in Baupost’s general partnership in late 2007, would have underpriced that intangible asset.
One dynamic to keep an eye on is the reference you’ll get from your current employer after you leave: your boss may have complicated feelings and incentives around your leaving to do your own thing, and those might manifest in the implicit or explicit threat of a lousy reference. That’s okay — I would do the best you can to leave graciously while ignoring any threats. Some of the most revered investors in the world today were at best damned with faint praise when they left their old firms. Life is too short to be paralyzed by the threat of a mixed reference. The system of early stage funders is sophisticated enough to see the signal through that noise most of the time.
How will you protect the climate within your skull?
While hard work is obviously required, good decisions take form in a separate realm. Naval Ravikant has a great line: “if you’re leveraged with capital, code, or people, and own equity, then good decisions have a much larger earning impact than hard work.” There is no “product” in your future company beyond your ability to make decisions, that’s why selling your future investment platform to a strategic or going IPO will be highly unlikely. Your primary objective should thus be to maintain the right filters for people and ideas so that the delicate ecosystem in your head is as resilient and flexible as possible.
That makes good hiring crucial: the people around you will either protect or infringe on the climate within your skull. Often I see younger portfolio managers hire older analysts, controllers, or CFO’s. That may make sense from an experience perspective, but make sure the older members of the team are capable of truly believing in you — and if they don’t, be ready to address the issue head on, resolve it or show them the door. Older team members can inadvertently introduce a negativity or skepticism on your portfolio management ability through subtle body language or questions during inevitable drawdowns. This could be because their own financial situation does not actually permit them to take much risk, it could be because they’re neurotic in the technical sense, it could be because they’re right that you’re in over your head; regardless, your priority is to protect the climate within your skull and prevent feeling like an imposter in your own firm.
Beyond deliberately architecting the people who surround you, the best way to control your mindset is to “own” the way you speak to yourself, what sports psychologists call your “self-talk”. I have puzzled about what makes someone a “winner” for years, but only recently, as I was reading Jocko Willink’s description of “extreme ownership”, did I find a good vocabulary. I now see that owning every element of what happens to you, whether or not you can control it, is what leads certain people to be consistently described as “winners” by their former bosses and team.
I have been spending time over the last year with a new portfolio manager who used to manage a large portfolio at a prior firm. He said at one point that on the rare occasion he lost an analyst due to compensation issues he immediately knew he was “over-earning”. Note he did not say “my analyst didn’t raise comp with me the way he should have” or “that asshole other PM just stole my best guy.” Things are always happening “by him” and “through him”, not “to” him — he has an extreme ownership mindset. If the factors that drive the market shift from growth to value next year, he won’t be whining to himself or others about how other investors are undervaluing Netflix; he’ll be laughing ruefully at his being a touch late to see the shift.
You can extend this approach to owning your climate in the skull. In some ways that’s your primary responsibility as the founder. I love how when Scott Belsky at Benchmark is tempted to procrastinate on something difficult like firing someone, he says to himself, “Scott, do your fucking job” (note there’s evidence that using your own name as you talk to yourself is particularly effective). Years ago I sat next to George Stephanopolous’s wife at a dinner and she described how she would wake up at 4 am because she’d hear George saying “come on George, come on George” coming from the bathroom as he got ready for the Sunday morning show. For more examples of world-class self-talk, listen to Jocko’s audio book of Field Manual — it’s like an extended spoken word poem where you can hear how he speaks to himself as he goes about his highly disciplined daily life. My kids are now tired of me playing his amazing rant against carbs and sugar called “Sugar Coated Lies”.
If you do a listening tour with older established portfolio managers and ask for advice, one theme will be that they didn’t realize how much time wearing the “CEO” hat takes up (versus the “CIO” hat). The process of building trust with a bunch of new agents is inefficient and time-consuming, and there is a real risk it will take you away from the investing. Giving yourself a time budget for the number of marketing and current investor meetings per week is probably wise. It also creates scarcity, which can be a good thing when trying to attract capital.
Another thing that’s hard to own somatically (as opposed to cognitively) in advance is what it feels like to lose money for other people. In the book Simple but Not Easy, a long-time money manager named Richard Oldfield describes how his favorite family office client would call after a rough month in the markets and immediately ask, “so is any of my money left?” Oldfield could always say, “yes actually, you do have some left,” which he felt was a great place to start the conversation. Many of your future limited partners will not understand how a single passive-aggressive joke can affect your ability to take risk the way you might with your own capital, the way they should want you to behave. They are often just mismanaging their own anxieties. Your job is to protect your psychology in advance, so prepare yourself for innocent clumsiness by your limited partners.
David Tepper has described being haunted by the way constant investor pressure in late 1999 led him to cover a large short position on the Nasdaq in 2000, five weeks before the crash; he considers missing that trade one of the worst mistakes of his career. Tepper says he only realized afterwards that “it’s the manager’s decision to make the right calls for the portfolio … not the investors.”
How are you going to source enough good ideas?
In my experience, building gross exposure in high-conviction ideas in a new fundamentally-oriented portfolio is the toughest barrier to entry. The reality is that most senior analysts or portfolio managers actually have conviction in 3–5 opportunities at a given moment in time. They need to borrow conviction on other ideas from someone, usually analysts (if they have them) or friends in the business. Unless your plan is to run super concentrated and long biased, you need a road map for how you’re going to source and underwrite enough ideas in your first year. Ideally you have already identified your top two analyst hires and have ideas on the next three; having a team to hire in mind could be one useful threshold for when you’re ready to take the plunge. Hiring ten analysts you don’t already know from scratch can create an Ocean’s 11 feel to a new team — a collection of highly competent individual players but not that much existing trust.
