Thoughts

I think that the act of writing is an exercise in thinking, so whenever I learn something important I try and write it down. Below you’ll find the most recent things I’ve been learning/writing about.

• Our Brains are Lazy

  Baumeister’s group has repeatedly found that an effort of will or self control is tiring; if you have had to force yourself to do something, you are less willing or less able to exert self control when the next challenges comes around. The phenomenon has been named ego depletion. In a typical demonstration, participants who are instructed to stifle their emotional reaction to an emotionally charged film will later perform poorly on a test of physical stamina — how long they can maintain a strong grip on a dynamometer in spite of increasing discomfort. The emotional effort in the first phase of the experiment reduces the ability to withstand the pain of sustained muscle contraction, and ego-depleted people therefore succumb more quickly to the urge to quit. in another experiment, people are first depleted by a task in which they eat virtuous foods such as radishes and celery while resisting the temptation to indulge in chocolate and rich cookies. Later, these people will give up earlier than normal when faced with a difficult cognitive task.

  Thinking Fast and Slow, pp. 41-42

  While incredibly powerful, we only have so much energy to expand. A study done by Baumeister showed that when faced with tasks that are ego-depleting, people have a lesser ability to resist temptation or persist in difficult tasks.

  This phenomenon shows up everywhere. When doing something difficult, we can feel our attention pulled towards other things that are easier in the short term. When working on a tough essay or problem, we feel the desire to escape from the effort and check our phones or email as our brain tries to find an easier way to do tough things. The same thing happens when we are thinking through things. Despite our knowledge and intelligence, our brain wants to find a way that causes the least amount of ego depletion, so instead of thinking through first principles, we are pulled towards the answer that seems the easiest, convincing ourselves that the reasoning is sound to avoid deeper thought.

• Being Effectually Minded

  Goal Induced Blindness from Farnam Street

  Uncertainty is one of our least favorite conditions, we hate the feeling of not knowing what to do, and we dislike the frustration that comes from not having anything to really do. It leads us to believe that those who are successful are because they had the right goals from the beginning and were able to develop the skills necessary to execute perfectly on those goals. A successful entrepreneur was successful because their idea was so good and their drive was so intense that nothing could stop them from the success that they wanted. The truth is that the key to success is adaptability, or what Oliver Burkeman calls being “effectually minded”.

  Essentially, an effectually minded person has two main characteristics, they care about finding a goal that matches their abilities and they practice positive catastrophizing. Rather than finding a goal or an idea and doing everything that they can to become the person or build the relationships to reach a certain goal, they take the abilities and knowledge that they already have and find a goal or an idea that can be achieved using that. Rather than looking at (or ignoring) what they lack in the face of a lofty goal, they take what they have and find a goal or problems that can be solved.

  The other half is what the Stoics call positive catastrophizing, which is a lot sunnier than it sounds. While a lot of the time we might think of the end goal and the rewards that will come with it, an effectually minded person will instead choose to think about the cost. Instead of asking themselves how big the payoff will be at every step, they ask themselves the cost of failure for each action. Which allows them to realize that often the cost of failure is much less than catastrophic.

• TVPI and Secondary Market Asymmetries
  $latex TVPI=\frac{(\text{Distributions}+\text{Residual Value})}{\text{Paid In Capital}} $

  Often, returns for an LP investor are measured using the above formula, Total Value to Paid In Capital, its an expression of the ratio of the Net Asset Value of a fund to the cost of the LPs investment. Essentially, it expresses how much each invested LP dollar is returning. Distributions are the liquid assets returned to LPs, Residual Value is the value remaining in illiquid assets that the fund holds, and Paid In Capital is the money invested by the LP

  Where this formula gets interesting is at the end of the fund life. Typically TVPI tends to decline as funds reach year 8 or 9, so, in order to preserve their capital, it’s in the best interests of a LP to sell their investment. Let’s say hypothetically the LP invested $100 in a fund, has received $80, and the GP claims that there is $50 in residual value.

  [latex]\begin{aligned} \text{Distributions} = \$80 \ \text{Residual Value} =\$50 \ \text{Paid In Capital} = \text{\$100} \ \end{aligned}[/latex]

  Right now the TVPI of this investment would be 1.3x, or in other words, for every $1 invested, $1.30 in total value exists.
  

  [latex]\text{TVPI} = \frac{80+50}{100} = 1.3[/latex]

  And because our hypothetical fund is in its 8th year, this LP realizes that over time this TVPI metric will decline, they decide that it’s in their best interest to sell their stake in the fund. A secondaries investor offers to buy their stake at 30% discount to the GP’s estimated residual NAV, or in other words, they offer $35 for the LPs stake.

  [latex]\text{LP Proceeds} = \$80\ + \$35\ =\ \$115[/latex]

  In exchange for liquidity and short term returns, the LP takes a haircut on their already pretty low returns. While the secondaries investor already enters with a relatively high hypothetical TVPI of 1.6x.

  [latex]\text{Secondary TVPI} = \frac{50}{30}=1.66

  Even if the fund continues to “underperform” and the assets sell for 80% of the residual NAV predicted by the GP in 3 years, the Secondary investor will still exit with a 1.33x ROIC and a IRR of around 15%. The best part is that the LP doesn’t even underperform that much by exiting early. Selling at year 8 yields an IRR of 2.45%, while waiting to receive the distributions yielded to the secondary buyer through the sale, yields an IRR that is only marginally higher at 2.99%. Both IRRs are abysmal for Private Equity, so they are much better off getting liquidity and redeploying the capital.