Chapter 3
Two Moats
Lorraine Mabry’s text came in on Monday night while Andy was rinsing the dinner plates.
Driskill. Wednesday. 7.
He had called her on Sunday afternoon from the patio, the first time they had spoken since the spring. Lorraine had placed Fund III out of her office near the Galleria in Houston. She had not been asked to place Fund IV, because Andy had decided that Beth Ann and the existing LPs could raise it on their own, and he had told her so over a lunch that had been more gracious on her side than he had any right to expect.
She let him tell the whole thing without interrupting: Aspen, the anchor, the request list, the room that had opened on Thursday.
“When do they come in?” she said.
“The second. On site the fifth.”
“Who runs it for them?”
“Travis Oyler.”
“I don’t know him.” He heard a pen moving on her end. “I know Russ.”
She left it there. The line was quiet long enough that he took the phone from his ear to check the call had not dropped. Then she told him she was driving up on Tuesday night for an LP meeting downtown at ten, and that she would let him know.
On Wednesday he left the house at ten past six. Maya had come in late from the hospital and was asleep, and the kitchen light was still on behind him when he backed out of the drive. It was dark on 71 and dark on Bee Cave Road. When he crossed the river the sky behind the towers had begun to go gray, there were lights on in a few of the upper floors, and the first runners were out on the trail along the water.
He left the car with the valet on Brazos at 6:55 and went through the lobby, across the marble, to the café on the corner of the building. At that hour it smelled of coffee and warm bread.
Lorraine was already at the corner table by the window, where they had worked over Fund III’s pitch book the year she placed it. It was 6:58. She had her leather folio closed in front of her and two cups, and as he sat down she poured from the carafe into the second one without asking.
Andy set his legal pad beside the cup, his pen on top of it. The top sheet was blank.
“How’s the room?” she said.
“Open. Thursday, on time.”
“And?”
“The front is good,” he said. “Behind the front it’s mostly us.”
Lorraine took off her glasses, folded them and laid them on the folio.
“Your returns are fine,” she said. “Tell me your operations story.”
He had told it so many times that it came out whole. Twelve years and one strategy. Value-add apartments in the markets we started in, bought at a good basis and run hard. Fund II at one point seven times gross. Fund III tracking mid-teens net. A team that knew what it was doing and had been doing it together for a long time.
“That’s your track record,” Lorraine said. “I know your track record. I wrote most of the pitch book.”
“It’s how we operate.”
“I asked how the firm runs.”
He felt the small heat of being corrected on something he thought he knew better than anyone alive, and he let it go by before he answered, because it was Lorraine.
“Look at it the way they will,” she said. “One point seven gross on Fund II is a good number. The first thing any LP I know does with it is ask how much came from the debt, and your portfolio is carrying leverage in the high fifties. About fifty-seven percent. They’ll give you credit for the deals. They can’t tell from the numbers how much of it was the debt and how much was you.”
“Fund II has sent a lot of money back.”
“It has, and that matters more than it used to. These days the first question in every meeting I take is DPI. IRR comes second.” She turned her hand over on the tablecloth. “They look at your distributions and they nod. Then they put the returns to one side and pick up this.”
She opened the folio and took out a printed questionnaire, clipped at the corner, thick enough that the clip had started to splay. On the cover was the name of an investment consultant whose questionnaire most of the pensions she worked with either used outright or borrowed from, and under it, in smaller type, Due Diligence Questionnaire. The DDQ. She turned it to face him.
“Count the questions about returns.”
Andy went through the questionnaire from the front, quickly at first and then slower, and he folded down the corner of every page that had a question about performance on it. The section headings went by one after another: Firm Overview, Ownership and Governance, Key Personnel, Investment Process, Valuation, Compliance, Conflicts of Interest, Cybersecurity, Business Continuity, Service Providers, Reporting. The folded corners bunched together on two pages near the middle and then thinned out to a stray here and there. When he reached the back cover he counted the corners, and then he counted the headings. There were more headings than corners, and he closed the questionnaire.
“They already have your returns,” Lorraine said. “They had them from the pitch book before they ever asked for a meeting. Everything else in there is one question, asked every way they can think of to ask it.”
“Which question?”
“What’s still standing on a morning you don’t come in.”
“We have an investment committee,” Andy said.
“Who’s on it?”
“Me, Wyatt, Scott and Maggie.”
“And who decides?”
He thought about the last deal the committee had approved, and the meeting where it had been approved, which had taken about as long as it took him to say yes.
“I do.”
Lorraine said nothing, and Andy looked out at Sixth Street. It was still mostly gray out there, with a street sweeper working along the curb in front of a bar that had its chairs up on the tables.
“I can give you one operations number,” he said. “Eighteen cents of every fee dollar we take in goes to people finding things and copying them from one place to another. I did the division on Maggie’s numbers Saturday.”
