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Godot's Page: On rationality, irrationality, and the transitional grey area...

Godot's Page

Gatekeeper to the Theater of the Absurd

Tuesday, 29 January 2008

On rationality, irrationality, and the transitional grey area...

With all the bitching and moaning going on in the marketplace, one group of people have cast a sheepish smile…over-worked (as a function of pay), dissatisfied bankers. Before you get the wrong impression, this post is not an ode to the perilous finance warriors that strut to the dungeons at crack and are freed for a miserly 4 hours before dusk…not at all. Investment bankers, debt bankers to be more precise, are suddenly finding a strange addition to their lives known to the average man as ‘free time.’ Most bankers fret and panic at this ungodly invasion of idleness into their haven of humdrum routine…but not this banker. Whilst home owners squeal for a mortgage bailout, and top dogs are looking for their write-down statements, this banker is enjoying the Elysian Fields of watering holes and vice stations.

Amidst my multi-tasking struggle to concentrate on both my dram of scotch and that hot bird’s blouse, I seem to have stirred up an internal debate on why banks and funds are so narrowly focused. Well the obvious is…fuckin obvious. The multitude of special funds is there to serve the purpose of increased efficiency and efficacy through specialization. Investors are more likely to feel safe if they split their wealth into little parcels and gave each parcel to an individual that specializes in one trade, thus creating a diversified basket of parcels, managed by the cream of the crop. Makes sense from a consumer standpoint (please don’t argue with that in the comments section, you will be rendered a retard with an intellectual capacity of stale peanut).

What I am putting up for debate in this forum is a fund’s perspective. More specifically, the limited partner (LP) who contributes a certain amount of money to set up a fund (along with others like her) and have it run by a general partner (GP) who picks what should be in the portfolio. Why would they still be in the game? Consider this example: A private equity shop GP buys assets/companies based on a simple IRR model using a mix of its own equity (provided by the LP) and debt (provided by banks, private investors, etc..). Simple intuition tells us that since the private equity shop measures its IRR based on its equity contribution at entry and the value of said equity at exit, the IRR for a given asset investment has dropped since the credit crunch, due to the lower debt commitments that banks are reluctantly giving out. This means that pre-crunch, a bank that was willing to give $5 of debt on a $10 asset is now only giving $3 of debt, leaving the private equity shop with the burden of the extra $2. Get my drift? Since the fund is paying more equity for the asset, IRR drops. If the fund’s IRR drops below a certain level, it should close shop and focus its energies on higher return yielding investments. The obvious rebuttal to that is that assuming LPs are rational, they would have other parcels of wealth elsewhere in the economy that would absorb the private equity shock.

At that point I took a time out from my internal rant and thought to myself, what if I wanted to be a GP? Would I stick myself in this losers hall and be just another GP who pressed the eject button and landed safely with a golden parachute? (rant clearly continued) But what if the fund is more nimble than a rigid one-investment-thesis type fund? Centuries of thinking have yielded what is analogous to a child’s epiphany: rational investors should seek the highest return on their proverbial dollar. In light of this morsel of wisdom, why have we seen the lines thicken between activity-governed funds? Why aren’t we seeing more of the ‘We’ll put your cash in the highest yielding segment’ kind of fund? Is it because people jump on the bandwagon of short-term hot returns? Or is it because the financially naïve care more about positive news headlines whilst contributing to financial bubbles? Just as that notion flashed through my battered brain, I realized that I could no longer keep a cogent thought nor an eyeball on that bird...

Analysts, economists, actuaries, Oprah, and Dr Phil will go on about this crisis for the better part of this decade. Many conclusions will be drawn…but the obvious will not be stated. Fear not, for I will always give you the only correct conclusion: people are fuckin morons, never underestimate the collective idiocy of people in large groups.

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