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Emerging managers: Take a chance on me

8 Jul 2019

Butchers, green grocers, independent bakeries – small shops on the UK high street have been disappearing since the advent of the super and hypermarket in the 1990s.

In the 25 years to 2015, the number of butchers in the UK fell 60%, according to the Agriculture and Horticulture Development Board. Between 2008 and 2017, the number of green grocers fell more than 22%, data from Statista shows.

Big, it seemed for the UK consumer at least, is better.

But this trend seems to be on its way to reversing, as farm outlets, delicatessens and veg box deliveries are tempting shoppers back to specialists by offering improved quality and personal service.

The same cannot be said for the asset management industry. Monthly sales data from the Investment Association shows that most UK institutional assets are being funnelled into the industry’s behemoths, with little left for the minnows.

Consider that in the 11 years since 2008, BlackRock’s assets under management have grown from $1.3trn (£1trn) to $6.5trn (£5trn) – an increase of 400% – the acquisition of Barclays Global Investors, notwithstanding.

But if UK investors think there is safety in numbers and not straying too far from the herd, this is not the case in the US, where these behemoths are actually based.

Instead, emerging manager programmes, as they are known across the Atlantic, are a popular choice among pension investors. These programmes seek out new, small and often minority-owned fund management companies that do not have the marketing might or sales team of their much larger rivals. Not only do they often have fresh ideas, but they can also better reflect the make up of the pension fund membership, a criticism that is frequently levelled at the fund management industry.

California Public Employees’ Retirement System (CalPERS), the largest public pension in the US, has run an emerging manager programme for 25 years. In its latest annual report, CalPERS said the programme “identifies early stage funds with strong potential for success”.

As of June 30, 2016, the $358bn (£280.7bn) CalPERS had $8bn (£6.2bn) in these smaller firms across global equity, private equity and real assets.

The C$392bn (£228.7bn) Canada Pension Plan Investment Board also has an extensive program, recently hiring a Londonbased specialist to seek out new managers – and he may have the pick of the bunch.

DIVIDED BY A COMMON LANGUAGE

While some larger pension funds in the UK may have allocations to smaller managers, there is certainly not a wider trend across the sector. Nor do many want to shout about their programme, if they have one. For Todd Johnson, chief operating officer of Global Prime Partners, it may date back to the financial crisis.

Johnson, who now provides services to this group of smaller investment houses, once ran a fund of hedge funds. “Up to 2008, investors were often using fund of funds, which did not work out too well for them as they ended up being stuck in there as other investors got out quickly, so it is clear why some are cautious about coming back in,” he says.

He adds that this experience may have put off some investors, who were already trailing their trans-Atlantic cousins in the take up of alternative, or at least non-traditional, managers.

Additional rules on ticket sizes to avoid being the dominant investor in a relatively small fund, have also held some UK pension schemes back, Johnson says.

But by sticking to the Vanguards, BlackRocks and T Rowe Prices, what are most UK pension investors missing?

For Bryan Lewis, chief investment officer of Pennsylvania State Employees’ Retirement System, a long-time advocate of emerging manager programmes, it could be quite a lot.

The investment management world is not static or stagnant and we have to find the entry point to new ideas early.

Victor Hymes, Legato Capital Management

“Your fundamental portfolio belief should be that you can find and source top managers or those that have unique strategies that others cannot identify. Emerging managers fit into that profile,” he says. “All the good ideas are not had by just those managers that are in the largest companies. And often the talent in these smaller firms will spin out to create their own firms.”

There have been plenty of fund managers who quit larger houses over the years, and it stands to reason. Some people do not want to work for a massive organisation, others want to use the experience they have gained to do their own thing, others find they do not fit the mould of what a portfolio manager should look like.

A NEW BREED

Victor Hymes, chief executive of Legato Capital Management, partners large institutional investors with emerging managers. Hymes was instrumental in CalPERS placing of $150m (£117.6m) with UK manager SourceCap in 2008. The manager was bought by Hermes Investment Managers – then owned by the BT Pension Scheme – a year later.

“The investment management world is not static or stagnant and we have to find the entry point to new ideas early,” Hymes says. “The success of a manager can be measured on a J curve, but so many wait for the three or five-year track record only to find their chosen manager has begun to run out of steam.”

Johnson, who works with smaller managers in the UK, says that this need to wait for managers to build up a track record can stymie some of the enthusiasm some pension schemes on this side of the Atlantic have.

“There is more money flowing to emerging managers in the US as investors can allocate earlier in a lifecycle of a fund or company,” he adds.

