The Investment Manager Playbook: What Allocators Don't See

It happens hundreds of times a day.

An allocator awaits a meeting with a manager. They’ve watched the manager post strong returns implementing a strategy in a small, less efficient market. It’s exactly what the manager articulated when spinning out of a large firm a few years before.

The allocator hopes the manager will stick to their original plan just this once, but they have seen this movie before. Sure enough, the manager opens the meeting with four dreaded words.

“We’re raising more capital.”

The allocator shrugs and thinks to themself, “Don’t managers know size is the enemy of performance?? Why are all these managers so greedy?”

A manager’s business decisions are not as one-dimensional as many allocators think. Allocators often don’t appreciate why so many successful managers have grown beyond their initial expectations.

The investment manager's playbook hinges on its decision to stay the same or grow. That choice carries implications for the team, investment opportunities, and risks the manager will encounter to maximize its probability of long-term outperformance.

In almost any rational assessment, the playbook favors growth. Expanding organizations can attract and retain talent and capital, which creates durability. Staying the same may benefit from focus, but it carries significant business risk.

Allocators who understand the drivers of these decisions can better assess the prospects of managers.

I’ll describe the investment manager playbook across three stages. The early stage is all about performance and survival. The second and third stages offer the choice to stay the same or grow, which carries a set of opportunities and risks that consider performance, talent, and client stability.

The following chart displays the investment manager playbook.

Early Stage

A start-up asset manager encounters the same challenges as a start-up in any industry. It’s a time of focus, intense demands, and heightened scrutiny. The manager must build a team, set up infrastructure, implement its strategy, and deliver on performance all at the same time.

A manager reaches later stages of development only when it gets everything right. Building a team is complex, setting up infrastructure takes time and money, and generating performance requires both skill and luck. The land mines that await could fill a book; in fact, I wrote one. (So You Want to Start a Hedge Fund: lessons for managers and allocators).

When a manager succeeds, it earns the opportunity to graduate to the next stage of development. If it doesn’t, it can close the playbook right there.

Stage Two

With success, a manager chooses the firm's future direction. A fork in the road typically comes after around five years for a public market strategy or at fund two or three for a private market firm with the decision to stick with what worked or grow.

André Perold, founder of HighVista Strategies and Professor Emeritus at Harvard Business School, and Charley Ellis, founder of Greenwich Associates and renowned author, both have discussed the distinction between the profession of investing and the business of asset management.? Those engaged in the profession seek to maximize investment performance, whereas those in the business seek to maximize profits for their enterprise. Perold and Ellis draw a clear distinction between the two.

However, the profession and the business are not mutually exclusive. A manager that strives to be the consummate professional must have a stable business to optimize performance. A manager in the business of investing must deliver outstanding performance to grow assets and increase profits. Whether a manager remains a boutique or grows, it must solve for issues that come in the way of both business and performance success.

Option 1 – Stay the same

When a manager chooses to continue down the same path, strong performance in the early stage may attract more investors, but it will slow down or stop accepting capital. The manager’s clients will applaud the decision. Allocators that follow David Swensen's gospel love boutiques with closely aligned interests.

However, that view of the world ignores the reality that a manager must be in business for the long term to deliver long-term performance. The same allocators who preach the importance of aligning their interest with a manager often fail to consider aligning the manager’s long-term interest with theirs. One allocator who favors boutiques recently told me he is fine having to turn over managers if they don’t survive. That strategy may work well for the allocator, but it’s the antithesis of the long-term partnership mentality that he also preaches.

A manager that stays the same takes on substantial business risk from a reliance on performance, challenges with talent retention, and client stability.

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1. Performance.? History suggests that even managers with the best long-term performance suffer periods of significant short-term underperformance. At these times, clients usually head for the exits. A boutique may be in jeopardy when a rough patch hits too early in its life. There is an elegance to a manager solely focusing on performance, but an investment manager’s track record is almost never linear and creates inevitable challenges for a boutique.
2. Talent. A boutique tends to provide limited opportunities for its talent to develop and grow. A founder hires young and hungry analysts at launch. Five or ten years down the line, those analysts become experienced and get intrigued about what career options are available. They may get poached by a growing competitor or yearn to have their name on the door. A boutique can find it difficult to sustain outperformance without retaining its best talent.
3. Client stability.? Staying the same typically means focusing on a single product with a concentrated client base. Those business characteristics provide a shaky foundation to serve client needs over time.

