Skin in the Game

​“Never, ever think about something else when you should be thinking about the power of incentives.”   
​
Charlie Munger 

​Several years ago, I bought some units in a farmland limited partnership for my retirement account.  After 5 years, the LP wound up and I contacted the dealer in order to arrange for the proceeds to be deposited back in my RRSP brokerage account. 
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I had done reasonably well:  after substantial fees my compound return was just under 12%.  I tend to ignore comparisons to broader market (that’s a topic for another time), but since I brought it up, the return significantly underperformed the TSX.  Nevertheless, the absolute return was more than satisfactory. 
When a dealing representative called me back, he was quite reluctant to accept my redemption instructions.  The conversation went something like this: 

Rep:  “Well, Doctor...you did pretty well with the Farmland thing, but you could easily double that return in our new Oil Patch Reserves LP.  I’ll fire the paper work to your email right now...” 

Me:  “Hold on.  You’re not really supposed to promise a return, are you?” 

Rep:  “No, no, no.  Nothing like that.  I’m not saying you will get X%, I’m just saying this thing looks just really great and the GP’s here really have an amazing track record!  You have to get in by the end of the week, though.” 

Me:  “Mmm.  No thanks, I think I have some safer ideas for the money.  By the way, how many units of the Oil LP do you own?  And I mean by that, how many did you buy with your own money rather than from a sales incentive program?” 

Rep:  “Sir, I find that question offensive. My financial affairs are absolutely none of your business!” 

Me:  “Um, look, I respectfully disagree.  If you believe the opportunity is safe enough to risk your hard-earned retirement savings with, then I will probably be much more convinced it’s just as attractive for me.  After all, as an insider, you probably already understand the investment much better than I ever will and you probably know the GPs true level of integrity and skill.  If you own, say 5% of your net worth or more in these LP units, then please send me the OM and subscriber forms right away and I promise I’ll take a look today.  Otherwise, please just send me my money back.” 

Rep:  ***Dial tone*** 
 
There are many nuances in what we call the principal-agency relationship, many of which go beyond the scope of this blog.  For example, the ‘skin’ referred to in the quote can be more than just dollars.  It can be intangible capital such as an excellent reputation put at stake. 

Suffice to say that I believe that when I commit to an opportunity, the risk involved better be spread around fairly.  The dealing rep above wanted me to participate in a risky investment.  He was hoping for a juicy commission.  For him, it’s all upside with no downside (other than the time he may have wasted talking to me).   

As a value investor, I like to focus on the downside.  As a crucial part of this analysis, I need to understand the incentives and focus of my business partners, even if I never get to meet them personally.  If there is no question in my mind that a business’ operators have their eyes on the ball and a lot to lose if they don’t, I am that much more likely to get out my cheque book.   

Of course, there is no guarantee of a successful investment just because the operators are also substantial owners.  Frankly, I see the consequences of employees having ‘no skin in the game’ (accountability in this case) all day long at the hospital:  the results are often not pretty.  It’s difficult for me to trust strangers who don’t have the same incentives I do.  It’s for this reason that one of our mottos is “Invest Alongside Us.”  If you are a unitholder in The Osler Fund, you know that the majority of my life savings are at stake right next to yours.  If the fund’s performance is disappointing, I feel the pain doubly, both as an investor and an operator.  Alternatively, if we do well, I do well along with you.  In my opinion, there’s no other way to create a healthy long-term business relationship:  alignment promotes value creation and reinforces trust. 
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LDP