Private Equity

How Behavior Finance can Ruin a Private Equity Fund

Behavioral Finance within Private Equity

Continuing the push into turbulent times as an investor, one must take a step back and judge investments from a macro perspective. Are my investments going to end up OK? Should we stray from our mandated strategy if there is a significant lag in one particular industry?

These questions are entirely normal, and almost expected with any change in the market, (not to mention the longest bull run in history), and things got quite comfortable. The purpose of these questions from you and the greater investment industry? A concept most were exposed to in their undergraduate years called “behavioral finance.”

Our friends at Investopedia define Behavioral Finance as the following:

"Behavioral finance, a subfield of behavioral economics, proposes that psychological influences and biases affect the financial behaviors of investors and financial practitioners. Moreover, influences and biases can be the source for the explanation of all types of market anomalies and specifically market anomalies in the stock market, such as severe rises or falls in stock price."

When the market is causing rifts in the day-to-day and your quarterly valuations and deal flow prospects, it is easy to start doubting a specific investment strategy and looking for alternative options. Luckily within the private markets, economic effects take longer to realize within portfolio companies, giving extra leeway in developing a plan and finding where the highest amount of unrealized gains still lie.

Seasoned investors will identify that valuations are not where they need to be and put their biases aside. Still, for newer industries (like cryptocurrency and virtual reality) that haven’t had as much exposure to the market in general, the changes will be new for everyone.

So what is the basis of behavioral finance, and how do you recognize and overcome any creeping thoughts?

Whenever an investment is made, there are three steps within the process itself:

1. Perception of Information

2. Processing of Information

3. Acting on Information (Decision Making)

Any decision-making done within your life is (hopefully) done with this framework. Within finance, there are prejudices that will cause individuals to not only gauge risk incorrectly but make the wrong decision altogether, primarily influenced by what the hottest Twitter VCs are saying, or getting nervous seeing all portfolio company valuations in a scarlet red territory.

Perception of Information

We could present the same deal metrics to two different investors, and they would come with wildly different decisions. Everybody perceives information differently based on their prior experience, whether it is former deals done, wins, failures, or what age they learned to swim, it doesn’t matter - every path is different and culminates into every prospective decision that needs to be made. What the individual must do is push all biases to the side and be as objective as possible. What we recommend is to stick to the investment mandate of a fund, and not stray because software companies are holding up better, do not lower your minimum check size to spread risk across more portfolio companies. Your gut is always right, and the mandates, risk profiles, and target sectors were defined for a reason.

Processing of Information

Making these decisions with all portfolio company valuations in the red and capital commitments lower than ever, the opposite perspective can also be seen. Some investors see this as their time to shine, showcase their experience in the sector, and, when taking the contrarian approach, drastically overestimate themselves into thinking they will be the savior of the industry that maintains a 40% IRR when comparables are 10% of that.

This shows again that sticking to your guns, and not straying from what has been working for decades will cause everything to work out. Private equity’s time horizon exists for a reason, and, unless you have the absolute worst timing of buying and selling, a recessionary period will not outlast maximum expected hold periods (although certain industries are much more susceptible to losses than others, but Sharpe ratios of each industry is for another time).

Acting on Information

“If you follow the herd, you’ll be slaughtered.” All execution comes down to this statement. You see Warren Buffett preach this in the public markets, yet many high-profile investors tend to continue repeating one another by way of speculative investments, FOMO, or overreacting to a rift in the market and going ‘turtle shell’ mode.

Acting on information should be the same process whether it is 2008, 1984, or today. There is a reason NBA teams run plays, sales guys have calling frameworks, and investors have a systematic investment process. The frequency of doing the same actions over and over again creates permanence internally, and hopefully, that permanence was created over years of experience, tweaked as lessons are learned, and habits formed. Being too optimistic or too gun shy causes one to become stuck, overwhelmed, and close down their doors.

What is the key takeaway from this?

Create a process and stick to it, learn from those who have done this for decades and adopt it as your own. Have confidence in the reactionary decision-making done because you know that it is influenced by years of expertise, and you are not simply following a herd mentality of the hottest new tech (Elizabeth Holmes or Sam Bankman-Fried anyone?).

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