We had friends over for dinner on Saturday. One of the guys is a former senior General Electric exec, who now keeps busy with a variety of venture capital activities. He’s involved in developing a major server farm project out West. With plans and permits in hand, he’s leading the group pitching the project to investors, looking for the money to build the project, then ultimately sell it and return profits to both the investors and his venture group.
What he is finding is interesting. Nobody is willing to seriously discuss committing funds at a hurdle rate of less than 15%. “Hurdle rate” is an investor’s way of expressing his minimum return requirement, at least in theory.
The reality is that setting a hurdle rate of 15%, when risk-free assets are yielding less than one-half of one percent, is really just using B-school lingo to avoid doing any deal, without admitting that you are simply too scared to make any risk-oriented investment; it is a way of pretending to be in the game when you are really too timid to leave the sidelines.
We have learned a great deal about risk-tolerance over the last decade or two. In particular, we now recognize that risk tolerance is a very slippery concept. In good markets, individuals are absolutely terrible at estimating their tolerance for risk in bad markets, and vice versa. The self-identified high-risk speculator with the NASDAQ at 5,000 turns out to be a cowardly cash-hoarder with the NASDAQ at 1,200. Not only is risk tolerance highly variable in the same individual over time, it can change sharply over short periods and it is systematically inversely-related to actual investment opportunity.
The investment press is full of nightmare scenarios, driven by crashing French banks, soaring budget deficits or double-dip recessions. Few observers are constructing optimistic scenarios. Given a run of good news, from pretty much any quarter, I suspect those fantasy hurdle rates of 15% may suddenly correct to 8%, in which case a huge amount of money could find its way into the stock market — and into the type of private equity transaction my friend is pitching.