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How LP's Can Use "Moneyball" to Hit a Homerun with Emerging Managers

Institutional investors such as Massachusetts Pension Reserves Investment Trust, WestAM Private Equity Group and the University of Texas Investment Management Co. recognize the need for a strong bullpen within their private equity portfolios and have allocated more than $6 billion for emerging managers, says Brett A. Nelson from Altitude Capital. The motivation was forced, in part, by the reduced allocations of many of the established "dream teams", resulting in smaller funds. For example, Spectrum Equity reduced their fund size from $2.5 billion to $1.5 billion.

Performance in this sub-asset class is potentially substantial and can add significant alpha to an institution's portfolio. The batting averages of the top quartile first time funds have outperformed the universe of all top quartile private equity funds over the past 10 years. As in all areas of investing, where there is significant return, there is significant risk. Utilizing some of the concepts presented in Michael Lewis' latest book, Moneyball: The Art of Winning an Unfair Game, can help focus on important characteristics when assessing a new emerging team.

Who is Billy Beane? - Talent Scout

Michael Lewis, author of Moneyball, describes the story of Billy Beane, a supertalented professional baseball player who never achieved the success, as a player, that was expected of him, but who, as a general manager of the Oakland A's, was able to divine the critical characteristics in recruiting players and assembling winning teams with the lowest budget in the league. Beane is the first General Manager to build his organization around Sabermetrics. Sabermetrics is baseball data that indicates, from a statistical point of view, the important attributes needed to win baseball games. Beane questioned conventional wisdom and recognized that the statistics of stolen bases and batting averages were not nearly as significant in winning games as on-base percentages and number of walks. Beane would seek players who knew how to get on base, hitters who could push an at bat to over ten pitches, and players who would tire the opposing pitcher and come away with a walk or base hit. He would find players who the more popular "statistics" indicated would not be major contributors to the team. He would acquire these generally perceived "non-star" players for modest salaries. How can an LP use Beane's approach to select an emerging manager?

Selecting All-Stars

Baseball scouts use a checklist of "tools" to evaluate potential players including the ability to throw, run, field, and hit with power. Similarly, when a general partner of a private equity fund is being evaluated, skills, including the ability to source a deal, finance/syndicate the investment, add operational value-add, position it for an exit, and generate a strong IRR and cash-on-cash return are reviewed.

The qualitative and quantitative process followed in analyzing an emerging manager opportunity is not unlike analyzing the investment thesis of a group who has been together for several funds. The key is to understand the risk/return relationship. Clearly, getting comfortable with the unique risks of an emerging manager requires additional exhaustive steps, including validation of a verifiable track record, assessing the compatibility of the GPs with issues of investment strategy, understanding the groups economics, achieving a comfort level with their decisions, ensuring proper corporate governance, and adequate reporting policies and procedures.

The economic parallels of an emerging manager who typically raises a small, first time fund and the constrained budget under which Billy Beane was forced to operate are strikingly similar (no pun intended). Billy Beane needed to be both contrarian and creative in order to build a winning team. An emerging manager is working under similar constraints since an emerging fund is typically smaller and provides less of an annual management fee. This results in less flexibility to hire staff to source deals and perform due diligence. Additionally, there is less capital to be deployed which requires the investments to be more exacting.

When the Oakland A's evaluated hitters, they liked to see high on-base percentages, players who would go deep into the count and have good walk-to-strikeout ratios. The preferred player was one who would swing only at pitches that were in his comfort zone, ignoring every other pitch, including those that were clearly strikes. Warren Buffet would often use a similar analogy. He would only invest in companies which he perceived had a "circle-of-competence".

An emerging manager needs to have this mentality of looking for the right pitch, one that fits his strategy, sector and stage. Having the fortitude and patience to grind through hundreds of business plans is key to ensuring he swings only at the pitch which captures his "circle of influence" and provides the most attractive risk-return relationship.

The financial equivalent of an emerging manager that draws a lot of walks would be a manager that sticks to a strict valuation policy. A manager that avoids the temptation of justifying a valuation based on a price-to-burn rate or price-to-eyeball metrics is important. Ignoring the "new economy" rhetoric, and realizing that an asset at some point must generate positive free cash flow, will ensure the company has a higher probability of contributing to the cash multiple of the new fund.

