Notes from the Diamond #2: Until the Truth Comes Out

And somewhere men are laughing, and somewhere children shout
But there is no joy in Mudville, until the truth comes out.  
—  Thomas Davis, chair of the Committee on Government Reform of the U.S. House of Representatives, opening a 2005 hearing on steroid use in professional baseball.[1]

Trivia question #2 of 108: What was the longest pro baseball game in history measured by innings played?  Bonus points for identifying accurately (without googling) two future Hall of Famers who played in the game.  Answers in main text.

Pachyderms On The Loose

Plow too many dollars into otherwise sound forms of investing and you get problems, not only for rookie players but for accomplished veterans whose once-fecund fields of dreams become nightmarishly infecund due to overcrowding.  Plow too many performance-enhancing drugs (PEDs) into otherwise hale athletes and you create problems also — inevitably but perhaps not promptly for players who dope, and instantly and maddeningly for their competitors who don’t. Because baseball’s so-called steroid era  — a decade-long spell starting in the mid-1990s — altered the sport’s image and indeed record books so materially, it’d be feckless for this lifelong fan of the game to pen a series like this without discussing PEDs at some length.  I could initiate such discussion later in the series, of course, but with certain pachyderms at loose in capital markets at present, now seems as good a time as any to discuss the elephant in pro baseball’s room — an elephant whose tracks are depressingly evident in the data below among other indicia too numerous and grim to include here.

MLB Players with 50 or more home runs in a single season

Just The Facts

Presuming as I do that the busy and savvy capital allocators comprising ET Nation have ready access to comparable tracking data on the pachydermal investors alluded to above, I’ll burden you with little such data here.  Presuming further that readers are generally if not intimately familiar with the financiers in question, I’ll serve up few facts as distinct from opinions about them in this note, except to observe that their steadily ballooning dimensions are rooted primarily in the same causal factors underlying baseball’s ongoing PED problems: malign incentives and warped time preferences, magnified by artificially inflated results and widespread disregard of such artifice.

Where within money management circa 2018 are these mutually reinforcing traits most prevalent?  Sadly, the answer isn’t obvious, at least not to those of us whose graying noggins reflect substantial ongoing experience overseeing large-scale investment programs.  Truth be told — and Epsilon Theory exists for no reason weightier than its relentless pursuit of truth — multiple forms of investing fit the bill, including but not limited to hedge fund and venture investing.  In this note, we’ll focus on private equity (PE) — a form of investing  performed ably and honorably by many investment pros while also being done passably at best (for now) and dishonorably by other players.   Importantly, as with PEDs in pro baseball, the widespread juicing of returns and hence also incomes in the PE arena has morphed into a phenomenon not unfamiliar to ET faithful: it’s Common Knowledge — something that everyone knows that everyone knows.

Strange Things   

Did baseball cognoscenti, including Sports Illustrated’s ace journalists, NOT know that Mark McGwire was “juiced” when, in 1998, he broke major league baseball’s longstanding single season record for home runs? It strains credulity to think they didn’t, the slugger’s preternatural performance and bulging muscles being self-evident tells, to say nothing of the “andro” (androstenedione) that a reporter spotted in McGwire’s locker as his homer count approached Roger Maris’s pre-existing record of 61. That said, unethical though McGwire’s juicing may have been in some folks’ eyes (including McGwire himself, judging from his later apology to the Maris family), it —like the dodgy accounting and reporting protocols employed by some PE firms — was within the letter as distinct from spirit of applicable rules.

Andro wasn’t added to MLB’s list of banned PEDs until 2004, three years after McGwire’s playing career ended and around the time his former teammate Jose Canseco’s tell-all memoir Juiced catalyzed a Congressional hearing plus a follow-on investigation overseen by former U.S. senator George Mitchell. The hearing in question was both joyless and protracted, taking roughly 40% more time than the longest pro baseball game in history measured by innings (33, spread over roughly 8½ hours).[2] Disturbingly but importantly for our purposes here, the so-called Mitchell Report that rocked MLB in 2007, plus subsequent studies of PED use at multiple levels of organized baseball, confirm what experienced capital allocators know only too well: when potential payoffs are large enough, people do strange things, taking risks they’d otherwise shun in pursuit of riches they’re keen to seize before such hazards morph into lasting harms.

Panel testifying at March 2005 Congressional hearing on PED use in baseball

Money and Fame

What incites such risk-taking? Money, for sure, as well as fame, or more precisely a perceived insufficiency of one or both in the typical risk-seeker’s mind.  For example, Barry Bonds was already a rich man, and holder of three of his eventual seven league MVP crowns, when his heaviest if not initial use of banned substances purportedly commenced — around the time an attention-grabbing rival (McGwire) became MLB’s single season home run king in 1998.

