By John-Austin Saviano, Managing Partner, Cyan Capital Partners
Our recent note “A Strategic Allocation to Newer Managers” discussed the duty fiduciaries have to embrace innovation in order to protect against obsolescence, capture new sources of alpha and ensure a broad worldview. One stumbling block for many institutional LPs in pursuing these opportunities is an over-fixation on track records.
Track records are indeed important, but LPs need to be focused on the future— established firms and new firms alike face uncertain paths ahead. If it were as simple finding firms with “great” track records, we’d all just pay for a good database and allocate accordingly.
LPs can learn to navigate GP track records which are complicated, emerging or unavailable. Honing this capability opens up the possibilities of avoiding fading stars and finding diamonds in the rough even in areas dominated by newer managers, such as sustainable investing, our focus at Cyan.
Avoiding a Crash…
Early in my career, I was tasked with evaluating a then highly regarded private investment firm raising a higher Roman numeral fund. They had a great track record across early funds (as many firms did in the excesses of the dotcom era) though the record was less stellar in more recent vintages. This project was characterized as an easy underwriting as the firm was beloved and an “institutional name” — i.e. one that was easily recognizable by an investment committee.
As the fresh set of eyes, however, I saw a firm where most of its founding team had departed (now rich enough to never have to work again), a current team with a very uneven mix of experience as investors and a targeted fund size that was completely out of scale with the firm’s prior successes. Those facts, along with withering reference calls and other work, led me to not recommend the fund.
That fund ended up being a disaster that almost ended the firm. The fund in question invested in a fraud, saw team departures early in the investment period and lost the confidence of most of their LPs. Their following fund was one-third the size of the evaluated one.
Past success for the firm turned out to be of no value to future outcomes. Slowing down and approaching the work with fresh eyes yielded real reasons for caution. The specific failures of this fund certainly weren’t predictable, but it was clear the chances for disappointment were much higher than the track record implied.
As LPs, we must keep our eyes on the road ahead and not get too entranced by the rearview mirror.
Why We Look at Track Records
Predicting the future. That’s what we, as investors, are trying to do. We are making decisions about allocating capital today into an uncertain tomorrow and we hope that track records can improve our odds of predicting what will happen.
Nevertheless, effectively evaluating a track record requires a much more critical thought than “high numbers are good, low numbers are bad.” Yes, it is good to see strong absolute results and outperformance versus peers and market indices, but what we are really looking for is how those numbers came about.
Indeed, recent academic research seems to indicate the conventional wisdom of persistence is murky — particularly outside of venture capital funds — with low predictive value found in prior fund results.
The “how” of a track record matters because we are trying to understand the processes that created value in the past and judge whether they will do so in the future. Do the strong numbers represent luck or skill? Even if we have conviction they were based on skill, are those skills applicable to the present and future? Is the record dominated by a single outsized outcome? Has the market context changed significantly?
To answer these questions, we need to untangle the elements represented in a track record and view them against what we know or believe about the present and the future.
The ideal would be evaluating a large set of decisions, made by the same people, under the same conditions that have had sufficient time to mature. This diagram illustrates this theoretical ideal.
In the real world, this ideal simply never happens. A private investment firm typically makes a relatively small number of decisions with evolving groups of decision-makers that take a long time to come to fruition and stretch across varying market conditions.
As we are well reminded, “the plural of anecdote is not data” and most private investment track records are a set of anecdotes.
LPs need to focus on:
- Decision making — Relatively few private investment firms have a sole decision-maker, with most having a group of partners that approve investments. Over multiple funds, the composition of this group can change materially (for better or worse!).
- Sample Size — A private investment fund may invest in 10–20 assets over its life, and so over multiple funds there may not even be 50 decisions made.
- Seasoning — Private investments take many years to come to fruition. (Losers often declare themselves early, whereas many winners can take a long time to fully develop.) At any point in time, we may be faced with a large set of incomplete outcomes in assets that are still maturing.
- Deal Sizes — It is uncommon for a private investment firm to keep a consistent fund size. There is almost always an inexorable drift over time to larger fund sizes and, consequently, larger deals. The dynamics for those larger deals may be materially different than the smaller deals a firm started with.
- Market Conditions — An investment team forms a new firm and comes to market with a set of skills and experiences that may be particularly suited to a moment in time or part of the economic cycle and not as well to others.
It is a virtual certainty that each of these elements will change/evolve over the time horizon required to generate what most investors would consider a sufficiently robust track record.
Further, these elements do not address the changing circumstances of the individuals involved. Once an individual or a team of individuals have all become incredibly wealthy (as would be expected with a fantastic track record!) it is completely reasonable to imagine their future behavior being different from their younger, hungrier selves. (There are exceptions, but they are exceedingly rare.)
Swimming in Deep Water
The essential thought here is to not be overly confident in a track record. LPs need to keep their wits about them, not be afraid of open water, nor be overly confident when close to shore. Whether we are in eight feet or 800 feet of water, we still need to swim just the same.
A future note will share some of the ways we can evaluate a firm beyond focusing on a track record.
Special Note on Liquid Strategies
The above note is focused on illiquid strategies, with the key characteristics being the years-long process for investments to come to fruition, relatively few transactions in a sample set and group decision-making. This is obviously quite different for many firms in liquid strategies, where there can be a consistent single decision-maker, relatively high volume of decisions made and an ability to assess performance over shorter timetables and versus passively investable options.
In these circumstances, separating “skill” from “anecdote” can be more reliable. Nevertheless, the same pitfalls exist of the evolving lifecycle of a firm, its PM and team’s skill set aptitude for changing market conditions and the changing financial situation of its employees.
Download a PDF here
 https://bfi.uchicago.edu/wp-content/uploads/2020/11/BFI_WP_2020167.pdf Working Paper NO. 2020–167: Has Persistence Persisted in Private Equity? Evidence from Buyout and Venture Capital Funds (Harris, et al., 2020)
 This is very different for liquid strategies, where a sole PM or co-PM structure is much more the norm.