This is the major sticking point for UK investors, but there are other challenges, too.

“It is an attractive area, but it is necessary to have enough staff or outside help to navigate the nuances of the sector,” Hymes says. “A manager could have very deep experience but has only just launched on their own – for an asset owner, it is hard to know who is working in this world.”

Unlike picking up a sales brochure or meeting on a stand at a conference, emerging manager programmes require investors to seek out entrepreneurs, who are unlikely to have connections all around the investor community. For a large investor, allocating £100m or even £500m can be time consuming and ineffective without the right approach, according to Lewis, who runs almost $30bn (£23.5bn) in Pennsylvania. He has used third parties to connect with emerging managers for years.

THE LEARNING CURVE

“Using a third party can be beneficial for both sides,” Lewis says. “Often, when people spin out of large firms, they have little experience of negotiation over fees and terms with the end investor. They often don’t know how to approach potential co-investment opportunities either.”

A third party can also help carry out the extensive due diligence needed before taking on any manager, but with special focus on those with a smaller operation and dedicated teams.

“The challenge for these smaller managers is often not getting to fulfil an investment strategy, but fulfilling regulatory requirements,” Lewis says. “The costs of starting a firm have increased from both a domestic and international perspective.”

However, this has meant that since the crisis, the level of regulation imposed on fund managers of all sizes has set a minimum standard across the board, according to Johnson.

But there are additional risks to consider, the first being whether the manager will even get over the line in raising enough money to start operating.

“Fund-raising is hard for smaller managers, but some have been willing to take seed capital,” Lewis says. “We have seen investors taking ownership stakes in new managers, which allows them to have constant exposure to this growth capital. It also offers more predictability and enables them to help structure deals.”

For long-term investors, succession planning is key and while Pimco might have had a well-publicised split with the founder, it has carried on regardless. Smaller managers might not have that option.

“The founders might be doing a great job, but how can the business keep going if and when they leave?” Lewis says. “It is a real challenge for emerging manager firms – and something that long-term investors need to think about.”

Trustee boards are also often unwilling to take on the perceived risk of working with a small company, Lewis says. “Lehman Brothers collapsed, but that was OK as everyone was exposed to them,” Lewis says. “It is different when it is a smaller firm. It is seen as taking a bigger risk.”

Lehman Brothers collapsed, but that was OK as everyone was exposed to them. It is different when it is a smaller firm. It is seen as taking a bigger risk.

Bryan Lewis, Pennsylvania State Employees’ Retirement System

Hymes points out that if you are using a custodian, your assets are secure if the company goes out of business. “More likely, they don’t want to have to admit to a failure if it doesn’t work out, but companies – in all industries – fail all the time.”

Therefore, due diligence is important when looking at relatively new or small managers. “You have to understand their process, so you will know why they are under or outperforming according to the part of the market cycle you are in and see whether it is real skill or just the market moving the assets,” Hymes says.

FINDING A GOOD FIT

For Gerald Alain Chen-Young, the former chief investment officer of the $1bn (£784.3bn) United Negro College Fund, it is important to consider whether they can offer you what you want from that strategy. “How do they fit within the asset space and existing larger managers? If your manager is doing long only or investing in a major asset class, that is relatively simple to do,” Chen-Young says. “If they are looking at global macro or something more esoteric, it is hard to get right without the minimum infrastructure. If the manager is small, it is unlikely that they will have the best IT platforms – they are very expensive and require significant personnel support.” And there are even more considerations for smaller investors, he adds.

“CalPERS can allocate 5% of its portfolio to emerging managers and if it loses or makes money, it won’t have a significant monetary impact on the overall portfolio,” ChenYoung says. “If you have $1bn (£784.3bn), you’re not protected in the same way. You have to look at whether it is responsible to allocate to an emerging manager.”

For Hymes, as active management returns to the fore after a decade of central bank life support dampening volatility, smaller managers are going to be key for investors to spot and execute on new ideas. Their nimbleness, due to their size, should allow them to get in and out of a market relatively quickly.

The flipside to Chen-Young’s argument is that identifying emerging managers requires an awful lot of effort for little initial difference in performance – but taking that view limits the value of these managers, according to their advocates.

“If you allocate $1m (£784,200) out of a $10bn (£7.8bn) fund, it is not going to move the needle,” Hymes says.

“But the right manager has an impact as they make you take a different view of your internal strategy and how you look at new ideas.”

Lewis at SERS says that patience, planning and forward-thinking was key.

“As an early investor, you can establish a relationship that will grow in line with the company and its assets to eventually become a meaningful part of a portfolio,” Lewis says.

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