Lorraine looked at him for a while over the rim of her cup.
“Who measured it?”
“Maggie.”
“Good for Maggie,” she said. “Hold on to that.”
The waiter came for their order. Lorraine asked for oatmeal and Andy said the same without thinking about it, and when the waiter had gone he said, “You’re not placing Fund IV. I made sure of that.”
“You did.”
“So why breakfast at seven?”
“Because every new LP in Fund III came to you through my office,” she said, “and some of them came because I told them you were the real thing. My name is on that fund as much as yours is. I’d like it to stay a good name.” She drank some of her coffee and set the cup back in its saucer. “In 2019 I was placing a fund for a manager out west. We were three weeks from the first close. The lead LP had been allocating to real estate for longer than you’ve been in the business, and he had turned down every other mid-market fund that came across his desk that year. I wanted to know why he’d said yes to this one, so I asked him.”
“What did he say?”
“We were in his conference room, with his analyst at the end of the table taking notes on everything I said. He said, ‘I bet on the moat. The founder is the reason I take the meeting.’ Then he asked me whether I knew what he meant by that. I said track record. He said everybody says track record. I tried relationships, and he let me down easy on that one too. Then he told me, and I went out to the car afterward and wrote it down, and I’ve read it again before every placement since.”
“Tell me.”
“There are two moats,” she said. “He called the first one the moat of people. The founder, and the handful of people around him who carry the important things. The deals only he can see. The LPs who take his call and nobody else’s. It’s real, and it’s why that LP took the meeting at all. It also goes home every night, and one day it retires.”
“And the second.”
“The moat of platform. How the firm decides, written down before anybody signs. A record that someone who wasn’t there can open and read. LPs who come back fund after fund because the firm kept its word, whoever happened to be on the phone that year. Fees that keep coming in whether or not anyone closes a deal.” She picked up a spoon and put it down again. “When I sit in an office like that and ask why they bought a certain building in 2019, somebody who joined last spring pulls up the file and reads me the reason. The man who made the call doesn’t need to be in the building. Often enough he’s retired.”
“That’s the one the LP was betting on.”
“That’s the one he wired money to.”
Their oatmeal came. Lorraine stirred brown sugar into hers and did not eat any of it yet.
“When I took you on the road for Fund III,” she said, “every LP wanted you in the room. Every single one. The week you had the flu I sent Scott up to Hartford with the deck, and they rescheduled. They liked Scott fine. They wanted you.”
“I know the deals.”
“You do,” Lorraine said.
Andy looked down at the blank top sheet of the legal pad. Across the room a man in a suit was arguing quietly with someone on his phone, and the espresso machine behind the counter let off a long hiss.
“We’ve built a good firm, Lorraine.”
“You have.” There was no edge in it anywhere. “It’s a very good job, Andy. I’m asking whether it’s a company.”
He sat back in his chair. “Tell me how anyone tells the difference.”
“A buyer can. And an LP is asking the same thing a buyer asks, only for the life of a fund.” She opened the folio again. “Let me show you how a buyer prices a manager.”
She took out a placement memo, a spare copy for a fund that had closed in the spring, bound with a single staple at the corner. She turned it face down. The back of the last page was blank, the reverse of the legal disclaimer that closed every memo she had ever sent him, and she smoothed it flat with the side of her hand and uncapped a felt-tip pen.
Across the top, in her quick slanting hand, she wrote What your firm is worth =.
“Three pieces,” she said. “Each one is a plain question.”
She wrote recurring fee earnings.
“How much of what the firm earns arrives whether or not you close a deal this year, after you pay somebody a market salary to sit in your chair?”
She drew a multiplication sign, and after it she wrote the multiple a buyer will pay.
“How sure is a buyer that those earnings keep coming, and how fast will they grow?”
Another multiplication sign. She drew an opening parenthesis, wrote 1 − the founder discount inside it, and closed it. Then she laid the cap of the pen on the paper and waited.
Andy read the line from the start, and the last piece a second time. “How much of it goes when I go,” he said.
“How much of it walks out the door with you?” Lorraine nodded. “Yes.”
Over the years bankers had walked him through valuation books as thick as the questionnaire, page after page of comparable trades, and he had come out of every one of those meetings knowing less than when he went in. The whole line fit across the width of the paper with room to spare.
“Where do the moats go?”
“Everywhere.” She touched the parenthesis with the cap of the pen. “The moat of people is why there’s a discount at all. If the earnings depend on a few people staying, a buyer takes something off for the day one of them doesn’t.” She moved the cap to the middle of the line. “It holds this one down too. Nobody can be very sure of earnings that live in a few people, so a buyer won’t pay much for each dollar of them.”
Andy took the pen from her and drew a short arrow down under the parenthesis and a short arrow up under the middle term. “And the other moat runs both of them the other way.”