Why risk disgrace when one is already rich and widely lauded as being among the best-ever in one’s chosen craft?  Perhaps Shakespeare answered this question best in Measure for Measure, which among other lessons teaches that most folks’ vices are simply their virtues taken to an extreme.  Hyper-competitive as they were, Bonds, Roger Clemens, and other players who purportedly doped after if not also before they became rich and famous revealed through such antics not what they were hell-bent on proving — that each was “Da Man” in his chosen craft — but rather that they couldn’t bear not being so regarded. 

Know anyone with similar insecurities in money management in general and PE investing in particular?  So do I: lots of raccoons (to use ET speak) — investment pros whose reaches exceed their grasps.  Good starting points for readers wishing to conduct their own deep dives on such practices include a paper by Harvard Business School’s Erik Stafford available here; a McKinsey study available here; and a Harvard Business Review article available here.

Dodgy Methods

If overly large egos are the single best predictor of overreaching — of determining ex ante which individuals in any field of endeavor are likeliest to cross prudential, ethical, or legal lines in order to boost their own stats, money-wise or otherwise — unduly short time horizons are surely a close second.

Among numerous examples of such myopia from pro baseball one could cite, there’s the comment a talented but undisciplined rookie tossed out after his team’s general manager gave him a much-needed lecture on personal and professional ethics in 2013.  “Where I’m from,” Yasiel Puig told Dodgers GM Ned Colletti, “we don’t worry about tomorrow.” Sadly but unsurprisingly, the incidence of illegal drug use is much higher among foreign-born baseballers than it is among US-born ones — not because the former relish rule-breaking, but rather primarily because income opportunities for them outside baseball are so vastly inferior to those within it.  (Puig himself proves the point, having risked life and limb to escape his native Cuba to play pro ball in America, something he’s done well and in all likelihood without help from PEDs, albeit not without several non-drug related dust-ups.) Similarly, PED use tends to be more widespread among aspiring pro baseballers attending junior colleges than among those enrolled at so-called four-year institutions of higher learning. The latter schools may boast more PhDs and PhDs-in-training than the former, but “jucos” as a group boast more of what Mario Gabelli among other accomplished business types claim to be seeking when making new hires: “PHDs — Poor, Hungry [and] Driven.”

Are PE pros whose net worths are lower than they deem tolerable more inclined than their peers to cut corners in efforts to enhance their incomes – to add excessive leverage to companies they control, orchestrate hurried sales (or purchases!) of such firms, manipulate fund cash flows, rig reported results, or employ other dodgy yet familiar methods to become or merely remain prominent players in the PE arena? More to the point, how can allocators determine ex ante which PE pros are inclined to do such things?

I’ll spend many a note in this series answering these questions, and I’ll introduce my answers with two baseball-related tales, both involving the MLB team to which I’d be devoted exclusively if the Bosox went belly up, and both being cautionary for allocators employing leveraged strategies executed by external managers whose true priorities may differ greatly from their stated ones.

Showtime

The first tale involves a ballplayer who recently completed his eighth season in The Show (i.e., MLB), the first four of which were on behalf of my second favorite baseball franchise, the Dodgers. [3]  In May 2016, infielder Dee Gordon of the Miami Marlins received an 80 game suspension following positive tests for two decidedly old school drugs long-banned for use by pro baseballers: testosterone and closetebol.  Given the not-insubstantial number of big leaguers who’d been caught doping since MLB’s “steroid era” supposedly ended roughly a decade earlier, Gordon’s cheating wouldn’t be especially noteworthy, except for these disturbing facts: after a generally unremarkable stint with the Dodgers (2011 – 2014) and an involuntary transfer to the Marlins at essentially no cost to them, Gordon played sensationally enough in 2015 to nab a National League batting title, a Gold Glove award, and in due course a contract to continue playing for Miami for five more seasons for pay averaging $10 million per year.  Under MLB’s Collective Bargaining Agreement, Gordon’s 2016 suspension cost him $1.35 million in foregone pay, reducing to a mere $48.65 million what he’s guaranteed to earn over the life of his current contract presuming he doesn’t dope again and get caught doing so.

To his credit, Gordon has admitted he erred by doping, and he unquestionably did so, legally and ethically.  Financially?  Not so much — not when he swapped perhaps a few more years of PED-free and likely undistinguished work as a relatively low paid journeyman player for a year of PED-fueled labors (in 2015) that carried the potential — since realized — for the Gordon family to achieve financial security for decades to come.  As for the Marlins, they clearly erred in not deducing that Gordon’s vastly improved play in 2015 was too good to be true. 

Are allocators as a group making a similar mistake by entrusting vast sums to PE managers as a group on the assumption that the boundary conditions favoring leveraged equity plays witnessed in recent times — i.e., historically low debt costs coupled with generally rising stock valuations — will persist?  Well, did the Dodgers err in granting now-retired slugger Manny Ramirez a $45 million two year contract in March 2009, five weeks before he got slapped with the first of two major PED-related suspensions?  [4]

Readers get the point, I’m sure, which has less to do with the past misallocation of capital by Dodger execs or those of other teams who’ve been duped than it does with the potential misallocation of capital by investors contributing to the funding build-up depicted in the graph below, drawn gratefully from a solid McKinsey study of the evolving PE landscape published earlier this year.

