Monday, February 4, 2013

The Limits of Cooperation

The Limits of Cooperation

As a professional investor, I always got a sour taste in my stomach when I discovered that a lot of other investors were pursuing similar strategies or hiring the same managers.  The worst such feeling came when I attended the National Association of State Investment Officers.  Fifty or sixty of us would sit in a huge circle; each taking five or ten minutes to explain their investment strategy and key initiatives.  This was one meeting where I took notes instead of drawing, and worried when too many of my colleagues began describing the strategies we’d designed for North Carolina. 

Business Board (2008)

Generating investment results is a competitive endeavor.  There are only so many superior strategies and managers, and if you share your insights and access too freely your edge will disappear.  Every investor is seeking to generate a return greater than the benchmark.  This incremental return, known as alpha, has a finite supply.  One investor’s positive alpha must be offset by another’s negative alpha.

There are plenty of areas where institutional investors should be cooperating, but ironically, they tend to do a poor job acting collectively when they should.  I’ll leave the areas ripe for cooperation to tomorrow’s post, and stick to the competitive aspects of the business, where investors tend to over share.

Suppose you’re interested in hiring a real estate manager to manage property in Asia.  After extensive due diligence you unearth a candidate.  While you want the manager to have enough money to implement the strategy, you don’t want him to have too much.  If you go about sharing your due diligence too widely, you might just find that you’ve done a better job than the real estate manager’s marketer in attracting investors to the fund.

Moreover, when you’re first evaluating a money manager, asking who else has invested is one of the worst questions you can pose.  For example, if you find out that the Yale endowment or another quality investor has signed up for the Asian real estate fund, you might conclude that the “smart money” has endorsed the product and fail to do your own homework.  The so-called “smart money” makes plenty of mistakes.  In short, investing in what others have chosen isn’t a great strategy. 

Once you’ve done your own assessment, it’s okay to check out who else has signed on.  If no one has committed, then may be you’d better do some more homework to make sure you didn’t miss something in your due diligence.  Conversely, if the fund is attracting gobs of capital from investors, you might want to reconsider your decision.  One of two bad things can happen when a fund attracts too much money.  The manager might decide to take all the money being thrown at him and expand the fund.  While he’ll get even richer on the management fees, the fund will probably be too big to generate decent returns. 

Or if the manager remains disciplined, you may wind up with such a small allocation to the fund that it’s hardly worth investing.  For example, our Asian real estate manager might maintain a $500 million limit on the total size of the fund, but only allow you to invest $25 million, instead of the $50 million you’d originally intended.
On more than one occasion, I’ve declined to invest with a manager when the proposed allocation became too small. 

In one infamous situation, a private equity manager tried to cut North Carolina back from $100 million to $70 million because the fund, our second investment with the manager, was oversubscribed.  The State of North Carolina had just hired a consultant to help pitch in because I was departing the scene.  It turned out that the manager had allocated $25 million to the consultant’s fund of funds.  The consultant had piggybacked on our due diligence and the relationship we’d built the manager.  Not wanting to offend the consultant, the manager had given the consultant part of our allocation.  After chewing out the consultant, I called the manager and told him our new allocation to his fund was zero.  For about twenty-four hours, it looked like our relationship with the manager was over.    Late the following day, I got a phone call from the firm’s founder, confirming our $100 million allocation.  The consultant also got his $25 million, but lost North Carolina as a client shortly thereafter.  Unfortunately, other investors were cut back to make room for the consultant’s fund of funds.

When investors share too much, they’re playing poker with all their cards showing.  The odds of achieving success in investing and poker are long in the first place.  Sharing your cards, especially your best ones, virtually eliminates your chances for success.

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