“It does.” She took the pen back. “The moat of platform is everything you can show him that will still be there after you’ve gone. The more of it there is, the less he takes off for you and the more he pays for each dollar. That’s what a buyer pays the multiple for.”
“After I’ve gone.”
“Gone to a closing for a week, or gone for good. He doesn’t much care which.”
Andy nodded at the middle of the line. “What does a firm like mine get?”
“Today? About one point two billion of assets, closed-end funds, one strategy, and the founder at the top of every decision.” She wrote under the middle term as she spoke. “For a firm like that, I’d expect a buyer to start around six and a half times.”
“Six and a half times what?”
She tapped the first term. “That.”
“And what’s that, for us?”
“You tell me.”
He started to answer and stopped. He knew what the firm took in every year, to the dollar. He had never cut it the way she had just written it, and he could see from her face that she had expected as much.
“I’d have to ask Maggie.”
“When you ask her,” Lorraine said, “don’t let her round it up.”
“And a firm that gets more than six and a half?”
“Some get a good deal more. That’s another conversation.”
She picked up her cup, turned it a quarter turn in the saucer, and set it down without drinking.
“For you,” she said, and put the tip of the pen under the parenthesis, “a buyer takes off half.” She wrote half beneath it, next to his arrow. “So he counts the other half of whatever the first two pieces come to.”
Andy looked at the word under the parenthesis. “That’s a lot to take off for one man, before anybody has opened the books.”
“It is.” She folded her hands on top of the folio. “Here’s how he gets there. When I picture Service Capital without you, I can’t see who an LP calls when a deal goes sideways, because every one of them has only ever called you. I’ve known you since Fund II and I can’t see it. A buyer who met you last week won’t see it either, so he prices what he can’t see.”
Andy tried it. He pictured the upstairs floor on a Monday with the glass office at the back dark and its door shut, and he did not like how little effort it took.
“Every firm our size runs on its founder,” he said.
“Most of them do,” Lorraine said. “And most of them get priced like it.”
Andy put his hand flat on the legal pad. “We’ve tried to fix it,” he said. “You know we have. We put in an operating system. I paid a consultant. Years ago I hired a president, and he came and went.”
Lorraine waited until he looked up. “What did any of them show you before they asked you to trust them?”
He opened his mouth to answer and found he did not have one. Each of them had come in with a plan and asked him to believe in it, and each had needed months of his patience before it could put anything on the table.
The waiter came by and filled both cups and took away the oatmeal Lorraine had not eaten.
Andy picked up his pen. “Walk me through the DDQ.”
Lorraine put her glasses on and turned the questionnaire back to its first page.
She took him through it a section at a time, telling him which questions a team like Travis Oyler’s would read for the answer and which they would read to see whether there was an answer at all. At Investment Process she stopped.
“Two sentences,” she said. “How does the firm decide what to buy?”
“We buy older garden properties in Sun Belt markets with real job growth, below what it would cost to build them. We renovate the interiors and the common areas, push rents up toward the submarket, and we underwrite every deal on the rents we can prove from our own buildings nearby.” He kept going. “Then we run the property hard, and when it’s stabilized we either refinance or sell, depending on the market and the fund.”
“That was four, and it was what you buy.” She took her glasses off. “Again. Pretend I’m somebody on Travis’s team who has never met you.”
He tried again, and it came out shorter, and she made him do it a third time. At Valuation she asked who set the marks each quarter and who checked them, and he told her, and she wrote nothing down, which he had learned over the years was its own kind of note. At Key Personnel she turned the page without a word. Andy turned it back. The first question asked him to name every key person at the firm and what each one was responsible for. A little further down, another asked who else could approve an acquisition if he were unavailable. He read every question on the page, and then went on to the next section with his pen moving down the margin of the legal pad.
By twenty to ten the café had filled with people wearing lanyards from something at the convention center, and the light on Sixth Street had gone from gray to white. Lorraine looked at her watch and began packing the folio: her glasses, the felt-tip, and finally the placement memo. She bent the last page back along the staple, creased it with her thumbnail, and tore it off clean.
She laid the page in front of him, written side up, and set the questionnaire on top of his legal pad.
“The disclaimer’s on the back.”
On her way past she rested a hand on his shoulder for a moment. Then she went out through the lobby toward her ten o’clock with the folio under her arm, and when Andy asked for the check the waiter told him it had been taken care of.
He sat with the page a while longer. Her line ran across the top in black felt-tip, three pieces long, with his two small arrows, the six and a half under the middle, the half under the parenthesis, and nothing yet under the first term. He read it through once more. Then he folded it in thirds, the way he folded a rent roll to carry out to a property, slid it into the inside pocket of his jacket, and picked up the questionnaire and the legal pad and went out to Brazos to find the valet.