What We Believe: The 10 Ps of Manager Selection – Partnership
When we invest with a manager, we seek to create a partnership where both parties can enjoy mutual success and are aligned with client outcomes. Thus, we tend to partner with owner-operated, employee-owned investment boutiques where the manager is investing alongside us.
The first component of partnership that we look to is a firm’s ownership structure. Generally, we seek to partner with organizations where the investment principals and key decision-makers have a large ownership stake in the firm. We have found that firms with this structure tend to have a client- or investor-first mentality. Outside ownership can sometimes create incentives to focus on assets under management (AUM) growth instead of long-term investment performance.
We also look to incentive structures to assess if firms are focused on long-term performance, which is aligned with our clients, or AUM growth, which tends not to be aligned with client success. Put simply, the incentive structures should properly align with clients’ interests. We dive deeply into a firm’s compensation structure to ensure the team is incentivized to focus on long-term results. We also probe to see if a firm’s economics are broadly shared among the team. Structures where owners take the vast majority of a firm’s gains without sharing them with the rest of the organization are destined to have difficulties attracting and retaining strong talent.
In addition, we tend to invest with managers that compensate their teams based on overall portfolio performance rather than solely based on individual profits, which can create adverse incentives. Fee structures are also an important partnership consideration. We look for structures that are thoughtfully designed and are reasonable in light of the strategy and resources needed to operate the firm effectively. At BBH, we seek to generate attractive after-fee (and after-tax) results, and therefore seek to partner with firms that have fee structures conducive to that goal.
In addition, we look for managers who “eat their own cooking” – that is, who are invested alongside our clients. We expect the key decision-makers of any firm to have much of their liquid net worth invested in the strategies they lead. If they are not invested in their own strategies at size, we do not think our clients should be either.
There are several academic studies that provide evidence of the importance of managers investing in their own strategies. For instance, an Alternative Investment Management Association Journal article, “How Some Hedge Fund Characteristics Impact Performance,” found that managers who invest their own capital in their funds tend to outperform. And in a recent National Bureau of Economics research paper, “Skin or Skim? Inside Investment and Hedge Fund Performance,” the authors found that “funds with more inside investment outperform other funds within the same family.” In these cases, the firms made the appropriate “managerial decisions to invest capital in their least-scalable strategies and restrict the entry of new outsider capital into these funds.” To us, this evidences the power of incentives. When investment managers have a significant amount of their own net worth invested in a particular strategy, they have extra incentive to constrain the growth of assets, which is likely dilutive to long-term performance.
When meeting with prospective investment managers, we like to see that managers have conducted due diligence on us, just as we are conducting due diligence on them. This is yet another sign that a manager is not just looking for capital, but for a true long-term partnership. In the beginning of our relationships with many of our fund managers, we noticed that they proactively read many of our past publications on our investment philosophy, such as “What We Believe: BBH’s Principles of Investing,” to get to know us better. These managers also conduct extensive references on our team members and firm. This not only signals that they are thorough, but also increases the likelihood of true partnership.
Finally, we also look to invest in managers who have like-minded limited partners. We are encouraged when an investment manager has attracted other investors who are long-term-oriented, exhibit patience, and have conducted deep research to understand what makes that particular manager special. This diligence is what gives allocators the conviction to stay invested during inevitable (short-term) periods of underperformance. Being invested alongside investors who do not approach partnership in the same manner often creates distractions for the investment manager, taking time away from the investment research process when it is most critical.
We appreciate when investment managers seek a true partnership with their investors, choosing relationships with limited partners on the basis of the value they can bring outside of just capital. We believe great clients make for great investors; therefore, we aim to be the best client to each of our managers, as well as to ensure that those who are invested alongside us think in ways that will enhance the investment manager’s probability of long-term investment success.
Click here to learn more about our other nine Ps for evaluating our partners.