5 common LP investment biases

Welcome back and happy Friday!

I just got back from NYC - thank you to everyone who came. I’m candidly not sure how many people came, but were were definitely over 50 - looking forward to doubling it next time!

Thanks to TJ Burns for the picture - I forgot to take one because I was having too much fun :)Today, I’d like to compile all the biases that I continue to see LPs trip up on in one place. People say they do independent research, but in reality many times people are swayed by fairly simple things that ends up hurting them in the long run.

Let’s discuss, and as always I look forward to your feedback on any others!

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As you know, context and disclaimers are important. In all of the examples below, you’ll be able to find counterexamples when some of the presented issues become helpful.

While this is true, my point below is that in most cases they’re far less helpful than people think they are … I would also venture to say that for many LPs these issues (e.g. references or a review of a GP from someone you don’t know) end up causing more harm than good because they create a fake sense of confidence.

Here are 5 of the most common biases that can quietly distort an LP’s judgment, along with examples and what to watch out for:

• **Confirmation Bias - Seeking Validation Instead of Truth - **we naturally look for information that supports what we already want to believe. If we like a GP or a particular strategy, we subconsciously prioritize evidence that confirms that belief - while discounting red flags.

• What it looks like:

• Relying heavily on a glowing investor reference provided by the GP

• Ignoring inconsistent past performance because “this one feels different”

• What to do instead:

• References in general can be very tricky because the chances of a GP (even if they’re fairly honest) sending you an unhappy LP is slim to none

• If you still think references must be a big part of your decision, you can try asking for references to who passed on investing - or (better, but still has plenty of pitfalls) references who had deals with the GP that didn’t go according to plan

• **Recency Bias - Overweighting the Latest Outcome - **it’s easy to get excited about a sponsor who just had a “home run” exit. But what about the rest of their track record? Was that result repeatable, or was it lucky timing?

• What it looks like:

• Focusing on the most recent IRR instead of the average over several deals (particularly if those IRRs were in a time/vintage when higher IRRs were easier to achieve due to cap rate compression)

• Reinvesting with a sponsor after you start getting distributions on recent deals (don’t mistake distributions for performance and don’t over allocate to a single GP even if you’re confident that things are going according to plan)

• What to do instead:

• Don’t invest just because someone hasn’t had a capital call … conversely, don’t refuse to invest in a GP because they had a challenge.

• I would recommend reading last week’s article on struggling GPs - you have to understand that some investments don’t work out.

• The best way to compare GPs across one another is deal flow.

• **Survivorship Bias - Only Seeing the Winners - **by the time a deal lands in your inbox (or your feed on social media!), it's already been polished and marketed (whether you like it or not, you’re in the middle of a sales pitch).

• What it looks like:

• Judging a market or strategy as “proven” based on a few examples - market cycles and rents change over time

• Getting excited to invest based on a recent social media post or a friend of yours making a lot of money on such an exit (hint: their deal isn’t the same as your deal)

• What to do instead:

• Ask what deals the GP is having the hardest time on, and ask for a reporting package to see how honest they are with their investors.

• Every real operator has challenges (usually not “if” but rather “when”). If they don’t, they might not have been through a full cycle (which is fine - but know the difference).

• **Halo Effect - Letting Impressive Details Cloud Judgment - **a well-spoken GP who’s good at sales can inspire confidence, but that doesn't mean they’re a great steward of capital.

• What it looks like:

• Overvaluing pedigree (e.g. Goldman Sachs, Ivy League) - always try to understand what they did within the company, and focus less on the name

• Confusing charisma for competence or track record

• Letting AUM drive your decision making (PS many times AUMs aren’t fully accurate, similar to track records)

• I’d also recommend listening to Great Investors ≠ Great Marketers

• What to do instead:

• Focus on results, not resumes… it’s always a mix of understanding what the person has done before, what the plan is on this asset, and whether you expect that they’ll be able to execute (that’s the first pillar of LP investing for a reason!)

• **Social Proof Bias - “If Others Are In, It Must Be Good” - **it’s tempting to follow the herd, especially when you hear well-known LPs are in the deal. But those investors might not have done deep diligence, might have completely different risk tolerance and liquidity needs than you, or might even be getting compensated for your investment!

• What it looks like:

• Asking, “Who else is in?” and treating that as a proxy for due diligence

• Hesitating to pass on a deal just because others are saying yes, or because it was sent to you by a friend/family member

• Investing based on religious or social circle affiliation

• Investing based on someone else’s review or social media post (hint: many times the person writing doesn’t even understand that their own deal isn’t doing well in actuality)

• What to do instead:

• Make your own decision based on your own criteria. Respect the crowd, but don’t outsource your judgment to it.

• It’s generally great to speak to others, but only once you’ve formed your own opinion on a given investment and that counterparty isn’t biased

In summary, try to stay grounded an neutral and be self aware if you’re illogically being swayed by one of these. An investor's mindset and principles and does due diligence matter both have more on this topic as a skillset.

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