December 19, 2023

Hans Lovrek stumbled on Medieval Florentine documents that showed structures were being used to align interests in ventures with high information asymmetry that were uncannily similar to today’s limited partnerships.

Through a method of historical institutionalism, Hans demonstrates how the same techniques have been used to solve similar problems, down the ages, and that today’s private equity industry is based on ideas that successful trading nations have used before.

This episodes was recorded in March 2019 and is released on podcast for the first time in December 2023.

[00:00:00] Ross Butler: You’re listening to fund Shack. I’m Ross Butler, and this episode of the Fund Shack podcast is from our back catalogue, recorded in March 2019, but it’s never been released on podcast platforms. And as it turns out, in private equity years, this is a mere blink of an eye. So in this holiday season, I thought you might appreciate a thousand-year perspective on private equity.

Hans Lovrek structured the first Austrian private equity funds in the late 1990s. Since then, he has allocated almost €500 million to around 70 different private equity funds. He is currently an advisor to several of the larger Austrian private equity programs through his consulting practice, commender private equity. I first came across Hans when he gave a presentation drawing on some very interesting parallels between merchant trading of the Middle Ages and current private equity practices. And I was really intrigued to hear some more. So he joins me now from Vienna. Hans, these are fascinating parallels between the medieval commander, after which you named your firm, of course, and modern private equity. Can you tell us a little bit more?

[00:01:08] Hans Lovrek: Well, it’s interesting, maybe how I came across these parallels. It was probably in the year 2004 or five, when, as you said, I was looking for a name for my advisory company, and I was studying history and doing research in the history of bankruptcy, which in itself is an interesting topic. And I found among the assets of some bankrupt florentine banks, I found those commanders. And after uncovering my school Latin and reading those contracts, I was amazed how similar they were to the LPS I was concerned with in my everyday work.

And so over time, my focus very quickly changed from the history of bankruptcy to those commande. And I went to my professor and he liked to tease me because I was one of his older students, and he said, Hansi, that’s again so clever.

If you can explain to me where those similarities come from, you come back. And so I came back a year later after reading Douglas north and Oliver Williams, who got Nobel prizes. And kind of the theory to explain those similarities is called historical institutionalism, where you use history as kind of a laboratory to better understand modern institutions, because in social sciences you can’t have a laboratory environment because the environment changes all the time. And so you also end up with a principal agent theory. And then I got fascinated by the topic and wrote a thesis on it.

[00:03:23] Ross Butler: So how widespread was the commender structure? Is this a curiosity or was it kind of an.

[00:03:29] Hans Lovrek No, it was more or less. That’s the amazing thing. Unchanged over.

The oldest proofs I found are in the 6th century. Imagine.

And it goes all the way to the 14th century. So we are talking 600, 700 years.

In fact, Mohammed’s wife, Kadisha was her name, her father was a venturer. And so it’s more or less venture finance that financed his ascent to become a political and religious leader. So it was always this profit. The important factors was the profit share.

It was, in those days, 25%, and it was always 25%, as it is always 20%. Now, that’s an interesting topic we might talk about a little later. Very important is limited liability, because otherwise a venetian family couldn’t take other people’s money to invest, because if they would have lost the money without the limited liability, the whole family would have gone bankrupt and they would kind of be expelled out of venetian society. So limited liability, if you want, is the second important ingredient, and the third is the limited duration of those venture finances.

It was then for one caravan, for one project, for one voyage like it is today, mostly for ten years, and for very similar reasons, because thus the investor had the opportunity to decide if he wants to reinvest in the next project or not. And on the other side, the general partner was forced or was very much motivated to perform, because otherwise he wouldn’t have gotten any money in the future.

[00:05:52] Ross Butler: Okay, before we look at some of the specific structural aspects and linking them across, can we just step back and in very simple terms, explain who in this analogy is an LP and who in this analogy is a GP and what typically are the GPs doing?

[00:06:06] Hans Lovrek: Yeah, so the project I was most concerned, and probably that’s the majority, were the sea voyages across the Mediterranean Sea. So a ship had to be built or chartered or bought, and it had to be equipped with a large crew. Mostly it was galleys in those days. And so they would go typically from Venice to Alexandria in Egypt and then to Constantinople, do their trades and come back after several months or even a year if they got stuck during winter. And the gps were the merchants on board. Sometimes the captain was also a GP at the lps were, on one hand, the aristocracy, but it is amazing to see that it was really a retail business there then. So there were nuns invested and the church was.

Was, especially in Venice, where I know most about it, was quite widespread. So a typical ship, and the ships went in convoys in later days, was like a large fund with many lps going for a multiple month expedition.

[00:07:51] Ross Butler: Right, so you’ve got presumably mainly rich people, but also the church and perhaps even some widows and orphans. They’re putting their money together and they’re financing these expeditions.

[00:08:03] Hans Lovrek: Yes.

[00:08:04] Ross Butler: And so they’re looking for a structure that ensures they’re going to manage their risk, presumably, and have a fair share of the upside. And so this is how the structure has developed.

