Is There Anything Traditional About Alternatives?

In evaluating managers over time, we sometimes encounter the glitz and glamour of the story of investing.

In the traditional space, poking holes in these stories becomes somewhat easier given the vast availability of public information. In the alternative space however our approach is a lot more cautious – with an appreciation for the fact that “the devil is in the detail”. The alternatives space therefore demands a greater level of scrutiny from all perspectives, just as a consequence of its nature.

When one thinks of alternative investments, stale pricing, lower volatility and uncorrelated asset classes comes to mind. However, is there any such distinction from a manager research perspective? The distinction between traditional and alternative asset classes from a risk/return point of view has become more obvious and widely understood. The further distinction of the asset classes within the alternatives umbrella is in itself an illustration of the disparateness within the asset classes, let alone compared to traditional investments.  My colleagues would have alluded to a lot of these differences in the other articles in this publication. The question is whether there are any evident or obvious distinctions within the manager research space as a result of the unique features of alternative investments.

The answer to this is both yes and no. While the qualitative aspects of the manager research process remain unchanged; philosophy, process, people and the like; there are aspects within these categories that are of greater importance within the alternatives space than for more traditional asset classes (although these factors still remain important within the traditional space). We will use private equity under the alternatives umbrella as a proxy for alternatives to illustrate some of the differences within the process for ease of demonstration of these points.

Firstly, the people aspect becomes an increasingly important component to understand within alternative assets, even more so than under the traditional space. The traditional space has the benefit of repeatable structured processes that can survive the departure of key individuals. In the private equity space the process is very dependent on the individuals involved at the start of the investment, and whether they remain through exit as these investments are entered into based on the skills of these individuals and their ability to unlock value.

Secondly, managing conflicts of interest and understanding key-man clauses are other aspects that need to be considered more carefully given the compensation structures of these funds and the importance of the individuals within the team as highlighted above. Incentivisation becomes another focal point within the alternatives space in ensuring adequate alignment of interests of the team.

Lastly, in the traditional space a manager’s performance profile provides clarity around the manager’s ability to adequately translate the philosophy and process into an alpha profile with a reasonable degree of consistency. Yet within the alternatives space, this becomes less frequently available and reliance needs to be placed on independent valuation experts to assess the return generated. This occurs less frequently and is also subject to a range of assumptions which makes the assessment more difficult. I will elaborate on all of the above throughout the article.

Understanding the people behind the deal pipeline

Although it is equally important to understand the portfolio managers and investment analysts within traditional asset classes, a lot of these managers have well defined processes. These processes can be translated by another portfolio manager and still achieve the same desired outcome as a result of the entrenchment of the philosophy and process within the asset manager, hence survive the departure of any key individual.

This however is less relevant within the alternatives space and a lot more reliance is placed on the individual members involved. Specific deals are entered into given the skillset of the members involved and their ability to unlock value within these busineses. In the alternatives space this is more dependent on the individual involved than the process behind the selection of the investment. Within the private equity space for example, these individuals would need to have a history of successful deal origination and closing. Equally important is the ability to leverage strong networks within the industry to be at the forefront of these deals.

In addition to the manager’s experience and skills within industries, is their ability to identify businesses that are in the right industry from a thematic positioning standpoint (important given the long term investment horizon of these investments). The manager’s ability to ensure adequate representation on the board, governance committees and remuneration committees (so key individuals within the business are aligned to the same outcomes) is important. Reputation of the manager within the industry and with the investments made is also a crucial component for our team in assessing the manager’s ability to add value to an investment. Understanding how these businesses are turned around and exited attractively by these individuals is also crucial. These “generalist” skills within the manager are key components in the assessment of the manager’s skill.

Within the alternatives space, reliance is placed on the individual members involved. Specific deals are entered into given the skillset of the members involved and their ability to unlock value within these businesses…

Additionally understanding how the individuals determine an adequate fund size is important to distinguish between the overall incentives that drive behaviour. Large funds attract more fees and may not necessarily imply that there is an adequate supply of high quality investments to deploy this capital. Given the limited opportunity set of high quality investments within the private equity space, the manager may then add lower quality investments into the fund to allocate this capital.

