Thoughts on Margin of Safety and Value Investing

by Nadav Manham

Fortune profiles Chris Flowers, one of the best-known private equity investors in financial services companies.

My working hypothesis, as I try to expand my manager selection skills from stockpickers to other platforms like real estate investing and private equity investing, is that these other platforms can and should also be viewed through the lens of value investing. Simply put, you evaluate a private equity fund manager the same way you evaluate a hedge fund manager: by trying to predict that individual’s ability to generate superior risk-adjusted returns over time.

“Risk-adjusted,” in the value investor’s dictionary, simply means the combination of the probability of permanent (as opposed to quotational) capital loss and the magnitude of that loss when it occurs. In private equity, adjusting for risk in this way is especially important because private equity relies on leverage. In private equity investing in banks, it’s even more important because banks themselves are highly leveraged businesses. Small mistakes in predicting the future by managers become big mistakes to limited partners.

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