Which would you choose to add to your portfolio of private investments – an asset aggregator’s latest fund or a value creator’s fund? It is an important question that deserves deep thought. And it matters because too often, investors make the wrong choices, thereby increasing their risk profiles and undermining their odds for achieving decent returns when things do not go according to plan.
As private investments become an increasingly important part of any diversified asset allocation, representing anywhere between 10% and 40% for high net worth families as well as institutions, private investment managers respond in one of two ways. Certain managers choose to collect as many commitments as possible, focusing their energies on expanding the size of their AUMs and also expanding the variety of fund strategies they offer. Other managers continue to focus substantially all of their energies on value creation and to stick to what they are good at. Despite claiming they can achieve both objectives, very few managers do so.
Why is it so difficult to successfully focus on both aggregating maximum available AUMs for your strategies, while prolifically expanding the number of strategies offered, and continuing to successfully focus on true value creation within each strategy without sacrificing performance and without increasing risk profiles? The answer is – incentives. Incentives drive behavior and these objectives have competing paths to riches.
Before managers raised mega funds, their overwhelming priority and incentive was to generate a meaningful profit so that they could earn their 15-20% carry (their share of the profit). If they succeeded at creating value (which means not competing for the same deals and overpaying, not using excessive leverage or piling on other forms of risk, applying disciplined growth plans, and selling to a strategic acquirer after ~5 years of value creation efforts), they raised another fund (maybe of same size or slightly larger), and with consistent focus over time created meaningful personal wealth for their investors and themselves.
As the asset class became more popular and moneys flowed to it, managers who adopted the asset-aggregator-above-all-else-approach did so because the 1.5-2% annual management fees on a much larger pool of assets was an easier and quicker path to riches. 1.5% per annum of a $10 billion fund generates $1.5 billion in management fees over 10-12 years (that’s much more than is needed to pay for basic salaries and office space). And as more money flowed to these asset aggregators who built their brands initially using true value creation approaches, their businesses became more competitive and they felt more pressure to quickly put their capital to work, allowing them then to raise more AUM. Driven by these incentives, underwriting standards dropped as a result. Their pitches shifted from ‘we target a 20% IRR’, to ‘we now target a 15% IRR’, to ‘you should thank us for delivering a 10-12% IRR’ (while not drawing attention to the fact that many of their risk profiles increased in the process).
When you review your recent investment choices, take a look at your managers’ incentives and how well they are personally aligned with your objective. Don’t be afraid to drill down deeper to get your answers. Have their business models changed? If so, how? Is the risk profile greater? If so, why? Are they personally committing a meaningful amount of their net worth to the same fund or is their firm subsidizing their commitment? How does their underwriting model compare to previous funds? How has their competitive landscape changed? How has their focus changed? It is possible to do better and to find alignment. It just takes more effort.