Beware the parallels between smaller restaurants and asset managers. By Angelo Calvello
The New York Times reports that “large chains and well-funded restaurant groups have the resources to ride out a protracted shutdown, but the independent restaurants that make up about two-thirds of the American dining landscape — noodle shops, diners, and that charming urban restaurant that always had a line out the door — may not survive. . . . 75 percent of the independent restaurants that have been closed to protect Americans from the coronavirus won’t make it.”
The pandemic will have a similar effect on the asset management business. As could be expected, large, established managers will weather the storm. Many independently owned active managers, however, will be forced out of business — some because of poor performance, but others who generate good returns will also shut their doors because of cash-flow problems.
Allocators are already saying that they are postponing fund decisions; the slurry in these managers’ sales pipelines is drying up. Despite having built solid businesses that put up good numbers, without new business and the associated revenues, they will have to cut their already lean staffs and, soon thereafter, close for business.
Their loss is our loss too.
Unlike 2008–2009, when the cause of the market meltdown was at least industry-related, today these entrepreneurs who risk everything to create better investment outcomes for clients and their beneficiaries fail for no fault of their own. And these are the managers — especially emerging managers — that tend to outperform their more established peers and produce the alpha we so desperately seek.
We need to help these managers. I’m not suggesting a government bailout (although these managers should take advantage of such programs).
No. This is the time for forward-thinking allocators — especially those CIOs who have won all of the industry innovation and lifetime achievement awards — to realize that, as Gideon Lichfield writes in the MIT Technology Review, we are not going back to normal. It’s time to immediately step up and invest with these managers — especially the emerging managers — that are in the most precarious position.
I’m not suggesting these allocators weaken their fiduciary standards and make imprudent investment decisions. Quite the opposite. As Institutional Investor columnist Christopher Schelling told me, we should not let a good crisis go to waste. Just as the COVID-19 crisis is revealing both shortcomings and new possibilities in civil society (e.g., the U.S. healthcare system and universal basic income), it is revealing weaknesses and opportunities in our current allocation process. Here are three changes we can make to this process that will bring immediate relief to these managers:
- Open up the allocation window, specifically for emerging managers. Even modest allocations that might not move an allocator’s proverbial portfolio performance needle are incredibly important to these managers on multiple levels.
- Change your selection criteria. For example, be more flexible with the assets-under-management and track-record-length requirements. The crisis makes clear their arbitrary and punitive nature.
- Change your manager diligence process. Let’s begin by admitting that our kabuki dance with managers is generally ineffective (just ask Fund Evaluation Group how well this process worked in its selection of Malachite Capital Management) and potentially harmful.
Today, we see clearly the mandatory and multiple face-to-face manager meetings and physical site visits are an unnecessary luxury. The same objectives could be achieved more cheaply — with the appropriate social distancing and with a much smaller emissions footprint — by using technology.
Let’s take advantage of this health crisis and make all these video calls more robust by introducing a new protocol: Record and archive every video conference, and later apply emotion recognition artificial intelligence to discern possible hidden insights from each manager’s speech and body language. And let’s admit that given the contagious nature of COVID-19, the co-location of key employees might not be the ideal work structure.
Because of the exigency of the moment, there is no time for managers to complete and allocators to review the required 460-question due-diligence questionnaires. Allocators can effectively compress and expedite the decision-making process by literally interrogating managers. Just ask them on those video calls the most uncomfortable but relevant questions. They should also speak with current and former clients and services providers about their experiences with the manager. (Hiring a private investigator can also expedite the diligence process.) Set a high pass/fail bar.
Admittedly, these changes in criteria and techniques expose allocators to more business and investment risks — so emerging managers must mitigate these risks by adopting a posture of extreme transparency. No more coyness and secrecy; answer the questions quickly and honestly and provide whatever information allocators request. This means not just historical daily returns, but also daily trades and positions, employment contracts and nondisclosure agreements, business financials and burn rate, security procedures, and sales pipeline.
And, yes, be prepared to explain the secret sauce.
Managers and allocators should explore alternative fee structures, liquidity terms, and vehicle structures that align with and protect the interests of both parties. In 2019, we might have called these alternatives concessions; today, they are necessities.
However, allocators should not use the manager’s precarious position to their advantage. If this is to work, it must be a genuine partnership. In fact, this crisis is turning our current strategic-partners paradigm on its head: It is now the allocators that are the active partner, providing managers with not only capital and preferential fees and terms, but also much-needed knowledge transfer related to governance, financial management, human resources, and strategic planning.
Managers, like their restaurant counterparts, must also be prepared to pivot to different business models, including their own iteration of carry-out: creating investment signals that allocators would take and implement internally. Allocators too should be flexible and consider investing directly in a manager’s business (I like to think of this as a gift-card allocation).
Over the past five years, through inflows and merger-and-acquisition activity, we’ve seen a concentration of assets across asset classes in the largest managers. In this time of crisis, we should expect this “flight to quality” to continue.
However, given a substantial body of research shows that as assets under management increase, performance erodes — and the fact that these larger managers have shown little interest in creating innovative investment processes or adopting new technologies — we should expect that this consolidation will fail to provide us with the investment outcomes we seek and the innovation we so desperately need.
We are on the brink of losing a generation of new managers — managers with different skills, diverse backgrounds and experiences, and novel approaches to solving investment problems.
Allocators love talking about how they are long-term investors. Now is the time to demonstrate that by investing in these managers of the future. Without such bold action, we will be left with the equivalent of “large chains and well-funded restaurant groups.” And I don’t know about you, but after suffering the physical and financial hardships of this pandemic, I think we deserve better than Applebee’s.