Emerging managers, also known as boutique managers, are smaller or newer managers that often go unnoticed because they do not meet the typical screening criteria applied to a manager universe. However, not all advisors and consultants rely solely on a screening process and are introduced to new and talented managers through referrals and other means.
The upside of investing with emerging managers is often framed from the perspective that many have a niche focus, are nimble, and possess attractive employee-owned firm structures. Not to mention the negative forces that capacity and risk management have on a portfolio manager’s flexibility and performance objectives at larger firms.
There are, however, often trade-offs. As we all know, some emerging managers never actually “emerge” and promise does not always translate into results. Here’s our advice on how to address three common due diligence challenges related to emerging managers.
Challenge One: A Low Asset Base
The first priority with emerging managers is to closely evaluate the financial stability of the organization, a concern that is almost immediately triggered by an insignificant asset base. Will this manager be in business three years from now, or even next year?
Gain a clear understanding of the firm’s business plan with a specific focus on asset gathering goals, current revenue structure, distribution channels, and working capital. Working capital and the ability to maintain a robust budget are critical criteria in the evaluation process, as it may take several years to reach profitability. In addition, it is critical to conduct due diligence on the firm’s back-office operations to ensure proper compliance, trading, and risk oversight.
To help illustrate this challenge, here is an example: In 2009 we evaluated Elessar Investment Management, a $20 million small cap value manager (at that time) founded in 2006. While the firm had a very small asset base, the “ongoing concern” risk was mitigated by an equity investment by Northern Lights, which provided enough working capital to survive for the next several years at 2009 asset levels. Although Northern Lights provides an extra layer of comfort, it is still essential to review the monthly budget, audited firm financials and firm’s growth plans under different scenarios.
Challenge Two: Limited Personnel Resources
As many independent RIAs can relate, demands are high and resources are light at the start of a new venture. The portfolio managers have to prove that they can manage and build both a business and an investment portfolio.
Check to see if the portfolio manager has created, or has plans to create, some delineation of investment roles and business roles. It is unreasonable to expect significant research analyst support at a boutique shop, though it shouldn’t be a one-man-band either. In the case of Elessar, they were able to leverage Northern Lights industry experience and contacts to enhance distribution channels, in addition to strategic consulting on marketing, operations, technology and best practices, thus freeing up the manager to focus on their core competency: managing the money.
As always, it is also important to understand the personal background and financial commitment of the key personnel at the firm. This is normally a strong suite for newer firms as many of the portfolio managers have a strong pedigree and an entrepreneurial nature. Elessar is no exception. Rick Giessen, Elessar’s portfolio manager, has over 20 years of experience investing in the small-cap value asset class, so this part of the evaluation was fairly straightforward. Also, it was reassuring to see that Elessar’s principals have significant ‘skin in the game’ with sweat equity and personal net worth invested in the strategy.
Challenge Three: Limited Performance Track Record
As most emerging managers have limited performance records to evaluate, the ability to conduct quantitative analysis poses an additional challenge. To overcome this obstacle, consider portfolio managers with previous experience applying a similar investment philosophy at a prior firm, accounting for the differences in personnel and technology resources. If a prior track record is not available, the current performance record must be reviewed with additional care, adjusting for asset size and the market environment.
To better understand Elessar’s performance, we studied Mr. Giessen’s previous results from Munder and National City, which involved not only looking at the returns, but also going over those portfolios to confirm that the process and philosophy are consistent with Elessar’s. To help further validate the consistency and repeatability of the process, we reviewed a 10-year back test of the firm’s Quality at an Acceptable Price Model (QAPM), which was provided by an independent third party.
More often than not, investors search for firms with long track records and sizeable assets under management due to the uncertainty and business risk associated with the three challenges we discussed. However, with additional due diligence on your side, the benefits of exploring undiscovered managers can outweigh the challenges. After all, emerging managers can help differentiate your practice, support your value proposition, and expand your opportunity set when seeking investment quality for your clients.