This blog post is based on comments Jan made in an interview with Institutional Investing in Infrastructure magazine for this article (subscription required): Aligning With Managers: Fund Managers Can Be a Key Ingredient for Success.
Aligning the interests of institutional investors and their private markets investment managers is a key part of their relationship, but success requires thoughtful planning and close monitoring by the investor. On the part of investment managers, for an effective relationship it is essential that they provide regular, clear, and timely reporting, in addition to delivering on target returns and strategies, to ensure investor expectations are met. Communication about firm-level and portfolio-related issues, changes to the team or strategy, and the deployment of capital commitments is key.
As a starting point to help them in ensuring this alignment of interests, institutional investors can educate themselves about the investment market through research in two different ways. In the first way, investment managers often present at various industry conferences; this gives board members and staff the opportunity to interact directly with investment teams to hear about trends and current market opportunities.
In a second method, institutional investment consultants can help clients appreciate the broader market, especially the risks and considerations that may not be clearly communicated by investment managers. Consultants can help clients understand the differences between strategies, and often have broad client exposure across a sector, which allows them to have additional insights about trends, opportunities, and other issues (e.g., reputation and track record of investment firms/professionals).
Selecting Private Markets Investment Managers
Manager selection is driven by qualitative and quantitative factors that only differ slightly for different types or sizes of private markets investment funds. The key issues to examine with each manager include:
- Is it stable?
- How deep is its bench?
- How much relevant experience does it have?
- How diverse is the team in terms of backgrounds and seniority?
- Does it benefit from being part of a larger organization?
- How consistent is it?
- Is it appropriate for the desired results?
- Is it appropriate for the team in place?
- How much leverage is used?
- How does this team and its strategy compare to others in the market?
- Where are they particularly strong?
- Is there a track record in line with the stated strategy?
- If not, what experience does the investment manager have as a firm/team that qualifies it to invest in its particular strategy?
- How consistent is the track record over time? What are the loss rates? How many “one-hit wonders”?
- What drives the track record? Is it financial engineering-dependent, or driven by operational improvements?
Manager Alignment: Key Questions
As the manager selection process gets underway, Callan recommends that a potential investor address the following questions early on, to ensure its interests are properly aligned with the manager under consideration:
- How much is the investment manager contributing to the fund (alongside limited partners) as the general partner commitment? Who within the team is funding that commitment? What is the funding mechanism (cash out-of-pocket vs. management-fee deferral)? Callan prefers a meaningful GP commitment, and out-of-pocket funding.
- Is the management fee in line with market standards for a fund of this size and the strategy in place?
- Is there a performance fee? If so, is there a preferred return for investors? Are there clawback provisions?
- How are members of the investment team compensated—through a share of the fund’s performance incentive fee? If so, how broadly is that performance incentive shared across the team? What are the vesting mechanisms?
- Can members of the manager’s investment team invest in the fund, separately from any GP commitment?
During the diligence process, red flags can emerge. These can include manager materials with incorrect/incomplete data, difficulty in communication with the manager, a high level of staff turnover, or unexplainable problems with the track record.
Once a manager is selected, investors should expect relevant and timely reporting so that investors and their consultants can follow the progress of the fund. Here are a few guidelines for managers that Callan recommends:
- Investors want to know their specific net-of-fees performance.
- Investors want basic information about each underlying private fund investment: investment name, location, sector/property type, year of investment, how much capital has been invested, how much capital has been distributed, what is the leverage/NAV/IRR/multiple to-date.
- Overly complex reports do not help. Neither do superficial reports.
- Delayed reports are a nuisance at best, and red flag at worst. Reports should be delivered within 60 days of quarter end for 1Q-3Q and 90 days for 4Q.
- If there are problems within the portfolio, it is best to communicate directly and quickly. Be upfront. If the market has changed and certain strategies do not make sense, communicate that and work with the fund advisory board regarding any changes and also communicate that to investors.
For a successful relationship, it is also helpful to give advance notice on fundraising activity so that investors can plan for potential re-up commitments.