Fund manager due diligence: Culture club

The alternative investment team at Goldman Sachs Asset Management has an open-door policy: any private equity manager that wants a meeting, gets one. The team saw 1,528 GPs last year. In doing so, it heard a lot of stories. The challenge is decanting objective insights from the understandably self-serving narratives espoused by managers pitching for allocations.

All the different pieces of data – track record, professional and personal history, macroeconomic environment – are bound up in a presentation, which means LPs are to a certain extent guided towards a certain conclusion by the GP. “The manager presents all of the facts in a narrative that makes sense, a narrative that usually has an emotional response, and which usually results in the manager being the hero,” Chris Kojima, global head of Goldman’s alternative investments and manager selection group, told last week’s AVCJ Japan Forum.

He believes this potentially exposes LPs to a series of biases in their decision making. Notably, like most humans, they have a confirmation bias (placing more weight on evidence that confirms things they already believe) and an availability bias (wanting to believe what is in front of them). The solution – one which many LPs claim to pursue – is to get granular. By collecting a series of data points pertaining to the manager over an extended period, it is possible to create a scoring system that underpins meaningful assessment.

Goldman also studies approaches to value creation (whether the manager embraces the come prepared, start immediately model; how it leverages resources across its platform to drive growth in a business) and applying technology (how the manager uses data in its investments now; how it expects to use data in the future). All these elements come together in due diligence so there is no need to become overdependent on track record during a due diligence process.

Kojima’s view is that track record is an incomplete signal. It is the product of three things – investment team, macro environment, and competitive landscape – and they must remain in balance if yesterday’s track record is going to be any help in predicting performance over the life of a fund. “What we are talking about is 10 years of balance between these three factors leading to continuance into the 2020s. It’s a very challenging proposition,” Kojima said.

The most intriguing aspect is the team, which comprises individuals who are every bit as human as the LPs assessing them and therefore equally susceptible to inconsistency. Private equity firms often like to talk about their institutional qualities, but people lack the robustness of institutions: they don’t have infinite lifespans, they are not environmentally resistant, they tend not to have ironclad constitutions and governance. So, can they create a sustainable ethos that is more than the sum of their parts?

Goldman asked 100 of its larger portfolio GPs what they thought was the key reason for talent leaving their organization. The top response was culture fit. Assuming culture underpins institutionalization – it helps bind together a group of gifted individuals – LPs must try and understand the dynamics. This already happens on an ad hoc basis: think about the LP that seeks out junior team members and quizzes them on job satisfaction, motivation, and self-progression. The difficulty is taking human qualities and plugging them into a scoring system.

There is no correct way of doing this and some LPs would still swear by gut instinct. But Goldman’s efforts have generated a couple of interesting observations. First, once an investment professional achieves a certain level of net worth, rivalry and legacy can become bigger motivators than economics. Second, private equity firms are often built around a single great investor, but once an organization grows, that individual’s role changes to that of risk manager, talent developer, and torch carrier. The best CIO doesn’t always make the best CEO.

Smaller Asian GPs are routinely labeled non-institutional, which is sometimes freely interchanged with un-investable. It is a catch-all for a multitude of sins: youth, insufficient track record, weak internal systems and governance, limited bench strength, piecemeal efforts to share the economics throughout the team. The cultivation of a strong culture can rectify these shortcomings. An LP’s ability to spot a potential winner rests on identifying whether the ingredients are there and the recipe is being followed. 

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• Topics
• Fundraising
• LPs
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• Fundraising