• Diverse interests. No two allocators seek managers that perform identical roles in their portfolios. Dave Morehead, CIO at Baylor University, uses a baseball analogy to describe his preferred managers. Dave hires a manager to play third base (a boutique). He doesn’t want that third baseman to play the outfield (growth). However, he is comfortable if his third baseman roams the left side of the infield – where it might charge the infield for a bunt, play back to field a double play, or shift to adapt to a hitter. In non-baseball language, Dave prefers a boutique and is comfortable with a modest amount of latitude for adjacencies.
• Others feel differently.? Letitia Johnson, CIO at Amherst College, wants her managers to be ‘best athletes’.? Her portfolio seeks those who can play all the positions on the field, and maybe even pitch like Shohei Otani. Amherst prefers managers with flexible, opportunistic mandates.
• Still others might look for something in the middle, like a utility player who can field any position even if it’s not a strong hitter.
• A manager’s clients often have different expectations for how the manager should behave. A boutique with a concentrated client base may find it hard to fulfill the interests of all its clients simultaneously, especially as client needs change over time.
• Allocator Turnover. A boutique often finds an ideal initial fit with its investor base, but CIO turnover can change the dynamic. As discussed in The Investment Office Playbook, the duration of a CIO’s tenure in the investment office is finite. A subsequent CIO at the same institution might have a different investment approach.

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Staying the same poses a significant business risk that leads a manager to consider evolving. Let’s take a look through the same lens at what a manager considers when choosing growth.

Option 2 – Grow

A manager frequently looks to the future and concludes that growth offers the best chance to outperform. Asset growth brings additional financial resources, which can be invested in talent and R&D. A manager may choose to raise more capital in its existing strategy or expand the product offering into an adjacency that leverages the team’s skillset.

Communication of the manager’s evolution is essential to earning the confidence of allocators. Allocators are likely to embrace change that they believe will lead to continued strong results. They are skeptical when growth appears driven by greed. Every manager has an incentive to give reasons why growth is good for performance; allocators judge the authenticity of the claim.

The decision to grow brings opportunities for the team, introduces risks for performance, and faces uncertainty over clients’ response.

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1. Talent. By providing the team opportunities to increase compensation, engage in new projects, and take on decision-making roles, the manager fosters a productive culture that offers a platform for its top talent to develop and maximize their potential within the organization.
2. Performance. Asset management is ultimately a performance business. Just because a manager does well with a single strategy does not mean it will outperform with newer or larger ones. Growth may compel the manager to move away from the sweet spot that allowed it to generate early success. Deploying more capital in the same strategy requires the manager to change what they do.[1] Expanding into an adjacency presumes the team’s skills are portable. If either proves less successful than in the early stage, the manager gives allocators a reason to question the future.
3. Client stability. Growth may bifurcate the investor base between early adopters who favor boutiques and later arrivals who embrace growth. By offering a range of products that allow allocators to select the one best suited for their playbook, the manager aligns its offerings with its client’s interest. When a CIO departure occurs, the growing manager will have more options to continue a productive working relationship with the new CIO.

Playing the Game

In the ensuing years, the manager will outperform, underperform, or fall somewhere in the middle. In any case, the probability of business continuity for those choosing the path of growth strictly dominates those choosing to stay the same.

Outperformance

When a manager outperforms, all is well irrespective of the path chosen.

Stay the same

A boutique with outstanding performance becomes a stronger boutique. Historical clients gain further confidence in the strategy and are more likely to stay around through tough times in the future.

At the same time, the more time that passes without growth, the more a boutique may face challenges keeping the team together. Boutiques are dependent on a few key players, and should any of those players move on, the manager’s culture and strength can get rattled. Allocators perceive change as a negative and will heighten scrutiny anew.

Growth

A growing manager that outperforms earns the right to continue to grow. The manager provides evidence that its skill, not its niche, is driving returns. It provides a path to grow assets in its core strategy or expand to adjacencies.

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Great results are accelerants for culture and team development. Maturing analysts can take on decision-making roles. Senior professionals can expand into new products. Lateral hires can bring complementary skills and new strategies. When the economic pie grows, team members see a path to increasing their compensation without competing internally for a bigger slice of a fixed pie. Professionals see a path to a career at the firm, and that excitement keeps everyone engaged.

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Underperformance

If performance suffers, the consequences for a boutique are more severe than for a growing organization.

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Stay the same

When a boutique’s performance suffers, it may face existential risk to the business. The manager has bet the farm on its ability to perform. When that premise falls short, there is no backup plan. A boutique is left trying to convince clients to give it more time. Where additional clients once waited in a queue to join the fund, the manager may find the queue is empty when it tries to open the doors for new capital.