Overdue Diligence

My second and closing cautionary tale about “juicing” broadly defined also involves the Dodgers, who were purchased by a sharp-elbowed bloke named Frank McCourt for $430 million in 2004.  As the world would eventually learn, essentially all of the dough that McCourt and his then-wife (and current U.S. ambassador to France and Monaco) Jamie used to gain control of the Dodgers comprised borrowed money.  Making a long and ugly story short, McCourt sold the team to its current owners in 2012, netting an estimated $1.15 billion after adjusting for taxes, debt repayments financed by the buyer, and dollars paid in accordance with McCourt’s 2011 divorce settlement with Jamie.  Not a bad financial outcome for McCourt, I gotta admit, especially given the fact that he put one of America’s the world’s most storied sports franchises into bankruptcy along the way — a step triggered in part by the McCourts’ siphoning of an estimated $190 million from the Dodgers’ coffers to finance personal expenses and other non-baseball outlays.  Since McCourt purportedly held all of the franchise’s equity (solely or with Jamie) throughout his time at its helm, no other stockholders were left asking themselves what they’d missed when entrusting capital to him.

Not knowing personally any of McCourt’s creditors, I don’t know whether or to what extent any of them have conducted a post-mortem on their dealings with McCourt.  What I do know is that careful contemplation of McCourt’s baseball-related machinations prior to his debt-driven purchase of the Dodgers should have given his putative creditors pause.  Why?  Because such machinations included a failed effort to buy his hometown MLB team with the utterly selfish and short-sighted aim of shifting its base from an old-time stadium built 80+ years earlier to a new one McCourt proposed to build on land he owned several miles away.  The team?  You guessed it: the Boston Red Sox.  The stadium?  Fenway Park.  Talk about malign incentives and warped time preferences.

Thank goodness the Bosox were purchased not by McCourt but rather by principals with loftier aims, longer time horizons, and sounder risk management protocols — the latter reflecting in part principal owner John Henry’s verifiably successful experience trading commodities on a leveraged basis.  Who knows? If McCourt had indeed seized control of the Bosox, he might very well have run the team as well as its beguiling ballpark into the ground so to speak, leaving me no choice but to shift my allegiances to the MLB team he eventually bought and perhaps inevitably was forced to sell at a time determined by others.  Thank goodness, too, that Ben and Rusty have granted me license to pump out many more notes about pro baseball and money management, separate fields of endeavor that have much in common, including a tendency to bring out the worst — and best — in people.

On deck: the use and abuse of performance-based incentives in money management and baseball (including incentives imposed unwisely on Paul “Big Poison” Waner).

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P.S.  You won’t want to miss the endnotes below.

End Notes

[1] For the benefit of readers not previously exposed to the second-most sublime poem written in English, we’ll note that Mr. Davis was channeling Ernest Thayer’s 1888 masterpiece Casey at the Bat.  The poem that outshines Casey  will feature prominently in a future note, focused appropriately on couldas and shouldas in baseball and investing.

[2] The 33-inning game in question began on April 18, 1981 and involved two Triple A teams — the Pawtucket Red Sox, featuring future Hall of Famer Wade Boggs, and the Rochester Red Wings, featuring future Hall of Famer Cal Ripken.  At 4 am on April 19, with the score tied 2-2, the game was suspended after 32 innings.  Play resumed on June 23, 1981, ending 18 minutes later when a Pawsox batter hit a bases-loaded single to give his team a 3-2 win.  FWIW, the longest major league games measured by innings and time, respectively, were a 26 inning affair between the Boston Braves and Brooklyn Robins in 1920 and an 8 hour and 6 minute, 25 inning tilt between the Chicago White Sox and Milwaukee Brewers in 1984.  Amazingly, the 1920 game took just three hours and 50 minutes to play, with the starting hurlers for both Boston and Brooklyn pitching all 26 innings.  The game ended in a 1-1 tie when the umpire called it due to darkness.

[3] I’ve omitted the Dodgers’ geographic prefix because the franchise was based elsewhere than its current home when it executed a move that earned it my undying respect, breaking MLB’s color barrier by promoting Jackie Robinson to its big league team in Brooklyn in 1947 — an embarrassing dozen years before the Bosox become the last MLB team to integrate racially.

[4] Nor were the Dodgers the only team that Manny took for a ride. Are Bosox fans like me pissed that dollars which might otherwise go to active players continue to flow to Ramirez, at a rate of $2 million per year for another eight years pursuant to a $160 million contract the Bosox and Ramirez executed in 2000? YES.