We pluck the lemons, you get the plums
Is there adverse selection in seeding, and if so how can you mitigate it?
‘I don’t want to belong to any club that would have me as one of its members’
Groucho Marx’s letter of resignation to the Friars’ Club
We are often asked whether investors should discriminate between asset managers that have a strategic partner and those that do not. In this Seeds of Wisdom, we discuss whether there is adverse selection or negative implications associated with managers who decide to launch with a strategic partner.
For the purpose of this discussion, we will define a strategic partnership as an arrangement involving an early stage investment into an asset manager in return for some form of economics in the business. This is also known as a seed investment. Strategic investors will become partners in the firm in return for providing initial investment capital, and sometimes additional operational and distribution support. Partnerships are typically structured as bottom-line equity stakes or top-line revenue shares. Day-1 investments where investors receive heavily discounted fees and other strategic benefits such as capacity reservations are not considered seed investments; therefore, will remain outside the scope of this discussion.
By providing early-stage capital, strategic partners can be instrumental in the development of emerging asset managers. Seed investment can not only help these managers attract outside capital by serving as a stamp of approval, validating the manager’s viability, but also allow managers to surpass minimum AUM levels that often restrict the capital deployment of many institutional investors (1).
Even though smaller and younger managers have shown to almost always outperform larger managers on a risk-adjusted basis (2), the traditional argument against seeded managers is that managers who need to take a seed and give up economics are of a lower quality than those who can launch without a seed (3). Evidence for this traditional argument most often comes from the latest raft of high-profile launches: managers who launch with +$500M of Day-1 capital. In other words, the next Chris Rokos is not going to take a seed, nor has Steve Cohen had to take one for his re-launch to external investors earlier this year.
Stable’s view is more nuanced: we accept that in more mainstream and generalist public markets strategies, the most successful and high-profile managers will often not require a strategic partner. This is because in large capacity strategies, one can expect the best managers to have managed large funds and enjoyed higher profiles. As a result, they will have amassed sufficient personal wealth and established deep investor connectivity to launch successfully without engaging a strategic partner.
For this reason (and many others outside the scope of today’s discussion), Stable focuses on partnering with specialist managers. Our specialist focus helps mitigate the adverse selection that traditional mainstream focused seeders often suffer. Like the wise customer in Akerlof’s market for lemons, we go to great lengths to pluck the lemons so we can partner with the plums. The best specialist managers are, generally speaking, less wealthy and less well connected given that they deploy more focused, less popular and mainstream strategies. Examples of such strategies include small- and mid-cap, country, and sector focused L/S equities, emerging market macro, specialist liquid credit, cross-capital catalyst driven, commodities, niche systematic, litigation finance, music royalties, etc.
The top specialist talent is therefore not only open to, but also most often proactively searching for strategic partners like Stable. This in turn ensures better performing and more productive partnerships between Stable and our managers. Additionally, Stable investors also benefit from the capacity constrained nature of these strategies and their focus on generating returns rather than on growing assets (4). As we lock-up our capital commitment for a number of years, managers know that our partnership guarantees them the runway they need to build a long-term business. This is immensely valuable to a manager launching their own firm, allowing them to hire their team and sign their office lease with the assurance that Stable’s capital and partnership commitment are there to stay.
Analysing the track record of our investment team’s Day-1 investments over the last 10 years yields what many consider counter-intuitive results. There is no evidence at all for adverse selection among seeded specialist managers when compared to small and large launches that were not seeded – see table below (5).
Notes: Average AUM is for the first 7 years of operation; Small launches defined as <$100M; Morgan Stanley data defines small managers as AUM <$500M, large managers as AUM >$500M, new launches are including any launch within 2 years prior to the performance year end, mature managers all older than >2years. Sources: EuroHedge, UBS, Morgan Stanley, Stable Research, n=67.
Strategic partners have become more valuable to emerging asset managers over time as the minimum efficient scale (MES) of asset management businesses has grown. There have been a number of drivers behind the higher MES, including increases in regulatory compliance costs, operational complexity of certain markets, institutionalisation of business operations required by investors.
Widely publicised research has underlined the importance of a strong operational infrastructure among managers. Research has shown that more managers fail due to poor business practices than sub par investment decisions and that the higher failure rate of new managers compared to established ones is more often due to operational rather than sub-par investment performance (6). Investors must therefore also avoid being adversely selected in terms of a manager’s operational robustness.
To mitigate operational risk, Stable has developed a differentiated hands-on business and operational support framework built on our experience as operators and private equity investors. We help build the asset managers that we back with our capital. Having an experienced operational partner like Stable not only mitigates operational risk, but can also contribute to higher returns. Our support allows the managers we back to focus on investing, and gives them the peace of mind that comes with being able to count on an experienced partner who has a proven track record of building successful asset management firms.
We believe that managers need support more than they need capital. Whilst maintaining the identity of each manager – as its own separate and individual firm – Stable supports the setup, launch, ongoing operations and distribution of each investment partnership. This ensures institutional-quality operations prior to launch that mitigates operational risk, maximises growth potential, and minimises distractions from investing.
In summary, there are clear ways for strategic partnership investing to mitigate adverse selection effects. Stable focuses on specialist managers who see much more benefit from bringing on a partner than just a large capital commitment. Furthermore, the managers that we back genuinely wish to have an experienced team of partners working alongside them every step of the way, de-risking their launch and supporting them during the early years of their new business. They want a partner who has seen it all – or almost all: we still learn and improve every time new challenges are thrown at us, which happens more often that one would think. In fact, the lessons learned from each new challenge in turn becomes an invaluable experience that we can share with the managers in the future. They want a partner who can help them with every detail of the launch and business building process. Such help ranges from advising them on employment contract design, to reminding them that – no matter what level of success is achieved – that the water feature in the office lobby is probably not value adding to their business. This allows Stable to establish healthy and productive business partnerships – not with teams who need to partner with us, but more importantly, with teams who want to partner with us.
- “The life cycle of hedge fund: Fund flows, size, and performance”, Getmansky, M., 2005
- “The performance of Emerging Funds and Managers”, Aggarwal and Jorion 2009
- “The Predictive Value of Performance”, Myers, 2010
- “Capacity Constraints and Hedge Fund Strategy Returns”, Naik, Ramadorai and Stromqvists 2007
- “Quantification of Hedge Fund Default Risk”, Christory, Daul and Giraud, 2007
- “Hedge Fund Development and Performance”, Martin and Pescatore, 2007
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