La plus difficile de nos vertus

The economic rationale for long term relationships in business (and elsewhere)

I wrote this in the early summer of 2022 and, as is the way of these essays and this practice, promptly forgot all about it. In the course of the last week it resurfaced and, feeling that it had stood the test of at least a short time quite well, decided to reshare it if only for the newer crop of readers of these Picthfork Papers. I hope you enjoy it.

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Writing to his mistress, Sophie Volland, in August 1759, the great encylopedist, man of letters and serial womaniser Denis Diderot congratulated himself (and presumably his chére Sophie) on the longevity of their relationship by writing

“La magie de la constance! La plus difficile et la plus rare de nos vertus.”

[The wonder of constancy! The rarest and most difficult of our virtues]

I have always found this self-congratulatory exclamation of constancy hilarious. Presumably Mme. Diderot was not quite as enthusiastic about her husband’s achievement and would have had a slightly different perspective on the “vertu” bit, but whatever you might have to say about the specific circumstances of the quotation, Diderot was definitely onto something with his description of the difficulty and relative rarity of maintaining anything, especially a virtue, for an extended period of time.

Benjamin Graham, in his excellent, but seriously under-read book “Storage & Stability” wrote in the Foreward, in respect of fiat currencies that

“All these inventions have one feature in common to distinguish them from the standard money of an earlier time. Their value and their stability depend upon the wills of men, mortal men, more certainly consistent than the rest of us. The dollar, the pound, the mark, the franc could be given a higher or lower purchasing power by administrative fiat. The financial authorities who bear this responsibility mean honestly to hold the value of money to a fairly definite level, but muscles tire and nerves falter.”

~ Benjamin Graham, Storage & Stability, 1937 [emphasis mine]

Given that “muscles tire and nerves falter”, constancy, or doing something worthwhile but difficult for an extended period of time is, well ‘difficile’ and we are hard-wired to avoid pain today even when the promise of joy tomorrow, or several tomorrows hence, beckons. The ‘jam today or jam tomorrow’ conundrum, the ability willingly and deliberately to delay gratification (not a subject the keepers of mistresses are particularly qualified to hold forth on - cucullus non facit monachum, as it were), is one our species has struggled with since the dawn of time and probably well before that. I would conjecture that the entire discipline and psychology of economics, that odd collection of activities Ludwig von Mises referred to as praxeology or the study of human action, is at its core an examination of how we express preferences and manage our requirements across time and in the face of our urge to have now what theoretically we could have much more of down the road. Carpe diem or perhaps not.

All of which I mention by way of introduction to a fascinating conversation in which I was privileged to engage this week around the subject of long-term relationships in business in particular long-term relationships between investors and their general partners.

On the surface, it seems to present as a false dichotomy, one not even deserving of reflection. Of course you would want long-term relationships. What other rational objective could you have but to - at least before the fact - establish a relationship at all. My conversation partner - a gentleman in the fullest sense of the word, with decades of investing experience at the highest level of professional excellence - countered that it was by no means obvious that that objective was either the only one or the necessarily the most rational. He, in his practice, was constantly having to defend his conviction that relationships per se were better for business than what he referred to as a ‘transactional’ approach.

What do we mean when we say we seek a long-term relationship with our investors? 

We make the distinction between “transactional” and “relationship-based business activity.

In our minds “transactional” means exploiting our advantage and negotiating the best deal for ourselves every time. In this mode of operation, every deal is a fresh start and bears little or no relationship to past or future interactions. The deck is shuffled and dealt freshly every time. Transaction economics is adversarial and takes no account of the individuals on the other side of the negotiating table.

“Relationship-based” on the other hand is principally concerned with the individuals at the table and sees them not so much as adversaries but as partners, pursuing reasonably well-aligned and similar objectives. This paradigm actively precludes the pressing for maximum advantage. It is a fuzzier concept that is at its core “non-adversarial”. It conceives a single interaction not as a unique activity unrelated to the past or future, but as a link in a chain of interactions, each one building on the last and reinforcing the next.

Benjamin Franklin referred to the return on ethical behaviour in business as “enlightened altruism” and that the power of “doing well by doing good” was never underestimated by the wise businessman (see “Poor Richard’s Almanac”) whilst Warren Buffett in my oft-quoted Owner’s Manual refers to his principle as follows

I wrote about the deceptive nature of friendship in business a few months ago in a piece entitled “Forgive Us Our Trespasses”. In it, I described my own oft-repeated failure to recognize that a temporary alignment of business objectives along with perhaps a certain personal empathy is not enough the meet the criteria of a true friendship and that a business friend is possibly only a few rungs up on the dependability scale from a political friend. Once the mutual objective realigns, even if only slightly, the transactional nature of the arrangement reveals itself and raw self-interest takes over. And there is nothing inherently good or bad about this, it is just how the game is played.

So this is not about friendship per se, but about ensuring durability to the alignment of interest from which, no doubt about it, friendship may eventually result. The question is why bother and how to achieve that objective?

What are the Advantages to NOT regarding each Deal with a “transactional” Mindset?

