Beta vs. Alpha
I was extremely lucky to begin my career at Citi where I worked with many companies in the metals and mining / automotive sectors amidst a tumultuous time. I took away from my time a critical lesson. One that Warren Buffet of Berkshire Hathaway espouses, “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact”. I recognized pretty early on that much of a return stream primarily arose from beta(1) vs. alpha(2).
Simplistically, think of alpha as your individual ability to swim and beta as the current. The average swimmer is able to achieve a rate of approx. 2 miles per hour vs. the average speed of the Gulf Stream is approx. 4 miles per hour. If you’re the average swimmer swimming against the Gulf Stream, it’s unlikely you’ll ever get to your destination. Conversely, if you’re swimming with the current, you’ll likely get to your destination significantly faster.
Given the afore example, the logical concept to maximize your return on effort (“RoE”), would be to pick your destination based on when the fastest currents are at your back and when you’re at peak condition to make the journey. As such think about the career path you seek to pursue, early on it was clear to me that my background, non-target university and relatively limited alumni network (both College and Banking) would make it difficult to get a job at one of the prestigious investing firms during the regular private equity recruiting process. I took some time to be honest with myself, what was I good at? There are four traditional realms within traditional private equity, most which can be encapsulated based on growth trajectory and current capabilities.
The four realms are (i) Venture Capital (“VC”), (ii) Growth Equity, (iii) Leveraged Buyouts (“LBOs”) and (iv) Distressed / Special Situations. In laymen terms, think of venture capital as a baby, high growth potential but limited current capabilities. Growth equity as a recent college graduate, high growth potential (perhaps less than that of a venture capital backed firm) with some current capabilities. LBO as your mid-career adult with a stable growth outlook and comfortable with their current skill set. Distressed / Special Situations as your 90 old year grandfather who is in decline and with limited capabilities. I really struggled with seeing myself being a (i) VC as I didn’t have a technical background (in engineering or computer science) so didn’t feel like I could walk in the shoes of the entrepreneur. (iii) LBO was the most competitive as everyone and their grandma seemingly wanted to be the next Master of the Universe.
(ii) Growth equity and (iv) distressed were domains slightly less trafficked as growth equity was known for firms dedicated to cold calling and for distress, no one really wanted to be known to an asset stripper. Both were sometimes viewed to be unsavory. Given I had attended a non-target and worked to establish relationships with alumni, I felt fairly confident that I could be relatively good at the cold calling and that early on, I should try something different. By process of elimination, I decided to pursue distressed / special situations and made that my focus. I did a significant amount of work understanding who the best firms in the space were and made my intentions clear to headhunters during the recruiting process. Lone Star was on my list of the top 10 firms within distress, but when I received the offer, I wasn’t even sure that was the right firm. The firm was in Dallas, and the common refrain was that, doing finance in Dallas was effectively where careers went to die.
I sought the counsel of a long-time mentor of mine, we’ll call him Greg. Greg lit into me when I shared my concerns as unfounded. It’s rare that someone (NOT your family) has a strong opinion about your career as they fear collateral damage to your relationship arising from their opinion. For his willingness to have a strong opinion, I am internally grateful, going to Lone Star changed my life.
Lone Star was a phenomenal training ground as everything was about risk, reward, possibilities and probabilities. Why would you invest in the equity at an 8.0x creation multiple vs. creating a potentially better return profile (current cash pay) by levering the debt at a lower attachment point (5.0x) with effectively lower risk? It was an environment that prized intellectual honesty, practicality, intensity and execution, an environment that I thrived in.
So how does this all tie back to Alpha and Beta? I would say there are 3 lessons to be found in the above, I captured beta by (i) having grown up in brand name firms (Citi and Lone Star) — counterparties picked up the phone and were responsive, (ii) by pursuing something less popular (vs. VC and LBOs), I avoided the morass of bodies competing for the next broadly auctioned process and lucked into alpha (iii) as Lone Star’s culture of being a meritocracy and prizing new ideas allowed me the degrees of freedom necessary to grow.
For the reader, I might ask you to reflect, am I in a situation where I am effectively capturing beta (my job is grooming me / serves as a training ground) with a alpha call option on independence (the chance to strike out should I see the right opportunity)?
As I thought about the opportunity set for Parallaxes, I believed that the opportunity while too small for established players, would be one ripe for a niche focused manager which allowed us to captured the beta from the growth of the asset class and hopefully some alpha from the lack of institutionalization.
(1) Beta is a measure of the risk arising from exposure to general market movements as opposed to idiosyncratic factors.
(2) Alpha is a measure of the active return on an investment, the performance of that investment compared with a suitable market index.