Playing with Other People's Money

Always treat money like it is your own.

This should sound pretty obvious, but it isn't. And I think a lot of people have been violating this rule, particularly on Wall Street and in big corporations. The economic mess we are in is at least partly because of this problem.

One of my favorite investors on Wall Street is a guy I've known for almost ten years who has been in and around the hedge fund business for more than 25 years. Whenever he talks about his business or the funds he is invested in, he always cites how much of his own money is in his fund and how much of the fund managers he invests with have in their funds. The numbers are impressive. Often 25-50% of the funds he invests in are comprised of the manager's own money. His business was affected in 2008 like everyone else, but I have a lot of confidence that he'll come out of this mess way ahead of most others.

In our business, we have put a significant amount of our own net worth into our funds. It's often difficult to have a lot of your net worth tied up in illiquid assets like venture capital funds, but when you are writing a check every time you make an investment, it has a way of clarifying the mind.

This is particularly important when you are facing the decision to support or walk away from an old and difficult/troubled investment. Most of the time, these kinds of financings are highly dilutive and very punitive if you don't participate. It's really tempting to put more money in because if you don't, you'll get wiped out. But if you do put money in, and the investment still fails, then you've lost even more of your own money and your partners' money. The bigger personal check you have to write, the more likely you'll make the right decision. If you don't have to write any checks and all the money you are investing is other people's money, then it's incredibly tempting to "pour good money after bad."

If I think about all the issues we've had on Wall Street over the past year (see Michael Lewis and Daniel Einhorn's two-part column for a great description of them), I think most of these issues have been caused by investors playing with other people's money without enough of their own net worth at stake. Financial leverage is a good example of playing with other people's money. You put up a tiny amount of your own money and you borrow the rest. If things don't go your way, you write off the little you put up and the lender takes the bath. That's been going on in the financial markets and the housing markets for the better part of ten years and we are now seeing the cost of that approach.

Why is it that most of the best-managed companies are operated by their owners? Think about Apple (AAPL), Google (GOOG), News Corp, (NWS) etc. All of these companies are run by owners who have a huge amount of their net worth tied up in the business. The same was true of Microsoft (MSFT) until recently when Gates left the business for the most part. But even Gates still has a lot of money tied up in Microsoft. When these leaders make decisions, they are risking their own capital/net worth, not just the capital and net worth of shareholders who they supposedly work for, but really don't.

We don't like to overfund the companies we invest in for a lot of reasons, but there are two big ones. First, the less we invest, the more the founders and managers own, and that makes them operate like the company is theirs, not ours. And I also like the discipline that managers have when they are operating with small balance sheets. It causes them to look at every expenditure carefully and act as if the money is their own. As I've said, that generally leads to better decisions.

It is true that entrepreneurs and managers often are too conservative when all the money they are working with is their own. And that's a good reason to bring in other capital, ideally sophisticated investors who understand the business and can add value. But even when you do that, you should treat the investors' capital as if it was your own. It's a mindset, and an important one. We've seen all too frequently what can happen when people stop operating that way.

Comments

[E Thomas St.:]

This is also the reason micro lending is effective

Jan 05 11:57 AM

[bobbobwhite:]

If Trump would have done this, he wouldn't have eventually lost so much money for his investors, as he never put anything other than his name into any of his partnership investments ever, so he didn't lose a thing when all his investors did. I worked in the development biz in the 70's /80's that only put up 3% money into any project and we thought that was great, but Trump even beat that. We used to discuss with awe his power to get 100% investor's money on only his name, until we found out how much money he eventually lost his investors. If he had his own many in his work, he would have not been so foolish with it as his god-level pride and arrogance eventually brought him down. Anyone hear of him lately? Good riddance.

Jan 05 01:05 PM

[UnderCover ...:]

I don't entirely agree with what you say. I know many people who are very stupid even with their own money and that is why they seek a third party to handle it in the first place.

There are are alot of stupid people out there that don't know how to manage and make decisions even if it is their OWN money.

Jan 05 01:36 PM