[00:08:18] Hans Lovrek: It is interesting. There is a spanish professor, she teaches in Valencia, and she showed that, or let’s put it this way, the commander only became important after Venice stepped up the regulation to a higher level. Many people will not like to hear this, and I don’t like to hear this, because the end of my fund of fund business, the happy end, was regulation. It was solvency too, but so I’m biased in the other direction, normally. But in Venice, it is shown that regulation was a prerequisite for the rise of the commanders. Before they had something called sea loans, and sea loans had this limited liability if the ship would go under or would be taken by pirates. But it had a fixed interest.

And this was not a perfect reflection of the party’s interest, because from the investor’s point of view, the risk was high that the ship would be lost. And if it would be a home run, as we would put it today, he would still get only his interest. And from the merchant, from the GP’s point of view, if he’s very successful, everything is good, the upside will take care of itself. But if the business is difficult, he still has to return all the money plus the interest, and thus be forced to lose all his profit. But the big difference, and this is what I’m aiming at, is the accounting for a sea loan is so much easier than for a commander or limited partnership, because for a sea loan, you just have to return the principal plus the interest, and that’s it. But for a commander or a limited partnership, you have your income, you have the cost, you have to bribe the customs official, you have to have security and everything, and in the end, you do the profit share.

And especially in those days and today in some areas as well, it was too much of a moral hazard for the GP.

And so what Venice did is they regulated kind of the whole voyage of the money and the goods. So every ship had a scribe, all the goods were sold and bought by public agents. In the important points, like Alexandria, there would be a consul and a venetian warehouse and a venetian court. And only then, when the investors were confident enough that everything is going to be fair and accounted for, there was a sudden rise in around 1241 230, where you can see that the sea loans were reduced.

Most of 80% of the investments were commander. And this with a very large volume, so it’s a larger volume, so it’s a nice story how regulation can create an environment for venture investing to thrive.

[00:12:15] Ross Butler: I assume we are talking purely in the sense of analogies and people coming up with similar structures to solve similar problems. Or is there some kind of direct line of sight between this type of regulation and the commender rules and today’s european?

[00:12:30] Hans Lovrek: No, there seems not to be. And from my point of view, this makes it even more interesting because one comes to the conclusion that there are certain types of risky ventures, that financing for risky ventures that demand a certain contractual structure.

And so it’s kind of significant. And this is what this historical institutionalism wants to show, that in a totally different environment, a similar risky structure was financed in a very similar way from today.

And so if you want, the theory is the LPS is the institution of choice to finance this kind of ventures.

Information asymmetry being the key element.

So the doge of Venice in the twelveth century knew as little what his merchant, his GP, would be doing in Constantinople as the chief investment officer of a pension fund, knows what his guys are doing in Silicon Valley. And so it’s very comparable structures that are financed by comparable institutions.

[00:14:12] Ross Butler: Yeah, I suppose some people might be thinking, well, this is a stretch in terms of the asymmetries of information. But it’s not just that the pension fund guy just doesn’t have access to the networks. He’s also investing in a black box.

[00:14:24] Hans Lovrek: Exactly.

The problems arising out of these situations are very similar. You are confronted with moral hazard after you assigned contract.

How do you make sure that the GP doesn’t cheat you? Today it is via auditors and so on. And before you sign the contract, the whole story is called adverse selection because the gps knows about his abilities and track records so much better than you know about him. And so we try to deal with a very thorough due diligence. This is why we do this, very thorough due diligence because of the informational symmetry. After you signed, you’re locked up. And this is the similarity because of course it is stretched. But I mean, for a german speaker it becomes more obvious because a limited partnership in German is a commandit Geselgia and it is identical. And obviously the commandit Geselja comes from the word commander.

[00:15:44] Ross Butler: Can we drill into some of the specific aspects of the structure that kind of gave you your eureka moment? So you’ve already mentioned the split of.

[00:15:54] Hans Lovrek: The carry is interesting. Let’s talk about the carry. And one of my favorite is, you know what a cheapy clobber is, Ross? Not everybody does.

[00:16:04] Ross Butler: I do. But could you just give a…

[00:16:09] Hans Lovrek: Let’s talk first about the GP clawback.

And when I did due diligence here in Austria, very few people knew. It’s really a specialist insider thing. It is if in funds during the lifetime of this fund, the GP gets too much profit share in the beginning, and the performance of the fund gets less and less as time goes on, which is very often the case, because the longer living companies are often the difficult ones, then the lps need a methodology to get back the profit share that the gps got too much in the first part of the. In excess of his real profit share. So this is called GP clawback.

And there are different methodologies to do this.

The best, of course, is that if it’s made clear in the lps that the GP only gets his profit share after all the capital is returned, and then there is anything in between. There are escrow accounts where the GP has to put half of his money in the escrow account and so on.

