You Want It To Be One Way, But It’s the Other Way

Dealing with Inconvenient Markets

There’s a chilling scene in The Wire when a store security guard calls out drug kingpin Marlo for shoplifting and then, realizing the danger in what he’s done, says that he wasn’t “disrespecting” him. Marlo, seeing that the guard hopes he’ll let the incident slide, says, as his hitman Chris rolls up into the frame, “You want it to be one way. But it’s the other way.”

While I’m neither a security guard nor a kingpin, this moment hit me in the gut. Many times in my investing career I wanted things to be one way, but they were the other way. In 2022, I wanted Vladimir Putin to recognize the folly of a war in Ukraine and allow Firebird to continue enjoying our perfectly constructed portfolio of Russian companies. Or, going way in the past to 1994, three months after we’d launched our first fund, I wanted there not to be a ruble devaluation that set us back two years. But there was, and it felt unfair. Unfair!

Two Cautionary Tales

Markets are challenging, maddening at times, but they’re also inconvenient. Picture a young Goldman Sachs trader, let’s call him Kyle or Ash or – wait, Beau. Beau Vandelay. Beau has generated solid returns over the last few years trading grapefruit juice futures, getting annual salary and bonus of $3 million, but he’s not satisfied because he has ex B-school friends getting rich in Silicon Valley or at funds.

So Beau decides to quit and start his own hedge fund, called Culbertson Partners after his UVA dorm, seeding the fund with his family’s and friends’ money, plus a nice investment from Goldman. After a few months of hard work setting up, Beau launches with $100 million, but just as Culbertson’s trading begins, inconveniently a grapefruit blight breaks out, which changes everything about making profits in citrus. His fund is down 2% in the first month.

To go on his own, Beau had had to take a 90% pay cut, which he was willing to do in pursuit of great wealth – oops, “financial independence”. With this cut and no performance fees, drawing on savings, he starts to have trouble covering the nut of apartment, garage, insurance, Hamptons summer rental, and daughter Arabella’s $50,000 preschool tuition (his wife quit her job to stay home with the baby, Liam). After two years, down 5% from inception, Beau gives back all the capital and returns to Goldman. His strategy might have paid off eventually, but his investors will never know, because he’s given up.

Let’s turn to one of Beau’s b-school friends, whom we’ll call Jason Shapiro (pronounced “pyro”). He invests in healthcare stocks (pharma, biotech, etc.). Like Beau’s fund, Jason’s Bubby Partners (named after his favorite restaurant) launched with a modest sum, but unlike Beau’s the timing worked out. After three years of impressive returns, Jason has finally raised a substantial amount: the current month’s inflows have doubled his assets. A little very fun arithmetic says if he can maintain just his same performance, this year’s incentive fee alone will set him up for life.

Jason quickly tops up all his favorite stocks, but a few days later the healthcare sector starts to wobble because of regulatory actions and sky-high valuations. Within days, the fresh inflows that were supposed to make Jason rich are well underwater. A voice in his head tells him that something has changed and he might consider selling, but a louder voice shuts the first one up, exhorting him to “ride out the volatility.” What the voices in Jason’s head do agree on is that the timing of this market blip was unfair.

The volatility he has to “ride out” winds up not being a blip, but a correction that lasts for years. Jason’s failure to reduce exposure at the top, which he could’ve done just by holding onto the inflows, has only prolonged Bubby Partners’ time to recover. Finally, after investors have entirely lost interest in healthcare stocks and valuations have been squeezed down, the sector turns, setting up for a new bull market. Jason and Bubby have survived, but unfortunately most of the investors redeemed a while back, he’s starting with a small fund again, and no one wants to give him money.

Lessons From the Tales

These hypotheticals aren’t exceptions in the world of professional investing: they are the norm. Everyone starts out with a plan, and like Mike Tyson’s proverbial boxer, everyone gets punched in the mouth.

From Beau’s tale, we learn that the best asset one can bring to a new venture is modest expectations. When I co-founded Firebird, I was living in an inexpensive rental, had no kids in private school, and barely knew what the Hamptons were. My partners and I had plenty of time before we needed to start making much money, which was good because we had to get through two ruble devaluations and two presidential elections before we did. Or take my friend Geoffrey, who thought everything was coming together nicely for his Iraq Fund until ISIS invaded. (He and fund toughed it out and eventually thrived.)

Beau’s quick capitulation is so common that I would never invest in a fund launched by someone coming out of a highly paid job unless they convince me they’ve taken a vow of relative asceticism. Their spouse must also have wholeheartedly agreed, for as long as it takes, to live an “uncomfortable life,” unlike Parker Posey’s character in White Lotus. Also, they have to show a passionate interest in whatever they plan to trade, no weaker than a startup founder’s in their tech — it should be almost a hobby, because for quite a while it may be paid like one.

Jason’s tale is more interesting. It seems that almost every fund manager takes in all the money after they’ve had a great run of performance and the risk-reward has become skewed to the downside. This can be highly inconvenient, as it was for Jason, but it’s still necessary to keep one’s head and do the right thing.

In 2007, after a great run, Firebird was inundated with inflows. The first right thing would have been to turn money away, but that proved a hard choice after 13 years trying to convince people our ideas were valid. Also, maybe the investors clamoring for us were right (“this Kool-Aid actually is delicious”)!

So you’ve taken in the money, now do you deploy it? Well, just as the new investors in Jason Shapiro’s Bubby Partners wanted healthcare exposure, the vintage 2007 Firebird investors thought they were buying into our stock markets. If those had kept going up and the investors discovered that we’d gone to cash, they’d have been furious. Or so we reasoned.

Still, because we were uncomfortable with the high prices of Eastern European stocks, we found a compromise, putting most of the inflow into pre-IPO/unlisted companies at more reasonable valuations. This might have worked, had we not run into the 2008 buzzsaw, a shutdown of IPO and financing markets, and a fund liquidity squeeze as the cherry on top.

Conclusion

With emerging markets again showing signs of life, my team has discussed what we would do if we faced another 2007 scenario, even though it seems remote. I said, anyway I know what I wouldn’t do: seek refuge in illiquidity.

Where I would start is by facing reality, even an inconvenient and unfair reality that things are not going to be the way I want, but the other way.