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March 14, 2011 at 06:31 AM
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