And I read in an islamic commentary, which was from eleven six, citing a scholar, his name is Shabayani, and he wrote in the 7th century, if someone gets 1000 Diraham to invest and he comes back and he is successful and doubles the money, and he returns 750 deer hums to the investor and keeps his share of 250 deer hums to himself and then reinvest. And then he reinvests the principal and loses it. And so Shabayani says he has to return his 250 because the profit does not arise before the capital is returned.

And I really use this in one due diligence in New York. I remember it because it was exactly this discussion. And I said already in the 9th century, everyone knew that you have to first return the capital before you are allowed to start thinking about your profit share.

[00:19:16] Ross Butler: I was going to ask you if you’d ever actually had any practical use of.

[00:19:25] Hans Lovrek: It’s something that is very useful. That is very useful, because what I do think, and this is what people from IlPA, would you pronounce it? Ilpa.

What people from IlPA think is that most of these rules have very good reasons, have very good reasons why they are like this. And we’re talking about profit shares, but there are of course, things like human risk and so on, or fees.

In those days, there were no fees, so the GP had to finance his own personal cost out of his own pocket. Only his burial was financed. If he would die in Constantinople, the investors had to pay for his burial. But all his other cost was pre financed by himself, and he was leaving off the profit share of 25%.

[00:20:29] Ross Butler: All right, well, maybe in that there’s an explanation for why we’ve landed with 20%, they’ve landed with 25%. They didn’t have the fees. But also there is kind of danger money as well. You’re not going to die in Mayfair doing. Hopefully not.

[00:20:44] Hans Lovrek: That’s one of the reasons. But still, the whole question about this homogeneity of profit share, then 25 and now 20%, is kind of mysterious. It’s kind of mysterious because now, and even then, people were very able to quantify risk normally. So if you have a more risky venture, you will pay more interest for your loan and so on. But in this case, obviously, people were not able to quantify risk because it is a black pool, because there is information asymmetry.

And so people seem to tend to conventional solutions and a convention is what you think that I think that you think. I will propose to you.

And so there is a Mr. Shelling, who wrote a book about it, about focal points. There’s a certain tendency to, if you try to make those judgments, to focus on the smallest possible denominator. So the first option would be half two, which is not fair. The next would be a third, and then you end up with a fourth. So this is one of the theory, but it’s not clear yet. And I tried to find out. I tried to find out and I wrote emails to people from the petroleum industry in the beginning of the 20th century and to the first hedge funds, which I think were in the 40s.

Someone must have reinvented the 20% profit share. And from there on, it did not change. It did not change.

It’s the same for a very conservative UK buyout fund and for an ukrainian startup, it will always be, nearly always 20%. You know, the exemptions of paying capital, taking 30, or special agreements of lps and gps, but in the center, it’s 20%. So if you really find out, let me know.

[00:23:26] Ross Butler: Maybe standing back a little bit, there’s a big kind of ongoing debate about the private equity structures and whether they’re fair and whether they should be rebalanced or whether they should be optimized.

Given your historical perspective, what’s your opinion on this?

[00:23:44] Hans Lovrek: Well, the striking difference between those medieval and the modern contracts is the length.

A normal private equity commander was a one pager.

It just set the date and the parties where the merchant intends to go.

The 25%, which defined that this is now a commander contract, and when he plans to return. And this was everything. This was everything with my legal background was always hoping or praying for was an international. So the reason for the contract being so short was that all the rest was clearly defined in statutes. So here you have the one from Pisa, from. What is it? It’s the oldest one, I think it’s 1126 or something.

And then you had common law, and so everyone knew what to do.

And in the german environment, if you do a limited company, you can do it in the bar on a one pager, because it’s Ross and Hans being the party. We give it a name, we give it a purpose, we write who gives how much money in the limited bud, and that’s it. And all the rest is in the law.

And I think this is a big hindrance for the development of private equity, that there is not a codified institution.

And this is how I made my business, because very few people in Austria then knew the international private equity market and were desperate going through these 270 pages of the Fpas. The longest documentation was 3000 pages and so legal, only with side letters and stuff. And so I think this is that in many markets, and especially for the retail market, people are reluctant to do this because it’s just too complicated.

And this is what ILPA should be aiming at. If there would be an international codified structure, like if you buy a stock on the quoted stock market, I don’t have to go through all the Amazon contracts. I would never think about the contracts that Amazon wrote to get their stocks on the stock exchange. So I think that’s one big problem.

[00:26:59] Ross Butler: Given the time proven nature of limited partnerships, it is odd that the world of financial modeling, the legal world, even the academic world, has always just seen it as a kind of a curious interloper. And it’s idiosyncratic.

Hans Lovrek: Exotic. Yeah, exactly. It’s quite exotic. And there is no need for it. There is no need for it because in reality, the properties of the private equity contracts are very similar.

The profit share, the waterfall, the time, the prolongation and so on. And to discuss this in the due diligence process is just a lawyer’s game.

[00:27:47] Ross Butler: Are LPAs just a lawyer’s game? What do you think? If you’re watching on YouTube, why not leave a comment with your thoughts and press the like button? If you’re on a podcast platform platform, please give us a rating and a review.