Do specialist investment firm Founders outperform generalists?
“Jack of all trades, master of none” – a phrase dating back to the 14th century, often used in a derogatory sense for those well- equipped to be adequate in a variety of endeavors but not experts in any one sphere.”
“I have a very particular set of skills, skills I have acquired over a very long career. Skills that make me a nightmare for people like you.”
Liam Neeson’s ‘Taken’ speech, highlighting the importance of a specialized skillset.
As strategic partners, we prefer specialist Founders for various reasons. Some of these are investment driven (top tier specialist managers are more likely to need strategic capital, and thus as a partner we are less likely to suffer from adverse selection), some are operational (some strategies require larger teams which need larger levels of initial capital to break even) some of these are commercial (specialist Founders are more differentiated and find it easier to raise investor capital). Investment drivers are the focus of this research note.
Do specialist Founders outperform generalist Founders? This is a difficult question to definitively answer given there is no universally agreed-upon definition of specialists. Stable’s definition of specialist Founders is those who focus on a more clearly defined investment sector or universe; often with capacity constraints. A few examples of these are, within public manager: small/midcap L/S equity, sector or country-focused L/S equity, EM macro, special situations/distressed credit, commodities, volatility arbitrage and niche systematic. Within private markets, specialist Founders include those focusing on a specific size bracket of the market, such as the lower mid-market, a specific sector, such as healthcare, or geography, such as the US mid-west or specific countries or sub-regions outside of North America.
In private equity specifically, there is also a tendency for sector-focused funds to outperform generalist funds, as outlined in a Cambridge Associates report, which found significantly higher MOIC’s and IRRs amongst funds with a heavier sector focus. The conclusion was that specialist outperformance comes from a deeper, more intimate knowledge of a certain industry which generalists cannot replicate across multiple areas. It is commonly argued that this advantage carries over to hedge funds as well. A Novus paper found that there was a trend for more sector specialism amongst equity Founders and highlighted that specialists within certain sectors (I.e. healthcare, TMT, consumer or information technology) tended to have a greater potential for alpha given the greater levels of specific knowledge of the Founders as well as opportunity dispersion within these particular sectors.
For example, as you can see below, the HFRI Technology/Healthcare Index has significantly and relatively consistently outperformed the HFRI Global Equity Index.
In terms of capacity constraints, multi-billion funds have generally been shown to underperform due to their size, as limited opportunities or market volumes can affect performance and potentially lead to style drift. Return volatility can dwindles and Founders have been arguably known to become comfortable with significant management fee income rather than focus on generating performance. One study analyzed returns from 3,177 public funds and found that smaller, more nimble Founders outperformed larger Founders both before and after the 2008 financial crisis by an average of 2.75% per annum. Stable’s focus on capacity-constrained specialist strategies across asset classes helps to mitigate this potential size issue. Specialist Founders are able to focus on underfollowed, more dispersed opportunities to generate alpha and are incited to drive fund performance to earn their compensation, rather than rely on management fees.
As such, Stable has a preference for process-driven, sector and geographically focused Founders, as we have felt that this type of Founder is easier to underwrite and predict the future performance of than Founders with a more of top-down, generalist approach. We find these more specialist Founders tend to dig deeper into the fundamentals of an opportunity to deliver true alpha and can be seen in practice within our portfolios across both public and private market focused opportunities.
Stable’s view is not dogmatic, remaining mindful that there are generalist Founders who have outperformed their peers consistently and deliver top quartile performance. For generalists to be successful, however, they usually need large investment teams to be able to cover a wide investment universe in sufficient detail. This is difficult for a start-up Founder with a limited budget and a desire to keep breakeven levels low. Similarly, most successful generalist Founders have seen efficient teamwork structures, processes and cultures evolve so that large teams can work together optimally without yield loss or a move to a less nimble, innovative and streamlined investment process. Bridgewater, with its unique culture and structure of radical truth and transparency, is a unique example of this. Such evolution takes time and money, and so again is more difficult for a start-up Founder to get right in the early stages of their development.
One final thought is how specialist Founders fit together in an investor’s portfolio. Too often specialist Founders are relegated to a ‘satellite’ portfolio, with core holdings consisting of more generalist, ‘mainstream’ Founders and smaller investments in specialist Founders as ‘satellites’ to the core. A group of generalist Founders with wide investment universes, however (even if they have different approaches), may well end up investing in similar themes and areas, potentially magnifying concentration risk within an allocator’s portfolio. A portfolio of specialists helps to mitigate this, with investors being able to carefully add ‘building blocks’ of specialists with different areas of focus to create a well-diversified core portfolio, with more control and reduced concentration risk. This is Stable’s approach, selecting the best specialist Founders across different strategies and asset classes to offer our investors access to Founders who are truly ‘masters’ of their fields.
- Sector-Focused Private Equity Funds Often Outperform Generalists And Should Be Considered When Building Portfolios, Cambridge Associates, 2019
- ‘Asymmetric Returns and Sector Specialists’ by Alexander M Ineichen, 2013
- “When Does Specializing in a Sector Make Sense?” By Stan Altshuller, Novus Research, 2015
- Does size matter in the hedge fund industry? M Teo. SMU Working Paper, Singapore. 2009
- “Role of managerial incentives and discretion in hedge fund performances,” V. Agarwal, N. D. Daniel, and N. Y. Naik, The Journal of Finance, 2009.