Smaller and emerging managers can be a significant but overlooked source of alpha. Often hungrier and full of well-researched, actionable investment ideas, many first-time fund managers outperform established managers, who can become complacent while wedded to outdated positions.
At Appomattox, we have spent two decades evaluating and allocating to early-stage managers. We define small funds as those with less than $100 million in assets and emerging funds as those with less than a two-year track record. How do we evaluate those funds without a longstanding track record?
PRISM AND PATTERN RECOGNITION
We look at emerging managers through a prism. Like a venture capitalist evaluating a startup, allocators must look at several factors to evaluate a manager with little to no independent track record. In the absence of a performance road map, we seek a trail of breadcrumbs that focus on key evaluation factors and nuances: the team, experience, resources and incentive to perform.
The intangible factors and nuances driving a manager’s success — such as hunger, drive and a desire to win (within the law) — are hard to quantify. The art of selecting a successful emerging manager involves pattern recognition. Meeting hundreds of managers over the years and investing in them at an early stage builds up the pattern recognition that is helpful in separating the wheat from the chaff. There is a scarcity of talented investment managers. Finding them early can reap huge rewards.
We ask numerous penetrating questions and seek verification: Where did the manager begin his or her investment experience? Was it on a Wall Street trading desk, a large hedge fund or mutual fund complex? How much decision-making power did the manager have? What is the reputation of the people and firms where they worked?
Not all financial firms train their people well and ethically. Allocators need to know these nuances.
Is the manager pursuing a strategy that was deployed successfully before? Does the manager have the assets under management (AUM) to pursue that strategy successfully?
For example, a manager investing in bank debt and other illiquid credit instruments will need at least $50 million to $100 million AUM and potentially $300 million to $500 million to properly diversify the fund. There are ways to mitigate such large capital outlays by investing in more liquid credits or in special-situation equities, but that entails a different set of risk management parameters.
OUTSOURCING AND INFRASTRUCTURE
Are all critical roles filled internally or outsourced to reputable professional service providers? Who is running the business and managing the business risk? Are there checks and balances in place? How long have the founder and key team members (if more than one) worked together?
For hedge funds, is there a plan to use the prime brokers and other providers as back office? Who is willing to prime the fund matters a lot because most prime brokers can dual or multicustody assets. Does the manager take advantage of those resources? Smart outsourcing stretches management fee income and enables the firm to grow.
How much of the manager’s own net worth is invested in the business? Does the manager have the capital reserved to pay staff and survive the first few years to generate a track record? Do they have seed capital to execute their strategy?
A longer-term business plan to reflect the manager’s thoughtfulness and ability to execute a growth plan is an essential component in evaluating a manager’s investment approach and ability to manage a business. A manager accustomed to the resources of a large firm for trading and/or research might struggle without access to information and systems that accrue to large firms. The commitment of an active seeder can accelerate an emerging manager’s growth and should be part of the considerations when evaluating a longer-term plan. Managers should be realistic about the challenges of capital-raising and business growth.
CONCLUSION
Evaluating an emerging manager by applying an extensive and penetrating process, loaded with verification points, mitigates risk while offering opportunities to add alpha to a portfolio. A great deal of the business risk can be addressed by improved back-office and risk infrastructure that is now accessible to managers in the early stage of business. We believe that allocators who are tenacious, inquisitive and knowledgeable in the evaluation and selection process will be well-rewarded.