Billy Beane required his new players to play a stint in the minor leagues to ensure they had the all the pieces in place before they went to the "show". Being cautious with a new player accomplished two things: the player could absorb the Oakland A's approach without being under the bright lights, and Beane could vet his thesis on the player. Similarly, an emerging manger should cautiously invest in a company. Judiciously allocating capital provides further insight as to whether the perceived pieces of the puzzle of a company really do fit together. Besides the potential for excess returns, why else would an LP want to invest in an emerging manager?

Homeruns

Institutions recognize that an emerging manager program can be complimentary to their core private equity investment program. An emerging manager program can enhance the absolute return of the portfolio, diversify by equity manager and strategy, access a segment (smaller funds, spin-out funds) where they may have had little or no exposure, and establish early relationships with groups who may evolve into the new generation of "dream teams".

The advantages that an emerging private equity fund has include: the enhanced ability to negotiate valuations in smaller companies (as compared to larger funds with larger companies), the more significant multiple arbitrage afforded in a smaller company investment (due in part to the higher growth potential), and the enhanced exit environment (provided by the large number of mid- and large buyout, and later stage venture investors who are seeking investment opportunities).

Limited partners in an emerging private equity fund benefit in many ways. The General Partners interests in emerging funds are better aligned with their Limited Partners, since they are primarily motivated by the carried interest, and less by the management fees when compared to groups who have been around for several years. Significant institutional investors may also be able to access more favorable terms, since their anchor commitment can be a stamp of approval for other less active institutional players (providing a lead investor significant bargaining power). In addition, the GPs in an emerging fund are motivated to perform given the enhanced economics of being a founding GP, the importance of establishing a strong track record for future fund raising, and the issue of reputation and ego. What are the fastballs an LP should look for?

Strikeouts

Institutions clearly recognize the enhanced risk of striking out with an unproven, newly formed emerging manager. The degree of heavy-lifting and due diligence required to analyze an emerging manager is significantly higher than allocating capital to a top tier group with a historically strong track record and continued robust story.

The risks related to an investment in an emerging manager include: the newly formed partnership may not function smoothly relative to investment strategy, the focus of each of the GP's may not be clearly defined, and the allocation of the economics may require further refinement. In addition, decision making within the group may not be completely battle tested. Finally, general compatibility among the GPs, inadequate reporting policies and procedures, and related corporate governance are potential issues.

Winning Season

Oakland's success is very similar to the concept of strategic fit which was developed by corporate theorist Michael Porter. Porter believed that every part of a business is tightly linked with every other part, creating a chain that is only as strong as its strongest link. You achieve strategic fit when you have a clear sense of what you are, and what you are not. Billy Beane knew that the organization could not afford a dream team, but instead used statistical analysis to identify those characteristics in players that were most important in developing a winning team. The characteristics he sought and used were clearly contrarian to the recruiting ideas of the rest of the league.

The emerging manager equivalent of the characteristics that Beane looked for in his players, including high on-base percentage (being patient and only swinging at companies that fit his strategy, sector and stage), drawing a lot of walks (maintaining a strict valuation policy and not slipping into new-age valuation techniques), and playing in the minor leagues first (judiciously and slowly investing in a company) are important characteristics in particularly evaluating an emerging manager.

The concepts and characteristics used by Billy Beane to develop his winning teams are highly adaptable to evaluating an emerging manager team. The importance of these concepts is heightened given the similar economic constraint that a small emerging fund would have with that of a major league team on a tight budget. Following the approach used by Billy Beane in analyzing a new player to that of an emerging manager should yield more hits and further assist in identifying the new and emerging "dream teams".

Brett A. Nelson is the founder and a managing director of Altitude Capital, LLC., a Denver-based private equity advisory firm that specializes in providing consulting and subadvisory services with a focus on identifying the new emerging and "spin off" managers, as well as unique secondary and direct investment opportunities. Prior to forming Altitude Capital, he was a Principal at INVESCO Private Capital. Nelson has more than 17 years of corporate finance, hedge fund asset management, private equity investing and consulting experience. bnelson@altitudecap.com