A Strategic Allocation to Newer GPs

By John-Austin Saviano, Managing Partner, Cyan Capital Partners

I have spent most of my career working with or for mission-driven pools of capital such as foundations, colleges and universities and gotten to know many peers with similar experience in the pension world. Most people drawn to this world love the intellectual challenges of the investment work, and also the seriousness of purpose that comes from being a fiduciary. It is personally satisfying on multiple levels.

The fiduciary mindset is often one of defense. Protection. Investment committees often gravitate toward a “do no harm” posture which, while understandable, can work against the practice of investment management that actually requires the taking of well-reasoned risks.

One manifestation of this mindset is favoring established managers versus newer firms. I’ve even seen an institutional limited partner (LP) have an outright prohibition on backing managers before their Fund IIIs.

This note takes on that notion and posits that fiduciary duty actually compels us to embrace innovation as a necessary tool in meeting our financial goals. Newer managers can provide this enhancement and many other benefits to an institutional portfolio.

We note that:

• Failure can happen very conventionally, even investing in very established firms
• Outsized performance is hardly ever driven by large, established firms
• New thinking can generate less correlated streams of alpha
• LPs can gain greater conviction and higher capacity in newer firms, reducing sprawl in a GP roster

Embracing innovation requires an institutional openness to new ideas and a culture of appropriate risk taking.

A Nudge in the Right Direction

Academic institutions are hotbeds of innovative thinking across almost all disciplines. Except for the management of themselves. Entrenched practices can be hard to shake in colleges and universities.

To combat this rigidity, a major university I know requires at least 1% of each departmental budget to go to a new purpose every year. It’s not a lot of change, but breaks the logjam holding back new ideas and areas of inquiry. And, over a full decade, this means at least 10% of spending will be different from a decade prior.

That kind of mandated refresh — even a small one — embeds a change mindset into every year. There is always a budget for new ideas and a requirement to cut some old ones.

Institutional portfolios, like university budgets, can get stale and entrenched. It is all the more perilous for LPs because the investment world changes on a faster pace than the academic world, and the consequences of obsolescence are more brutal.

Backing conventional ideas and established firms can feel comfortable, but that very comfort is a risk that can come back to bite you.

Failing Conventionally

0.08x

As a total-value-to-paid-in for a private capital fund, this is a hard number to achieve, barring fraud.

Nevertheless, this multiple is a real outcome for a fund that scores of high-profile institutional LPs have in their track records. I know, because I share the dubious honor of membership in that club, having been the CIO who approved an investment in this ill-fated fund.

Under my watch as CIO for UC Berkeley[1], we backed a lot of younger/smaller firms. We had a remarkable team that was capable of evaluating newer firms, and those efforts contributed significantly to our investment results.

We did many conventional things too. This fund with a double-digit Roman numeral was one such conventional thing, meant more as a way to add “exposure” to our portfolio of a particular asset type than as a high conviction stand-alone idea.

We did as much work as a small (<1%) newcomer LP to a very established firm raising a high Roman numeral fund could do, but there was only so much access and insight our small check would get us in the context of an oversubscribed multi-billion dollar fundraise.

Despite the firm’s long track record and its blue-chip roster of institutional LPs, this fund went down in flames, crushed by a mix of leverage and changing market conditions.

I’d like to think the demise wasn’t predictable at the outset, and perhaps it wasn’t. It is most accurate to acknowledge that I was willing to invest despite not getting to know they firm as well as I could have had it been a younger/smaller firm. No doubt we took too much comfort from a long track record and the extensive pedigree of the other investors, and we failed alongside all of the other LPs in the most conventional way.

As an institutional LP, I have backed some real winners, dodged a few bullets, passed on future gems and once got creamed by the fund described above. Finding the gems and avoiding the disasters requires the right mindset, tools and governance and will result in a portfolio that is better able to adapt to a changing world.

Benefits From Backing Newer Investment Firms

Backing investment firms earlier in their lives creates opportunities for greater GP-LP alignment, securing capacity in a fund, closeness, insights and, most importantly (!), greater investment results.

Alignment

The founders and early employees of a new investment firm are most typically taking the biggest risks of their career. In front of all their friends and peers, they are often leaving a comfortable seat to take on the challenge of building something better. The stakes are incredibly high, both personally and financially.

In these moments, we find teams that have “burned the ships” and are committed to their new enterprise with a hunger and drive that will be unmatched in their careers. Backing firms at this stage means LPs can benefit from the full and undivided efforts of an ambitious and hungry team.

