Emily (our MD) sent me this cautionary tale about a guy who won an auction for the famous (because it’s a triangle!) Flatiron Building in New York City and then couldn’t even produce his $19 million deposit. You would have thought somebody would have asked for proof of funds from any potential bidder beforehand because now a lot of work has been done and no one is any closer to closing a deal.

If you remember your risks, this is counterparty risk, or “the risk that the other side of the trade will fail to perform.” The obvious lesson is that before doing a deal, make sure the other side has the money. 

But I also think counterparty risk is more than just black or white. You not only want to know if your counterparty has the money, but also where he/she/they got the money from. Because while the source of capital may not be what determines whether it’s there or not, it absolutely will determine how it behaves. And if you’re going to be stuck with your counterparty for any length of time after a transaction closes, that matters.

Here’s a hypothetical…

Let’s say you were Twitter. Would you have rather taken an investment from Warren Buffett or Elon Musk? If you don’t know what you know now about how Musk has run Twitter since his investment, I actually think the answer to this question is a pretty close call. Despite Buffett’s reputation, it’s unlikely he could have helped the company. He is typically hands-off and doesn’t cop to having much knowledge about technology whereas Musk is (was?) one of the foremost technologists on the planet. 

And – hot take – I actually think Musk could have been (and may turn out to be) a pretty great owner of Twitter. What tripped him up was the fact that he overpaid for the company using high interest rate debt and personal wealth tied to leveraged, highly volatile stock. This is not high quality capital. Instead, it’s expensive and short-term and what has happened at Twitter since Musk’s investment – the cost cutting, aggressive monetization, etc. – is always what happens when a deal is closed using expensive, short-term capital. In other words, the root problem isn’t necessarily who provided the money but where the money came from.

We teach kids that it’s rude to ask anyone where they got their money from, but (1) it’s a really important question and (2) anyone who actually has high quality capital should be proud to tell you about it.

P.S. Permanent Equity’s investing team is hiring. Click here for the details.

– By Tim Hanson

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