While once confident in its ability to perform and keen to bet the farm on that outcome, a manager at this point in stage two often regrets the decision to shun diversifying its client roster or product lineup. The allocators who once applauded them for staying focused no longer are as loyal as they represented.[2]

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Growth

A manager who grows and falters in stage two will also face challenges to the business. Pressure increases as the manager assesses the team, products, and process to learn what went wrong.

Trust and communication become necessary skills for survival. Managers that clearly articulate the validity of their strategy and diagnose the causes of underperformance stand the best chance of living to fight another day.

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Average

When results in the second stage are average, the manager’s communication and ability to instill confidence with allocators become the most important driver of the next phase of the business. Again, the outlook for a growing manager is better than a boutique.

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Stay the same

A boutique will stall out without continued outstanding performance. The manager may keep its clients, but the queue of interest from prospects will wane. A boutique manager often eschews engaging with prospects to focus solely on investing. At times like these, it will learn its closed-door policy was a mistake.

Team members may find their heads on a swivel as they consider what will happen if performance does not improve. Departures can undermine investors' confidence, leading to withdrawals.

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Growth

Similar to a growing manager with poor results, a growing manager with reasonable returns will have opportunities to assess what is working and what is not, make changes, and improve. So long as a growing manager does not significantly underperform, it will continue to have opportunities to expand.

A growing manager’s team is more likely to stick around and see what transpires. The manager has expressed its intention to grow, and a pause in that trajectory does not cause otherwise excited talent to depart for potentially greener pastures. Making changes to put the firm’s best foot forward strengthens the culture and re-energizes the team.

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Stage 3 and beyond

After another stretch of years, the manager will have more opportunities to reconsider its business strategy. Success begets more success, allowing a boutique to stick its knitting and a growing manager to expand further. Failure leads to business risk, with a boutique suffering sooner and more harshly than a growing firm.

Like the compounding of capital, the decision to remain a boutique or grow compounds over time. The more success a growing manager finds, the stronger its business becomes and the more resilient its organization is to inevitable performance setbacks. A growing manager builds a higher quality business with diversified products and customers, steadier income to support its team, and a reputation for excellence. In contrast, a boutique only modestly derives the benefits of compounding. A boutique manager is always one step away from a bad stretch of performance that creates an existential threat to the business.

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Other Factors – Public vs. Private Strategies

Public market strategies compress the time between decisions for both managers and allocators. Fund flows are continuous for the manager. Daily marks, monthly reporting, and frequent subscription and withdrawal dates lead allocators to draw conclusions about a manager's skill far more quickly than statistically significant data would suggest.

Private market strategies can undergo two or three fund-raising cycles over five or more years before allocators have any evidence of the success of their initial commitment. Private market managers have more time to write their playbook.

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Other Factors – Duration and Succession

Boutiques are not designed to outlast their founder. The investment offering rarely passes on to the next generation. As many hedge funds approach their founder’s retirement, only a few have successfully passed the baton. Almost every instance of a hedge fund lasting beyond its first generation has followed a business strategy that expanded beyond the manager’s initial product offering.[3]

Growing managers pivot the investment DNA from a single individual to the team, including a process to develop the next generation. Private equity firms have employed an apprenticeship model from the early days of the industry, and many have succeeded their founders. The large, public alternative asset managers expanding from private equity to credit, real estate, and insurance are the best examples.

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“We’re Raising More Capital.”

The next time an allocator hears a manager is moving away from its niche and expanding, it may think twice about dismissing the manager as another case study in greed. Money managers are in the business of assessing businesses[4], and a boutique asset manager is not a particularly good one. An allocator idealizing a boutique may want to consider how it feels about a manager who makes a sub-optimal decision on such an important choice in their life. It also may want to consider how the alignment of interests works when considering the manager’s duration in business.

Understanding the playbook from the manager’s perspective can help allocators assess the motivation behind a manager’s decisions and prospects for future returns.

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[1] In a public market strategy, the manager will increase the number of positions of the same market cap, invest in a similar number of larger names, or accept less liquidity by owning more of the same businesses. In the private markets, growth typically means competing to purchase larger companies at higher price points.

[2] See So You Want to Start a Hedge Fund: lessons for managers and allocators, page 60.

[3] To offer a small set of examples, Davidson Kempner and Farallon have continued to thrive under the next generation of leadership. Many single product long-short funds have not.

[4] Not all managers assess businesses. Arbitrage, real asset, and fixed income strategies are driven by other factors.