“I Love Other People’s Due Diligence.”
This flippant comment came from a reasonably famous investor we met a few years ago. He was describing an investment he was excited about. He hadn’t dug into the details but felt comfortable piggybacking off of the work of a private equity firm that was leading the deal.
As he explained his logic, it generally made sense. The lead firm was credible and running a thorough investment process. And from his vantage point as manager of a diverse global portfolio, the investor could compare the investment to a wide range of alternatives and see that the investment was priced attractively.
But potential misalignment among the investor group struck us as a red flag. The investor and the private equity firm were casual acquaintances with distinct investing styles. If the investment experienced some early problems, their differences with respect to time horizon, appetite to fund additional capital, and ability to understand company-specific problems could create tension or even paralyze the group. While invited to participate in the investment, we declined.
Our decision to pass notwithstanding, the investor’s comment about other people’s due diligence contained an important kernel of wisdom that comports with one of our core beliefs: In investing, as in much of life, the ability to properly rely on the work of others is a key to world-class performance. But getting it right is often a lot more complicated than it looks.
At East Rock, 15 years of forming partnerships with a wide variety of investment managers has taught us some valuable lessons about alignment. During this time, we have paid close attention to the motivations that drive the people around us, which has helped us understand the following:
- Incentives are easy to misjudge.
- Alignment behavior is often correlated with stage of career.
- Skin in the game matters—but not all skin in the game is created equal.
- Long-term aligned relationships can create superlative—and personally gratifying—results.
Incentives Are Easy to Misjudge
Before we discuss our own experience with incentives, a story. In 1998, two economists ran an experiment in Israel.
They were trying to get parents to pick up their children on time from Haifa’s day care centers. Haifa’s day care centers close at 4 pm, but parents were not penalized for showing up late. The economists directed six out of the ten participating centers to impose a fine for tardiness that, they hoped, would motivate delinquent parents to arrive on time. The experiment backfired. The number of parents who reported late to pick up their children more than doubled. It turned out that having to apologize to a day care worker exerted a more powerful hold on parents than money. Rather than reducing tardiness, the fine allowed parents to view late arrival as a legitimate option purchasable by money.1
At East Rock, we remember from many years ago an unfortunate surprise when incentives didn’t work as expected. In 2007, we committed capital to several private equity funds. It was planned at the time that the fund managers would deploy the capital over 4 to 5 years, i.e. between 2007 and 2012. As with most private equity funds, the managers were incentivized to deploy the capital fairly rapidly in order to begin earning carried interest on the funds’ investments. They were further incentivized to invest quickly because full deployment would allow them to move on to raise successor funds.
Despite these incentives, the problem with these funds did not turn out to be overly rapid deployment, but its opposite. The financial crisis that emerged in 2008 resulted in a period between 2009–2010 that offered some of the most attractive investment opportunities we at East Rock have ever seen. It should have been a prime moment for the private equity funds to deploy capital aggressively. But during this period only 35% of our private equity fund commitments were deployed. Why? It turned out that the funds had a number of investors who asked the managers to hold back. The investors were concerned about the liquidity and risk in their own portfolios and wanted the private equity managers to wait. The managers were under no obligation to do so, but they generally agreed. With the benefit of hindsight, we now know that this pressure, and the managers’ willingness to bend to it, resulted in a failure to take advantage of an unprecedented opportunity set.
Alignment Behavior is Often Correlated with Stage of Career
Each year we meet hundreds of investment managers. A striking pattern we see is how younger managers tend to be more focused than their more mature peers on alignment with their investors. Whether driven by the idealism of youth or a rational desire to create tight-knit investor relationships that can propel their careers, aligned behavior tends to be stronger among younger managers.
As with parents and daycare pick-ups, alignment between hedge fund managers and their investors can be hard to judge. At the launch of a new hedge fund, it is desirable for a manager to invest a substantial amount of personal capital in his/her own fund to share risk and reward with outside investors. However, as the fund succeeds, the manager typically accumulates a larger amount of personal capital and a valuable base of fee-paying outside capital. While nominally better aligned—the manager’s personal money often grows to represent a larger percentage of total fund assets—the manager has more to lose and may enter a new stage in which aggressiveness declines, often in contradiction to the goals of investors.
A recent study of 2,345 hedge funds found evidence of this evolution. It concluded that more experienced hedge fund managers tend to be rewarded with more capital for weighting their portfolios in favor of popular investments.2 Once managers have built a positive reputation, they can often protect their capital base by simply doing what everybody else does.
Knowing this, it is not surprising that data on hedge fund performance is fairly conclusive that younger hedge funds do better. A Preqin study on performance between 2012 and 2019 showed the following:
New hedge funds beat older funds by 3.7 percent on a three-year annualized basis, and outperformed by 4.6 percent over five years. In fact, hedge funds early into their lifecycle beat more established funds in every year included in the study.3