Emerging managers | Feature


community. For a large investor, allocating £100m or even £500m can be time con- suming 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 peo- ple 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 tak- ing on any manager, but with special focus on those with a smaller operation and dedi- cated teams.


“The challenge for these smaller managers is often not getting to fulfil an investment strategy, but fulfilling regulatory require- ments,” Lewis says. “The costs of starting a firm have increased from both a domestic and international perspective.” However, this has meant that since the cri- sis, 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 manag- ers, but some have been willing to take seed capital,” Lewis says. “We have seen inves- tors taking ownership stakes in new man- agers, 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 plan- ning is key and while Pimco might have had a well-publicised split with the founder, it has carried on regardless. Smaller man- agers 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 eve- ryone was exposed to them,” Lewis says. “It is different when it is a smaller firm. It is seen as taking a bigger risk.”


forms – 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,” Chen- Young says. “If you have $1bn (£784.3bn), you’re not protected in the same way. You


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 manag- ers. “You have to understand their process, so you will know why they are under or out- performing 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 plat-


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 man- agers are going to be key for investors to spot and execute on new ideas. Their nim- bleness, 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 ini- tial difference in performance – but taking that view limits the value of these manag- ers, 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.


Issue 84 | May–June 2019 | portfolio institutional | 37


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