Thoughts on Manager Selection
Luck, Skill and Out-performance in Private Markets (Part 3)
Manager selection is a necessary but insufficient condition for success in private markets. If you’re reading this, hopefully you read my prior installments on persistence and mispriced assets. “If you’ve come this far, maybe you’ll come a bit further.” (Andy Dufresne, Shawshank Redemption)
MANAGER SELECTION IN PRACTICE
Only 25% of private equity firms launched since 2006 have outperformed the public markets according to a report by Pitchbook.[1] That is significantly worse than a coin flip and should concern any Limited Partner (LP) measured against a public benchmark or any Chief Investment Officer wrestling the larger asset allocation decisions.
According to the Pitchbook data, highlighted in Figure 1, even if an LP could perfectly predict and select top quartile funds, the reward relative to public markets has been declining.[1,2]
Capital inflows and increased competition has made it more challenging for GPs to outperform, much less do it persistently. (See my previous post on Persistence)
There is clearly still reward for picking the best funds, but consistently picking those funds can be challenging for even seasoned investors (see Verdad: Lessons from Oregon or Asset Owners Hire the Managers They Know — And End Up Under-performing) Manager Selection is like a betting market for ideas. It is the collective wisdom of sophisticated LPs allocating to different managers based on well-researched and informed choices. Beating a competitive market is hard enough. Add to that, feedback loops are long, information is increasingly transparent reducing informational advantages, persistence is questionable, and the reward relative to public equity has declined. How do you win in that environment?
DIVERGENT THINKING LEADS TO BETTER RESULTS
I often find it helpful to look for inspiration in fields outside of investing. Branch Rickey was the General Manager of the St. Louis Cardinals from 1919–1942 with later stops at the Dodgers and Pirates. Rickey adopted several divergent strategies for his time, including a minor league farm system, recruiting non-white players like Jackie Robinson and foreign-born players, new technologies like batting cages, and an early version of “Moneyball”. None of those ideas sound divergent today because everyone has adopted them, but they were outside the mainstream thinking in his time.
The minor league system he built for the Cardinals is a great example. At its peak, the Cardinals owned or had partnerships with 40 minor league teams and sourced athletic talent through a creative tryout system, enabling them to tap into players overlooked by the traditional scouting system. Due to the strength of his Cardinals’ minor league system, Rickey didn’t compete with other general managers to acquire talent. He found and developed his own talent pool and didn’t have to “buy” a player for 25 years! Players that came up through the farm system included Hall of Famers such as Dizzy Dean, Stan Musial, and Enos Slaughter. Rickey’s team won 8 combined pennants under his watch plus another 5 in the seasons immediately after his departure. His teams won 1 out of every 3 National League Championships despite lower payrolls than other teams.
Rickey didn’t try to compete in the same way as other teams. Like manager selection, judging on-field talent was a relatively commodity and difficult to win consistently. Rickey went looking for talent in less competitive areas and created a structural advantage that other teams simply couldn’t match with money and the more conventional methods of the time.
SUPPLEMENTING MANAGER SELECTION
Unlike the declining persistence seen in private equity, venture capital has remained largely persistent, with strong historical performance correlating with future performance. Ashby Monk coined a phrase called “Structural Alpha” (see Mortal Inspiration from the Gods of Venture Capital) to describe why he thought their persistence was based on structural advantages and not on some “super-human ability to pick companies”. One form of structural advantage in venture is the signaling effect of brand name VCs. Ashby quotes research in the Journal of Finance that shows brand-name VCs can buy equity in a start-up at a cheaper price than other investors because the entrepreneur perceives it will be easier to raise future rounds of capital with the signal from a brand-name VC.
Some LPs have potential structural advantages too. Like brand name VCs, certain endowments have historically been a signal to their peers, giving them pricing power, early access or a preferred status with talented General Partners.
Other LPs derive a structural advantage by their size. These LPs are in the Goldilocks Zone of AUM. Big enough to create some of the leverage of the brand-name endowments but small enough to focus on less efficient market opportunities.
By no means are these the only two structural advantages available to LPs, so the question is what is your structural advantage?
Of course, manager selection is still important. A structural advantage without good manager selection is useless. But manager selection alone is simply hard to win consistently against a competitive benchmark or to generate the magnitude of outcomes we should expect from a 10 year+ fund. Developing a structural advantage AMPLIFIES your manager selection skill.
In the words of Michael Porter, “the essence of strategy is choosing what not to do.” For Limited Partners that don’t possess a clear structural advantage across every sub-category of private markets, they might look for 3rd party partnerships that do. Or maybe the right decision is to avoid a segment of the market. Consistent investment outcomes are a combination of candid analysis and a probabilistic mindset.
To wrap up this series, here are my 3 take-away thoughts;
1) Persistence has declined & LPs should carefully consider their strategy to minimize the impact of luck on outcomes.
2) LPs can try to up their relative skill or they can look for games with better probabilities.
3) When you find those higher probability games, and develop a structural advantage within them, your skill gets amplified leading to better outcomes.
[1] Pitchbook’s Benchmark Q4 2017 as reported in Private Equity International September 2018
[2] KS-PME — The Kaplan Schoar PME is calculated by discounting the private equity fund cash flows by a public market index value, in this study the selected public market index was the S&P 500. A KS-PME of 1 is “in-line” with the market, while a KS-PME > 1 signals outperformance
