Welcome back to the second of two definitional sections of that will lay the groundwork on my upcoming post on the corrosive myth of market rate impact investing. Thursday I took on additionality. Today I want to talk a little about “market rate investors.”
This is a term that should sound silly to most of you. After all, in most of the world we call these people, you know, “investors.” But in our little corner of the world where people are granting money or lending at a discount or seeding new ventures with only the haziest notion of when the money is coming back, it is important to define “market rate investor”, by which I mean each of the institutions and individuals who are looking to meet or exceed the “market rate of return” across a portfolio of investments. This is tougher to define than you might think, as every portfolio has a different mix of assets that reflect different mandates, plus the projecting expected “market rate return” for a particular asset is a mix of art and science. I am not going to rehash any of that here as a) you probably know this and b) there are places you can go read about that which don't have silly pictures at the top.
Instead I want to focus on a few key elements of the investment world that are not always appreciated by outsiders (it is sometimes not even fully realized by people on the inside):
If it’s not clear already, I am telling this one from the perspective of someone trying to raise money for a new impact investment that offers a market rate of return. (The picture above is Cheap Trick, who wrote “I Want You to Want Me,” one of the ten best rock songs ever. Get it? Get it? I remind you that this blog is free)
OK, here we go.
You probably already know this, so I’ll make it quick. Almost all professional investors, be they individual fund managers, pension/endowment managers or consultants, are managing someone else’s money. They are fiduciaries (as opposed to principals.) Here is a fun drinking game: google the term “fiduciary”, click on any link and then take a drink every time you see the words “prudent” or “prudence”. Fun, huh? Ok, now go sober up. I’ll wait here.
So, we have a couple centuries of professional ethics telling finance professionals that their fundamental duty to clients and investors is to be careful. There is a ton of interesting debate about what it means to be a fiduciary, but for now let’s just leave it at this: finance professionals are generally amoral, anti-social libertarians with a confidence in their own opinions that has been scientifically proven to have no basis in fact. You want their professional ethics to generally be telling them to knock it off rather than egging them on.
There is also a simpler math to this risk aversion as well. There are a few corners of finance - early stage VC, certain hedge fund strategies, some kinds of prop trading - where you will see investors taking big risks with other people’s money, but this is always in pursuit of equally outsized returns. In most asset classes and most investments though, you don’t have the possibility of massive upside, so the way you make your money is by not making mistakes - by avoiding the investments that actually lose money. For all of the talk about risk adjusted returns, in my 20 years in and around finance, we spend way more time talking about controlling risks than we do talking about maximizing returns.
Think about it this way. Lets say you have a bunch of potential investments. 70% of them will succeed and each of those will have a return somewhere between 10% and 12%. The other 30% will fail, resulting in a 100% loss. As you are researching and making your picks, will you focus your effort on making sure pick the successes that return 12%, rather than 10%? Or will you focus on making sure you stay away from anything that has a chance of failing? What if I went further and said, “The 10% return investments are easy to identify, but the 12% investments and the ones that fail are indistinguishable at the time of investment?” In that case, the clear optimal strategy is to load up on the sure thing.
So, on one side we have a whole profession of fiduciaries who are bound by ethics and self interest to avoid any additional risk that doesn’t produce commensurate upside. - a rational aversion to novelty, if you will. On the other side you have new impact investments who think they have made it over the hump because they have read about all these new “market rate impact investors” and they have an investment that theoretically provides a “market rate risk adjusted rate of return” (whatever the hell that actually is) Only, there's a fundamental problem: their investment is novel as hell. It usually has a) an unproven market, b) an unproven strategy, c) a first time manage and/or d) a new structure. This means it likely has a higher chance of failure than another comparable investment, but the same potential return.
So to interest a prudent "market rate impact investor", it's not enough to offer a good return. You also need to be "de-risked" in a number of ways, most of which involve executing your strategy for five years and coming back after all the risks have been buffed away. But at that point, if you have actually been successful, any investor would be interested in looking at your fund. So what use was that impact investor in the first place?
Stay tuned . . .
Patrick Maloney lives in Portland, OR where he helps nice people working on cool stuff. He tries to limit his blogging to things about which he knows something.