There are a number of other more tactical questions you’ll have to work through before you make a decision:
– Is there some way to be innovative in the structuring of the fund? What terms would you want if you were investing in your platform?
– If you’re long/short, do you really like to short or is that just to allow you to charge an incentive fee more easily? If the latter, is there some new way to structure the partnership?
– What’s the actual boundary of the firm? Can you outsource the CFO role, use analysts in India, or partner with someone else?
– Why won’t machines do what you do better over the next 3–5 years?
But the most important questions of all have nothing to do with the investment vehicle itself:
What are you compulsive about? Is it possible to put that at the center of the platform’s activity?
I like Josh Waitzkin’s framing of both work and life more generally as an opportunity for self-expression. Ideally this new venture presents an opportunity for you to dial up that self-expression while dialing down activities outside your zone of genius.
Some investors are compulsive about trading, but feel it necessary to play the role of macro thinker or portfolio manager or manager of people, when they really just want to sit in front of the screen and try to make money. Others prefer to go super deep on 1–3 investment ideas. Many high achievers are compulsively exploring the world in search of something — some for truth, some for power, others for beauty — and I think it’s a disservice to yourself and your future partners to not orient your platform around the piece of investing that you really love. Embrace your funk.
Waitzkin has a concept of “going into the cave” — spending time alone for several weeks with a blank sheet of paper — before starting something new, in order to help yourself see all the assumptions and constraints that you’re bringing from your prior container. It’s sometimes hard to recognize those constraints and assumptions at first, but I often hear them in the way many fund managers define their new platform primarily in terms of how it’s not their prior shop (which was too large, too sharp-elbowed, traded too much, etc).
In life and business, “approach” goals are much more effective than “avoidance” goals. It’s important to give yourself enough time to build a positive vision of a future fund instead of simply reacting against someone else’s vision or your own prior frustrations.
Novak Djokovic said in an interview with the Financial Times that “I can carry on playing at this level because I like hitting the tennis ball.” The interviewer replied in surprise: “are there really players who don’t like hitting the ball?” Djokovic answered “Oh yes. There are people out there who don’t have the right motivation. You don’t need to talk to them. I can see it.”
If you can find the thing you do for its own sake, the compulsive piece of your process, and dial that up and up, beyond the imaginary ceiling for that activity you may be creating, my experience is the world comes to you for that thing and you massively outperform the others who don’t actually like hitting that particular ball. I think the rest of career advice is commentary on this essential truth.
Are you really focusing on what you’re going to value over the long term?
If you zoom out, most of money management and perhaps even business activity generally is just lots of principals and agents building and destroying trust with each other over and over. Most agents are obsessed to the point of distraction with becoming principals. I think that being the “principal” — the owner of the capital — is often overrated. I like to consider myself an agent, at this stage of your life you’re probably an agent, and what’s great about being an agent is there is a way of framing it as servant leadership, which comes with built-in humility.
Much of the time, playing the role of principal actually comes with ego attachment that makes it harder to see reality. Either you made the money, in which case you have lots of identity around the “right” way to invest because it confirms you were smart rather than lucky. Or you inherited the money in which case you (often correctly) think people are friends with you only because of your money. One of the things I love about investment management is how zen it is — the more ego attachment you have, the more likely you are to fall prey to cognitive biases such as confirmation bias because it tickles your ego. Consider “I am an expert at energy stocks and experts at energy stocks should always have an opinion on where the commodity price is going” versus a quieter ego version: “I have no clue where the commodity price is going right now, and that’s okay”. Enjoy your relatively blank slate, and see if you can keep it blank in the right places.
What if being a young agent who is long on time and short on cash who loves hitting your version of the ball was actually the optimal position for you? What if there was no promised land of security and control on the other side of making a billion dollars? How would your climate in the skull change if that were your default belief? Does it extend your time horizon, injecting spaciousness around a given decision?
I sometimes see a certain equanimity in older investors, a way of working with and moving efficiently through the water in the pool rather than thrashing about. If you took away all of David Tepper’s money, I think he’d still have that wonderful grin on his face as he started trying to make it back — he just loves hitting the ball.
You can denominate energy in any number of forms, money and remaining healthy conscious time on the planet are just two of many currencies. A billion seconds is roughly 31 years. I think Rupert Murdoch or some other aging billionaire might enviously see you as a time billionaire — I imagine he’d pay multiple dollar billions for the next five years of your life if he could magically add your sand to his own hourglass.
What price would you sell the next five years to Murdoch for? Stop and actually come up with a true number. I found my own number in answer to that question has gone parabolic — now approaching infinity — as I have young kids and I found what ball I like to hit and started to play only that game. In retrospect I wish it had gone parabolic even earlier.
Tim O’Reilly has a wonderful metaphor for money: he says money is like gasoline while driving across country on a road trip. You never want to run out, but the point of life is not to go on a tour of gas stations.
My hope for you is that your new venture will take you far away from the sprawl of the smelly, transactional gas stations, and will instead be an artistic adventure, full of unexpected highs and lows, with just enough gas in your car — or better, fighter jet — to let you stay nimble and still go far. If you decide to go ahead with the venture, make sure to call me: my partners and I would love to provide the gas.