Economically, the rationale behind building relationships is that they enable future transactions to be executed with significantly reduced friction and costs. Reduced friction expresses itself as

• Time saved: Investors can be approached and secured quickly without the need for intensive priming, explaining, and convincing to build understanding and most importantly trust;

• Reduced costs:  repeat business with an existing investor base dramatically reduces search, brokerage, transaction, and other costs, leading to better margins and/or the ability to offer better more competitive fee structures;

• Speed: Opportunities can be secured and capitalized on quickly if the organisation is confident in its ability to tap into existing relationships which may not even require anything more than a phone call and verbal commitment. 

• Referrals: Expansion of the available pool of capital happens geometrically when existing satisfied investors feel comfortable enough to recommend their friends and business partners to invest alongside them and at no (or minimal) cost to the General Partner.

It is a truism to state that business from existing customers is significantly more profitable and cost-effective than business from new ones. The NPV of the accumulated benefits to building and maintaining long-term relationships is enormous.

There is a further aspect to the deliberate nurturing of trusted relationships, namely that they are more energy efficient. Our brains consume in the region of 60% of the total energy requirement of the body. Thinking burns joules and they require replenishing. As a result of this basic fact, we have become adept at evolving strategies massively to reduce the necessity of burning precious fuel in order to make decisions. Often these come in the form of heuristics or little mental models that are triggered like macros in our minds and lead to actionable outcomes. All our prejudices are based on pre-packaged decisions about how a certain kind of people “are” and how we need to respond to them. Encountering a hooded person, likely a male on a street corner at night, we do not have the time or inclination to engage into an examination of their personality or specific history. We do not even have the time or inclination to ask whether they might be a boxer in training, or perhaps a monk with a modern sense of dress. We react instinctively, our body floods with adrenalin and we prepare for conflict and flight.

Inversely we have heuristics that allow us to build bridges of trust over which we can walk to transact. Those are usually some form of social proof - the recommendation of a friend for instance - or reciprocity or authority or any number of other “energy saving” devices that shorten our due diligence process. Building relationships through personal behaviour and experience creates the strongest bond of trust within the narrow field of relevance to the decision. Just because I trust you to look after a portion of my investment fund, doesn’t necessarily mean I would trust you to guide me on a climbing expedition. But once I trust you to run the fund, I don’t have to make that decision from scratch every time anew.

What Behaviours support the Development of Long-Term Relationships?

Whilst discussing the question of “how do we have to behave today in order to earn a long-term relationship of trust?” I remembered Pastor A.R. Bernard’s book “Four Things Women Want from Men” and was curious to see if his famous guide on how to build a lasting, supportive marriage - probably the most difficult of relationship structures - might yield insights valuable for framing the investor-principal or LP-GP relationship.

Turns out it does. Pastor Bernard highlights four key behaviours that are the prerequisites of a stable long-term relationship, namely

1. Maturity: “ Maturity is when you stop making excuses and start making changes”

2. Decisiveness: “Decisiveness is insight in action”

3. Consistency: “Consistency requires congruence between values and actions”

4. Strength: “genuine strength is a matter of integrity”

I found it useful to attempt to adapt these four pillars to the relationship between the General Partner and Limited Partners, based on the fact that the GP always has an asymmetrical knowledge advantage over the LP whose capital he controls. The outcome is indeed helpful and apropos in describing how we have to be to earn the right to be a steward of capital over time:

1. Maturity → realistic appraisal of risk and reward, caution, understanding of the cycle, realistic appraisal of timings, not overpromising, conservative underwriting and investment parameters, downside protection, holistic view of the interests of all stakeholders.
   
   The following table - which deserves its own letter and indeed got one here - describes mature or “healthy man” psychology.
   
   

   

   (from Making of Men ~ Dr. Arne Rubinstein)
   the essence of which is the concept of maturity embedded in a sense of community and responsibility for the whole (relationships) rather than just the individual (transactional).
   

2. Decisiveness → ability to execute, move fast on opportunities, full commitment to the strategy, formulate responses to crises and emergencies, cut losses, (re-)negotiate financing terms if necessary, say “no” with authority - both to projects and investors.

3. Consistency → adherence to the investment thesis across markets and cycles, clear congruence between words and actions, transparency in communication, and reliable responses to both positive and negative outcomes. Observable efforts to be true to articulated values, even (especially) when doing so brings personal discomfort or disadvantage, clearly articulated and congruent philosophy.

4. Strength → Balance sheet quality, fiscal prudence, patience, calm under pressure, ability to concentrate, self-control, ability to stand up to threats, humility, care for those in positions of weakness or dependency, willingness to lead, ability to keep things simple, experienceable discipline and emotionally safe culture of kindness in the workplace, reputation for excellence in the marketplace (with vendors, local government, partners).

These are behaviours embedded in positive values and expressed in guiding principles that influence and direct every single action every day.

At the end of our discussion, my friend paused, reflecting, and added “for all the rational arguments, I guess we behave that way because, well, it’s just the right thing to do and we feel a whole lot better when we do.”

And that is about the gist of it.