Patient Capital: The Challenges and Promises of Long-Term Investing, by Victoria Ivashina and Josh Lerner (Princeton, 264 pp., $29.95)
Good investments increase a nation’s productivity and income and in general improve lives. What Victoria Ivashina and Josh Lerner, professors of finance and banking, respectively, at Harvard Business School, call “patient capital”—money invested for at least five years—plays a critical role in choosing goods and services that support a positive economic trajectory. But, they note in their recent book, Patient Capital: The Challenges and Promises of Long-Term Investing, “patient capital” suffers distortions and is becoming far less useful without reform.
As the authors define it, patient capital is money invested in “long-term, risky and illiquid” companies and projects—in other words, private equity and its younger sibling, venture capital. Sophisticated investors—typically wealthy families, university endowments, pension funds, and “sovereign wealth” funds that hold public-sector riches—commit money to an investment fund and serve as “limited partners” for a defined period. General partners, or people who work at the fund, earn fees (often 2 percent annually of the assets invested), plus an additional percentage share of the profits. These partners also invest in companies and projects not ready for general markets, including risky startups that can’t easily or quickly be sold.
This modern form of private equity emerged out of a “then-radical” insight grasped by British economist John Maynard Keynes, who managed the King’s College endowment from the 1920s through World War II. According to Keynes, institutional investors—such as a five-century-old college—should have long-term horizons for their internal investments. King’s College, for example, could invest in equities—that is, stakes in companies, generally considered to be riskier than investments such as government bonds—because its effectively infinite lifespan could withstand short-term setbacks. Keynes “established the centrality of equity . . . at the heart of a long-term portfolio.”
Private equity took off in the U.S. after the Second World War. In 1946, Georges Doriot, a French Army veteran of World War I and Harvard MBA dropout, started American Research and Development, an investment fund that turned knowledge incubated at America’s northeastern universities into commercial products. Though ARD grew slowly, it eventually realized about 15 percent annual returns between 1946 and 1971—higher than the 12.8 percent for the Dow Jones stock index of major U.S. companies over that period. The firm’s biggest success was Digital Equipment Corporation, which turned an investment of $70,000 into $355 million. By 1958, two military generals, William Draper and Frederick Anderson, had partnered with the Rand Corporation’s founder, Rowan Gaither, to start Draper, Gaither, and Anderson, Silicon Valley’s first venture-capital fund. Their business model reflected a new trend: rather than take in fees for managing money, they accepted 40 percent of their investors’ capital gains.
Together, these companies created the institutional framework for today’s private-equity and venture-capital firms, from smaller outfits on either coast to mammoth corporations like Blackstone, which manages nearly $500 billion. These firms also fueled Big Tech, with investments in Amazon, Apple, Google, Microsoft, Intel, and Cisco. On the investor side, meantime, Yale University became the “poster child” for endowments supported by private equity, earning “an almost unbelievable 77 percent annual return from its venture-capital investments” over two decades, the authors observe—effectively turning every $1,000 investment into $91 million.
Private markets are increasingly important to the U.S. economy, having raised $2.4 trillion for companies in 2017, more than the collective $2.1 trillion in public stock markets. The industry also has far more money to invest: U.S. public and private pension funds have $20 trillion in assets, the authors estimate, while sovereign wealth funds hold $7.5 trillion. And yet the private-equity industry is rife with “wasted money and little real progress,” the authors argue. Examples of disastrous investments abound, such as Boston University’s decision in the early 1990s to place two-thirds of its endowment into a faculty-led biotech firm—liquidated later at just a few cents on the dollar.
Overall, though, Ivashina and Lerner contend, the problem is that “private-equity performance has deteriorated to the point of mediocrity.” When fees and risk are factored in, private-equity funds, on average, fail to exceed the returns offered in broader, less risky markets. Long-term investing, it turns out, is difficult, inconsistent, and impossible to predict. While some firms score well because of luck, they then fail to repeat the performance for new investors. Even sophisticated investors struggle to choose good managers; investors pay the same fees regardless of performance.
Researchers have found that much of the buyout business—private-equity firms using borrowed money to take publicly traded companies private and restructure them—is economically useless, at best. And cases of outright fraud abound, with fly-by-night firms often preying on less sophisticated investors or sealing corrupt deals with officials at public-pension funds in return for their money.
Ivashina and Lerner have ideas for “how to make sure that when good ideas arise, they are funded and nurtured by patient capital,” but they acknowledge that solutions are elusive. Ensuring that people who manage money have their investors’ interests in mind is critical but “very hard,” they concede. They prefer the current model that allows managers to take a share of general profits, keeping their interests aligned with investors’, but suggest a higher “hurdle” rate—13 percent to 14 percent—to compensate for the risks. (The hurdle rate is the rate above which private-equity managers begin to take their share of investment returns.)
The authors also note that the fee component of the existing model—2 percent, annually, of managed assets—can reward failure as well as success. They suggest that investors negotiate a venture firm’s overall budget directly with the firm’s managers rather than pay a set annual fee to cover that budget.
On valuation—how to know what assets are worth, to ensure that managers are paid according to whether the values have increased—Ivashina and Lerner say that too-frequent asset valuation can encourage short-term thinking. Yet infrequent valuation invites fraud. To address this dilemma, they suggest that the industry and its investors create a nonprofit third party to assess performance.
Lerner and Ivashina think that big investors putting money into “patient capital” funds should have expertise on their side. Public-pension funds, for example, should nominate financial experts to their boards, rather than government cronies. This approach is laudable but difficult to execute—it’s hard to ensure that the experts won’t succumb to herd mentality, or that they’ll act with a pension fund’s best interests in mind.
The fundamental tensions will remain hard to overcome. Large institutions with hundreds of billions of dollars to invest—from New York’s public-pension funds to Saudi Arabia’s sovereign-wealth fund, a major investor in Uber—are often staffed by people who don’t know how to invest the money. Picking a manager is almost as hard as picking the investments themselves. Ironically, a more successful industry might be a much smaller one, without trillions of dollars in capital chasing after a few good ideas. Absent reform, Ivashina and Lerner see “dramatic shrinkage” as a risk, but shrinkage could be part of the reform, helping to avert another result that they hope to avoid: a “broken industry” that still attracts money “for a decade or longer,” even when “returns are not there.”