Lastly ensuring that these key individuals are adequately locked into the business is very important. As a consequence of the importance of individuals within the team, upon investing into a fund, limited partners will list individuals they deem as key to the fund and explicitly state that should these individuals leave, this would become grounds to exit an investment. As we have emphasised throughout the article, investments in this space are largely reliant on these key individuals initiating the deals and deploying this capital given their level of expertise. It is therefore important to assess the adequacy of this tie-in measure to ensure that these key individuals are tied in for the duration of the investment through to exit.

Managing conflicts of interest

Conflicts of interest exist in the traditional space, but are amplified in the alternatives space and require additional layers of oversight and governance. Some examples are given below of aspects we would need to consider from a manager research perspective.

The Agency dilemma

The principle – agent problem arises when one party (the agent) makes decisions for another (the principal), but is conflicted to act in their own self-interest instead of in the interest of the principle. In private equity, the manager known as the general partner or GP, is able to make decisions on behalf of investors known as the limited partners or LPs. The conflict arises because the general partner is very well incentivised to make investment decisions that could result in excessive risk (because of the leverage created by performance fees). Although this conflict exists in all aspects of investing it becomes increasingly important to understand in the alternatives space given specific features of the asset classes. 

For example, it is important to understand the number of funds that are managed by the same teams, as one underperforming fund may create an incentive to act in the best interests of another outperforming fund to the detriment of the underperforming fund, or simply to ignore underperforming funds and focus all resources on the outperforming funds. It therefore becomes very important to ensure that there are legal and other mechanisms that counter this conflict.

Skin in the game for the long term

Understanding the incentivisation structure of managers within the alternatives space is somewhat more important than in the traditional space given that a large part of the decision to invest is taken as a result of the key individuals within the manager. As a direct consequence of this, it becomes increasingly important to ensure that the members of the teams are adequately co-invested and aligned with the performance of the fund. It is however important to understand that co-investment may only have a very limited impact on the conflicts and behaviour. This would be due to two primary reasons. The first would be if the amount invested is small compared to the size of the fund, and the second would be if the amount invested was small in relation to the individuals overall wealth.

Performance fees as call options

Carried interest (performance fees) has the characteristics of a call option. While a deep in the money call option (which would result if the fund’s performance was well above any hurdle above which performance fees will be paid) would provide an alignment of interests between GP’s and LP’s (as these options will have deltas – or sensitivities – close to one). Out of the money call options however, 

provide no alignment of interest, and may in fact provide an incentive for excessive risk taking (as option values increase with an increase in volatility of the underlying). Appreciating these conflicts and nuances is therefore important.

Return outcomes are somewhat opaque

While an alpha profile for the underlying manager within the traditional listed space is readily available, the assessment of a track record within the alternatives space is a bit opaque given the long-term investment horizon of these investments and some of the other characteristics of the asset classes. Additionally the Internal Rate of Return (IRR) of the fund and individual investments, supplied by the manager may not be entirely objective and independent. Although valuations are provided on a monthly or quarterly basis, they are typically calculated by the managers and would come with a plethora of assumptions that would need to be understood. Heavy reliance must therefore be put on independent valuations which are typically required at least annually.

Conclusion

uperficially, it may seem like the aspects that are important from a manager research perspective in the traditional asset class remain the same in the alternatives space. I’ve attempted to highlight some of the differences that exist and that warrant a deeper review given the uniqueness of the asset class. The level of depth of review of managers that invest in either the traditional and alternatives space remains the same.

Alternatives as a group of asset classes are very heterogeneous, but so too are many of the individual assets within each sub-asset class. Each of these heterogeneous asset classes would have distinct nuances that require slightly different focus from a manager research perspective. The underlying premise of manager research is to ensure that we understand these managers and what they are attempting to deliver within their unique space, so from this perspective at least something has remained traditional.

The underlying premise of manager research is to ensure that we understand managers and what they are attempting to deliver within their unique space.

By Kamini Moodley,

Head of Manager Research,
STANLIB Multi-Manager