Preface to Paperback Edition
In Search of Value

Many successful investors are contrarian. They buy when most sell and sell when most buy. During the Asian Financial Crisis of the late 1990s, when the story of Money Games begins, foreign investors in Asia couldn't sell fast enough. In 1997, South Korea's currency, the won, lost nearly two-thirds of its value against the US dollar. Its stock market shrank by 49 percent. In US dollar terms, the Korean bourse had lost more than 80 percent of its value in one single year. The crisis showed no sign of abating the next year-Korea's GDP contracted by 5.1 percent-when I went to Korea on behalf of Newbridge Capital, the private equity firm I represented, in an attempt to buy a failed bank that had once been the largest in the country. It was the perfect example of a contrarian move.

How did we do in the end? Obviously, I wouldn't have written a book about it if our investment had been a failure.

In hindsight, our timing was perfect.

But hindsight is 20/20. Truth be told, we were not trying to time the market. I don't think such a thing is possible because markets are inherently unpredictable. Certain market conditions present good investment opportunities, but private equity investors cannot just wait around for such opportunities to drop into our laps. Good timing helps, but timing the market is not how a firm like Newbridge makes money.

Newbridge Capital was a buyout firm-a private equity investor that seeks a controlling stake in a business in order to improve it and ultimately sell it at a higher price. A buyout firm makes money by carefully picking its target, setting the terms of the deal to minimize risk and maximize potential returns, paying the right price, and most importantly, creating value by improving the operations of the target company.

A good investor must be discerning, only investing in businesses that are considered unique. By that I mean they must have key factors that differentiate them from their competitors: proprietary technology, intellectual property, strong brand recognition or market share, regulatory licenses, first-mover advantage, and so on. Without such barriers to entry, a profitable business quickly attracts competition, and its profitability soon erodes. Only these entry barriers allow a business to sustain its profitability. As Warren Buffett once said: "A truly great business must have an enduring 'moat' that protects excellent returns on invested capital."

It is always challenging for a buyout firm to find a good target and buy it under acceptable terms, including a reasonable price. Teams of investment professionals scour the market for deals. Every private equity firm maintains a record of potential investments, known as a deal funnel, that shows how many deals are evaluated and how many actually go through. Usually, out of 100 deals at the top of the funnel, fewer than 1 percent filter through to emerge from its bottom end. Even fewer are actually closed, because it takes a willing seller as well as a willing buyer to strike a deal. The process is not unlike sifting sand for gold.

A fully priced, top-performing business is unlikely to be a buyout target because it may not be possible to squeeze more efficiency or additional value out of it. An underperforming business, selling at fair market value, is likely to be bought out because a capable investor knows how to create value by turning it around.

The process of originating and closing a deal is hard enough, but buying a company is only the beginning of the investment process. Henry Kravis, the cofounder of KKR, one of the world's largest buyout firms, likes to say: "Don't congratulate us when we buy a company; congratulate us when we sell it." Of course, no congratulations are due unless the company is sold for a good profit. Kravis is also fond of saying that any idiot can buy a business by paying enough; what really matters is what happens after.

So, what does happen after? What does a buyout firm do with an acquired company? The next steps involve a lot of hard work, chiefly by the buyout firm's operations team, a group of seasoned and experienced senior executives who know how to run a company. The operations team functions like an internal consulting firm. Their job is to identify the best management team for the investee company and to help them continuously improve its operations and profitability. The operations team is also responsible for setting up an incentive scheme, such as an employee stock option plan, so that the interests of the management and employees are fully aligned with those of shareholders-if the shareholders make money, the management does, and vice versa. The management also knows that if it underperforms, it will be fired.

A private equity firm raises funds from, and manages capital for, institutional investors known as limited partners or LPs. The fund manager is referred to as the general partner or GP. The GP typically gets to use LPs' capital only once-it needs to return the capital to LPs after exiting from an investment. Once a fund is fully invested, the GP will have to raise another fund. If the GP fails to raise a new fund, it is out of business.

If a GP underperforms the market, it risks not being able to raise new funds. If a GP consistently outperforms the market, more LPs will be interested in investing with it, and its capital under management is likely to grow. A private equity firm cannot plan its own growth-it can only grow if it consistently produces good returns for LPs.

It isn't difficult to beat the market some of the time. One just needs to get lucky. But to do so all the time is exceedingly difficult. In private equity, LPs always look to invest with "top-quartile" GPs-those whose returns are in the top 25 percent among their peers. However, past performance is no guarantee of future results, as the common disclaimer cautions. Data show that top performers of one vintage year have no better chance than bottom performers to achieve top-quartile results in the next vintage. The investment acumen of a GP can only be ascertained if it has consistently performed at the top of its game over a long period, across many funds.

Acumen implies the ability to make the correct decision most of the time. Where does that come from? Not just from talent-nobody is born with the ability to make the right decisions. It comes from accumulated knowledge and experience, including lessons learned from past failures.

But a good investor should know his or her limitations. To err is human. Even the greatest investors make mistakes from time to time. For any firm, it is too risky to rely on one individual to make all the major investment decisions. Private equity is not an individual sport, like golf. Teamwork is critically important. At a private equity firm, decision-making power typically rests with an investment committee (IC) consisting of the firm's partners. If the head of a firm has too much say in investment decisions, or too much influence over other IC members, the firm is more susceptible to big mistakes. Collective decision-making usually leads to safer bets.

If you ask me what it takes for someone to be a successful investor, the first thing that comes to mind is judgment. Without good judgment, no matter how hard you work, you are unlikely to succeed. It is like running an ultra-marathon: if you lose your way, effort is futile or counterproductive.

Good judgment goes hand in hand with hard work. If you do not know enough about a business, its industry, or market conditions, you must work hard to learn. Every deal requires full dedication and tenacity. Frequently, the window of opportunity is brief. If you do not seize it, it may be gone forever. One must strike when the iron is hot. For that purpose, it is necessary to sometimes keep at it day and night, around the clock, until the deal closes.

Investment acumen and hard work are necessary conditions for success, but they are still not sufficient. One factor that often determines the outcome of an investment is totally beyond anyone's control. That factor is luck. Some investors let their string of successes go to their heads, believing it is all because of their own brilliance, not realizing they have also had a good run of luck. They take increasingly bigger and bigger risks until one day, their luck runs out.

On April 8, 2021, a few months after the first edition of this book was published, a Bloomberg headline screamed: "Bill Hwang Had $20 Billion, Then Lost It All in Two Days." Hwang, a hedge fund manager, had learned his trade under Julian Robertson, one of the most successful investors of his generation. Hwang later launched his own fund and was so successful that at one point he had built a personal net worth of $30 billion. He must have thought he was invincible. He kept betting on big technology stocks with so much borrowed money that his loans amounted to five times his own capital. When the market turned the other way, his investment vehicle, Archegos Capital Management, simply imploded.

If Bill Hwang stumbled big time because his was a one-man show, what about the case of Long-Term Capital Management (LTCM), founded and managed by the smartest people in the world including not one but two Nobel laureates-Myron Scholes and Robert C. Merton? In its first three years, LTCM beat the market handily, producing annualized returns of 21 percent, 43 percent, and 41 percent, respectively. Then bad luck struck. It lost $4.6 billion...