Capacity

What is of greater use to an institutional LP, a new relationship with an equally good Fund I or Fund VI?

If the investment results are the same, the LP will likely have gotten a much larger allocation to that Fund I than as a new investor in the Fund VI. Fund Is are much less capacity constrained, and the competition is lower as few LPs have the resources required to back Fund Is.

Conversely, consensus “no-brainer” Fund VIs are well known to the market and are often very capacity constrained.[2] As a result, the actual dollar impact to the institutional LP’s portfolio can be far greater from finding an equally good Fund I. Further, by backing a firm early, the LP is much more likely to be able to maintain or expand its allocation to future funds that may become capacity constrained.

Many LPs share the goal of condensing manager rosters with larger allocations to high conviction ideas, and this can be achieved by spending time/resources in backing more firms earlier in their lifecycle. Small allocations can grow to “core positions” over the course of a couple of funds.[3]

Insight

One marker of a well-established firm is the presence of an investor relations team whose very job is to insulate the key decision makers at the firm from the pestering attentions of investors. LP diligence for such a firm most typically is limited to data rooms, brief access to key decision makers, extensive IR coverage and tight timelines. In these cases, the quality and quantity of data may be high, but true insight may be harder come by.[4]

Newer firms, conversely, are much easier for LPs to get close to. They don’t have the resources to keep LPs at arm’s length. They put in the time to establish meaningful LP relationships because they have to.

At UC Berkeley, when my team and I cultivated relationships with new firms it would involve multiple onsite meetings with their whole senior investment team together and individually. We’d often complete 15–20+ reference calls, conduct onsite visits with existing portfolio investments, engage in direct negotiation on the LPA and secure LPAC seats for virtually all the funds we backed. We typically had plenty of time to run an extensive due diligence process, that allowed us to develop a deep understanding of the team and their firm.

A new LP to an already-successful fund will find that kind of access and insight into an investment team and their process incredibly hard, if not impossible, to achieve.[5]

Investment Results

It is axiomatic that it is easier to generate larger outcomes on smaller pools of capital in most investment strategies. There are almost always diminishing opportunities with scale. Newer firms need to achieve a viable scale but, even then, are usually smaller than their peers, meaning their funds achieve more financial impact from success in smaller investments.

Published research on newer firms lends credence to outperformance being at least as common in newer firms as in more established firms. Preqin found first-time private capital funds have outperformed funds of established managers in every year except one over a 13-year period.[6] Cambridge Associates found that new (Fund I or II) and developing (Fund III or IV) funds were consistently the majority of the top ten venture funds by vintage year.[7] These are just two pieces of published research, but they align with my personal experience.

Interestingly, the conventional wisdom of persistence is murky — particularly outside of venture capital funds –with low predictive value found in prior fund results.[8]

Agility

Newer firms are often unburdened by legacy ways of thinking. Further, it is often a new insight or approach that is the driving reason for the firm’s creation. New thinking and approaches within an organization that is built for the current investment environment (and not some past investment environment) can prove a substantial advantage. Newer firms also have far fewer legacy assets to manage, and so can devote greater time and attention to current opportunities.

Portfolio Benefits

Newer firms are frequently formed around new thinking, approaches or markets and often have more diverse founders. All of these can combine to create new sources of alpha and bring into sharp relief stale and outdated ideas in other parts of a portfolio.

Many of us learn most effectively by doing, and so even an LP’s small investments in new areas can yield insights that are valuable across that LP’s broader activity. As examples, think of the small investments pioneering LPs made in hedge funds, buyouts, or venture. They laid the groundwork for what are now core elements of institutional portfolios and led to modern risk and portfolio construction practices.

Challenges in Backing Newer Firms

So why do many newer firms have a hard time finding institutional support? I’ve seen many institutional LPs face constraints due to lack of resources or self-imposed policy barriers.

Resources

It takes greater effort to back newer firms. As noted above, they may not have fully built out IR functions and a Fund I can be a bit more of a D.I.Y. project for LPs.[9] Because the firm may not have mastered telling its story and/or have exhaustive materials, LPs may get further into a due diligence process before finding things that would cause them to go “pencils down.” These false starts can weigh on an investment team’s productivity.

