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Chronicles of an Allocator

Chronicles: March 2021

Issue 13, March 2021

Let’s face it, we’re all nerds and “numbers people.” As investment professionals, we like to follow the ups and downs of major indices, rely on our long list of ratios, and get on our high horses (or Twitter) when we notice a trendline or performance indicator that others are missing. Sometimes, however, our knack for the numerical gets in the way. But, in manager selection, we have to remember we are hiring teams, full of human decision-makers. That must count for something, right?

Due diligence is often said to be a mix of art and science. While there are a lot of historical quantitative statistics we can measure, the qualitative elements may end up being the differentiator on a forward-looking basis. This edition of Chronicles seeks to provide some helpful resources to aid in the due diligence process. Starting with the results of CAIA Association’s recent research (informed by hundreds of CAIA Members), which focuses on the drivers behind manager selection, we then delve into some relevant industry insights from fellow practitioners. These resources can help you take a closer look at due diligence and further explore some of the less quantitative—though arguably more influential—aspects of the process.

The CAIA Content Team

John L. Bowman, CFA, Senior Managing Director, Twitter, LinkedIn

Keith Black, PhD, CFA, CAIA, FDP, Managing Director Content Strategy, Twitter, LinkedIn

Guowei Jack Wu, CFA, Content Director, CAIA APAC, Twitter, LinkedIn

Aaron Filbeck, CFA, CAIA, CIPM, FDP – Director, Global Content Development, Twitter, LinkedIn

In other news...

Qualitative > quantitative in due diligence

Among the biggest takeaways of our recent Member survey, we found that 96% of investors believe that qualitative analysis is equally or more important than quantitative or operational analysis during due diligence. Qualitative factors were also considered most powerful in predicting future performance and mattered more in certain alternative asset classes than others.

For more coverage of our survey, we invite you to check out the new Due Diligence page in the Research section of our website. There you’ll find our Members-only survey report, an eBook that can help investors reflect on their own due diligence processes, and related blog posts, webcasts, and resources.

Size doesn’t matter, but operations still do

Our survey also found that while fewer investors say that manager AUM is important in hiring decisions, they tend to hold emerging managers to higher operational standards than they use to evaluate larger, more established managers. That added scrutiny may be a challenge for newer, smaller managers who must make “a substantial investment of personal capital to build the internal team and systems required to impress.”

What really counts in ESG due diligence

Over the past several years, we’ve seen a variety of ways in which asset owners attempt to judge the ESG capabilities of the managers they hire, and it’s been tough for managers to know how to demonstrate their commitment at any given time. According to one study, signing the Principles for Responsible Investment now seems to count for quite a lot, and the majority of investors would be unlikely to hire a firm that was not already a signatory. The importance of sustainability also took a significant jump in the minds of investors, from 41% who said it plays a major role in selection in 2018 to 60% today. (Ref 1)

Do arbitrary metrics limit our chances at greater diversity?

Past performance has proven the merits of greater diversity at asset management firms, but according to a recent commentary, the current norms in manager selection processes, such as AUM thresholds or track record minimums, often handicap allocators’ consideration of women-and-minority-owned firms, which tend to be smaller and newer than those owned by their white male counterparts. Instead, manager researchers should forgo stats-based shortcuts and take the time to ask the questions that more directly speak to a firm’s future strength and performance.

Getting privy to the motivations of private debt managers

Given many of today’s top private debt investors work for niche firms rather than the more well-recognized global firms, we see a parallel narrative, where due diligence processes prioritize getting to know the life goals of the people who make the investments. A recent whitepaper by Arixa Capital, which outlines both qualitative and quantitative steps in private debt due diligence, makes the case that simplicity is key when evaluating a private debt manager, and investors must be able to clearly and concisely articulate their elevator pitch. The authors suggest that “a strategy based on making loans on real estate that you can see and visit for yourself may be safer than an esoteric strategy that involves a degree in finance to understand.”

Charisma beats cash flows in VC

Now, moving from manager due diligence to due diligence conducted at the deal level, we see a similar push against a pure numbers-driven approach. In the March issue of Harvard Business Review, researchers from some of the country’s top business schools shared the results of a survey focused on decision-making within venture capital firms. According to the survey, 95% of VC firms say that startup “founders” were an important factor when narrowing down the list of potential investment candidates. In contrast, the valuation of the business ranked much further down the list. In addition, “20% of all VCs and 31% of early-stage VCs reported that they do not forecast company financials at all when they make an investment,” which might be attributed to the fact that exits years down the line matter more than near-term cash flows at the time of the investment.

Looking to alt data to evaluate PE investments

If investors start to find it tough to measure or verify some of the more intangible factors when evaluating their prospective investment targets, the market may offer new solutions through alternative data. Forget about self-reported cash flows; a recent report from Eagle Alpha outlines how private equity investors are now tapping into third-party repositories of credit card transaction data, patent filings, web traffic stats, online reviews, or even satellite imagery when conducting due diligence ahead of an investment.

Referenced Material:

Asset owners say ESG expectations now play ‘major role’ in manager selection
(https://www.institutionalassetmanager.co.uk/2021/02/08/295576/asset-owners-say-esg-expectations-now-play-major-role-manager-selection)

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All posts are the opinion of the contributor. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CAIA Association or the contributor's employer.