On investment firms, brand & reputation

Investment firms may not have a brand, but certainly have a reputation. It may well be the most valuable thing we have.

“I don’t want your praise, dammit. I want your respect.” – Denny Crane, in Boston Legal.

Does an investment firm have a brand? No. Not in a conventional sense. Ones raising institutional money are B2B businesses anyway. Most ride on one or two key individuals, whose departure materially changes the nature of the firm. Without enduring associations, firm names are labels, not brands.

However, investment firms do have a reputation. And, in a commoditized business (peddling money) with no entry barriers, a reputation may be all that an investment firm has. While we feel like geniuses when the going is good, we shouldn’t forget that we’re in a business with zero terminal value. A few bad years, clients lose faith, money leaves, we’re left with nothing. A half-decent reputation may be the only thing between us and an inglorious fall.

What determines an investment firm’s reputation? Eventually, only one thing - how well we invest.  But this takes decades to establish in markets, given skill, luck and all that. Too much fees may flow down the Ganga by the time “how well” is clearly established. So, we need to think of what determines an investment firm’s reputation over shorter timeframes. Especially because majority of money that flows in to and out of a fund does so on the basis of reputation, not returns.

In my view, there are two determinants of reputation. (1) How we behave. (2) How we invest. As I allude to in the Denny Crane quote, I am concerned about reputation, not perception. The former is more deep-rooted, substantive and long-lasting than the latter. While well-tailored, smooth-tongued investors can create a perception, it usually doesn’t spill over into a reputation once the initial sheen wears off and reality differs from formatting. This distinction out of the way, let me elaborate on the two determinants of reputation, at least over the medium-term.

1.       How we behave

Investing, like the rest of financial services, is a den of atrocious behaviour. There’s something about turning money into more money that brings out the worst in humanity. Most of us collect fees in return for gyan, not performance. I’d call ourselves parasites, but Pulak would object at the insult to our noble predecessors in the evolutionary chain.

There is only one tangible demonstration of good behaviour: walking away from fees. When Nalanda raised its second tranche of funds in 2011, we suddenly had access to double the fees for exactly the same team and cost structure. So, we voluntarily reduced fees and have charged well below what we’re allowed to charge ever since. Since there’s no guarantee that we will invest well, we might as well ensure that we behave well.

But walking away from fees doesn’t have to be direct or literal. It could also be indirect, in the form of not chasing AUM at all cost. By not launching a new scheme or strategy every quarter. By limiting ourselves to what we can do justice to, not what we can get away with. By showing results before showing new pitch-docs. By sticking to one strategy, since no one can make two strategies work. By setting a fee structure where the team gets rich if and only if investors get rich.

Walking away from fees isn’t purely an altruistic act. It is selfish, coming under the gamut of being long-term greedy. In a business where even the best strategy can lag for many years and LPs can pull out in short order, investors with a history of behaving well get a longer rope. Well-deserved trust and respect, arising out of consistently behaving well, is crucial to building an enduring investment firm.

Beyond fees, there is a second demonstration of good behaviour: honest, responsible communication. Prashant Jain earned respect not merely through good investing. In following him for two decades, I have never heard him say an irresponsible word. No talking one’s book or making short term market forecasts or touting a fad that clearly flew in the face of history. In contrast, Cathie is seen as a caricature for claiming that valuation doesn’t matter or that her companies have a TAM greater than the mass of the observable universe.

Intellectual honesty matters. I have to speak of the future cautiously. There’s no guarantee I’ll generate alpha. There’s a good chance I won’t (80:20, in fact). Even if I outperform, it will likely be by a small margin. You can work out what that means for absolute returns, since long term record of markets is low double-digit compounding. Over the medium term, markets can fare way worse and so can I. So, onus is on me to set realistic expectations. The best I can promise is to stick to a certain investing approach and communicate honestly when I err. Anyone not admitting to these truths or claiming 25% prospective IRR doesn’t deserve money, trust or reputation.

2.       How we invest

We investors have a derived reputation, not a direct one. Our reputation is derived from the businesses we choose to associate with and the ones we choose to entirely avoid. We are only as good as the companies we back.

Rakesh Jhunjunwala is a great investor. However, his reputation was truly cemented because Titan was his most notable success. Along with making money, how money was made also mattered – through an outstanding, category-creating business owned by a trustworthy group and run by respected professionals. I am sure there were many investors who were ahead of him in 2007 by riding on Unitech, but we don’t know any of their names today. Even assuming one of them got out before Unitech disappeared, reputation wouldn’t be the same as making money on Titan. Similarly, Prashant Jain’s investing reputation is embellished by entirely avoiding frothy shitcos in real estate and infrastructure during 2004-07 boom. At the risk of looking bad, he did good.

At the opposite end, a legendary investing firm – Sequoia Fund – badly dented its reputation by making a big bet on crooked Valeant. And it doesn’t have to be all good or all bad. Way more good than bad is all we can strive for. Buffett’s reputation was built on the all-American goodness of See’s Candies, Nebraska Furniture Mart, Coca Cola, GEICO and, recently, Apple. When an occasional Salomon goes kaput or David Sokol goes rogue, it is rightly seen as an aberration and not the norm.

It is possible to make money punting on dodgy businesses. It is not possible to build a reputation by doing so. This isn’t merely me being snooty (which I am). More fundamentally, this is about the distinction between risk and return, between controllable and uncontrollable factors. As there is no reliable predictor of future returns, prospective clients judge us on risks that we assume and avoid. If we’re the kind who ride on fads hoping to get out before it blows up, it is one risk profile. If we resist FOMO at the risk of looking stupid, it is another. It is not hard to guess which risk profile is more palatable.

Our reputation is a surrogate for how we are likely to behave going forward and how we are likely to fare with others money. If we have a history of associating with decent people and businesses (preferably at decent valuations), there is greater comfort that we will not fare disastrously in future. Also, it is hard to repeatedly associate with dodgy people or bad businesses without turning out dodgy ourselves. It is untenable that we turn a blind eye to accounting fraud outside while being spotless on the inside. Cognitive dissonance is too powerful for any human to sustain such dichotomy.

Pattern vs instance

In closing, how we behave and how we invest is about the pattern of choices that we make, not isolated instances. Every investor, including Nalanda, makes mistakes. Some mistakes are egregious and indefensible. If each of us is judged by our worst decision, whether in life or investing, we’d all be out on a ledge somewhere.

However, there is a difference between a mistake and a pattern of bad behaviour. A mistake, however egregious, is an error of judgment. A pattern of bad behaviour is a breach of trust. If I fell for a fraud, I am a victim. If my portfolio is full of frauds, I am an accomplice. The latter should affect, and does affect, reputation way more than the former.

A pattern of launching scheme after scheme implies a marketing firm, not an investment firm. As does a pattern of frequent, glib salesmanship over cautious, responsible communication. While AUM and fees matter to all of us, it is not hard to spot a pattern of chasing these at the exclusion of performance.

The most harmful pattern, from a reputational viewpoint, is to systematically associate with dodgy people and unsustainable businesses. Every respected investor in history built their reputation by associating with respectable people & businesses, while staying well clear of fraud & froth. To follow the opposite path and expect a firm to be respected flies is peak delusion. If portfolio is filled with turds, no PR budget is adequate to come out smelling good.