To reduce these sorts of false starts, LPs can develop networks of peers or partnerships, formal or informal, to draft on others’ insights and signaling. In multiple circumstances as an LP, I have worked with a specialist fund-of-funds to accelerate our portfolio’s exposure to a strategy or asset class, build our direct relationships and/or develop the experience of my team.

Career Risk

New firms rarely come with the comfort of being conventionally good ideas. Investment teams at LPs often fear that the underperformance of an investment in a newer firm may come with more than its fair share of I-told-you-so’s, and so there can be a built-in reluctance to pursuing them.[10]

Walking the Walk

As CIO at UC Berkeley, I had 7% of the endowment invested in the public equity strategy of Generation Investment Management[11], the global leader in sustainable investing.

The thing is, I didn’t have a sustainability mandate. Despite Cal’s progressive roots, there were mixed views, at best, on my board as to whether a sustainability lens could actually improve investment results. Importantly, what I did have from my board was their support to exercise my best judgment in selecting investments.

In making this choice for Cal, I absorbed a lot of career risk: making Generation such a large part of our portfolio, of course, and the added potential for people to question my motivations. Sustainable investing was, in 2011, generally considered by most institutional investors to be an admirable but underperforming pursuit.

What gave me the conviction to act so decisively was the quality of Generation’s work. Their different approach had a rigor and clarity to it that crystalized into one of a very best stock-picking environments I’d ever underwritten. They saw the world differently, invested differently and were a factory for innovative thinking.

Over the last decade, this investment has paid handsomely for Cal — beating the MSCI ACWI by hundreds of basis points annually — and effectively paid for the education of thousands upon thousands of kids.

Institutional Support for Innovation

As fiduciaries, we need to embrace the constantly changing nature of our world and have a strategy for addressing it. Newer GPs are one such tool.

Investment teams at LPs need encouragement and resources from their investment committees and CIOs to support less conventional ideas and newer firms that foster innovation. The rewards for these efforts will be realized in improving portfolio returns, manager concentration, GP-LP alignment and insights, as well as protecting against obsolescence.

Most LPs have read David Swensen’s masterwork, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment, but often missed is its critical insight. It’s the unconventional thinking that drives investment results, not a formulaic approach that rotely emphasizes things today that were unconventional 20+ years ago when the text was written.

Some of today’s new firms and unconventional ideas will turn into tomorrow’s leading investment organizations and conventional wisdom. LPs that can emulate that university with a strategic commitment to innovation are most likely to find and benefit from them. They are out there, waiting to be found!

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[1] UC Berkeley is not affiliated with Cyan. The mention of UC Berkeley is for informational purposes only and does not constitute as endorsement.

[2] Capacity constrained raises are often much faster and can result in a less rigorous process that heightens risks.

[3] Many LPs will have limits on their share of a fund’s committed capital, and for very large allocators this may be a binding constraint in Fund Is. However, an undersized investment to a Fund I or II may be the only way to assure a full-sized bite for a Fund III or IV.

[4] It is worth noting that not all GPs behave in this way, but most do. Also, not all LPs get the same experience. An LP that is $25M of a $1.5Bn raise won’t get the same access as a $250M investor in that same fund.

[5] Coming into an already successful firm does give you a type of insight, but we must not forget it’s insight into the past. The trouble is, the insight we need is into the future probability of success, which a new LP may not get the access to achieve. Especially worrisome are aging firms, where talented founders may no longer be as focused or as adept at navigating a changing world.

[6] Preqin: Making the Case for First-Time Funds (2016) (this study includes a range of private capital including VC, buyout, growth & real estate; this is the latest study conducted on this matter)

[7] Cambridge Associates: Venture Capital Positively Disrupts Intergenerational Investing (2020) (this is the latest study conducted on this matter)

[8] Working Paper NO. 2020–167 Has Persistence Persisted in Private Equity? Evidence from Buyout and Venture Capital Funds Robert S. Harris, Tim Jenkinson, Steven N. Kaplan, and Ruediger Stucke (2020) https://bfi.uchicago.edu/wp-content/uploads/2020/11/BFI_WP_2020167.pdf

[9] It is this very lack of polish, however, that enables LPs to get closer to the founders and their work. A critical risk mitigation!

[10] We also need to acknowledge the cognitive errors we can all make as investors. Familiarity bias and the endowment effect are both real and can cause us to less critically favor a better-known option.

[11] Generation Investment Management is not affiliated with Cyan. The mention of Generation Investment Management is for informational purposes only and does not constitute as an endorsement.