Compelling Reasons to Choose A Sub-$100 million Asset Manager

SMALLER ASSET MANAGERS  SIGNIFICANTLY OUT-PERFORM

THEIR LARGER, OLDER  COUNTERPARTS WITH LESS RISK

BELOW ARE SOME OF THE PRIMARY REASONS WHY!

Talent:

" The most talented managers self-select to start firms rather work at larger firms. Many talented managers build experience in larger firms before launching their own firms. "*  

We find this especially true in the hard asset, cash-flow world where diligent vigorous research and hands-on management are critical. Where, to excel in an illiquid investment, the manager must constantly research to be certain of his position and routinely be able to negotiate daily for the good of the program, as opposed to just clicking a buy or sell button to acquire or liquidate an investment.

A Better Opportunity Set:

“Due to the size of their AUM, larger funds often have little choice but to dilute their best ideas. Emerging and smaller funds are better able to take advantage of opportunities in less efficient, smaller markets and sectors and have greater freedom to invest in less scalable opportunities. Emerging managers are less constrained by liquidity and can access a wider range of opportunities…Moreover, established managers may not be able to deploy a large proportion of their assets in niche opportunities, whereas a small fund is better able to.”***

Smaller price tags make for greater opportunity for the smaller fund whose investment threshold is $150,000 -vs- a large fund whose investment criteria starts at $10,000,000. Also, smaller thresholds often means that added value can be amassed my aggregating portfolios of assets together and selling the portfolio as one large cash-flowing unit.

In the private markets, we continually make exceptional returns buying and aggregating real properties that large companies and big fund managers don't have the time with which to bother.  Once they are aggregated, then they become a target for the large fund managers and companies.  It is not worth Devon's time to research an oil and gas lease that makes $100,000 per month or for U-Haul to acquire a $2 million self-storage property in Manvel, Texas, but put a $100 million deal in front of them and their ears perk up.  As smaller AUM managers, we take advantage of these inefficiencies routinely.  

Extreme Motivation:

“The psychological reason of ‘making it’ as a successful entrepreneurial investment manager may be a particular catalyst in the early years. As assets grow and managers reach certain levels of wealth, their working days, as well as their effort per unit of AUM is reduced, so that returns are more likely to gravitate to a lower level. Young early stage managers generally have more sweat per dollar of AUM, and work a lot harder to ‘make it’ as a successful manager.”*** We find this particularly true in the alternative space as it takes considerable digging to uncover and keep abreast of current happenings and developments in the areas in which we work.

The compensation of a small asset manager is also a motivating factor. " Performance fees are a higher percentage of overall compensation and drive asset growth and profitability. Analysis suggests that up to 80% of the enterprise value of larger firms is due to capitalized management fee EBITDA as opposed to performance fees. "*  

Also, “The fee structure of the fund industry and the relative massive amounts of revenue that a large fund can generate relative to its costs, goes a long way in explaining why larger funds often have lower returns. Large funds tend to be focused on simply preserving capital to maintain their assets and fees attached to those assets, a US$10 billion fund with a 1% management fee and a 20% performance fee on 10% returns per year generates US$300 million annually and, after paying a staff of 50 to 70 people, the principals are just not interested in doing anything which might jeopardize this amazing, extremely profitable, annuity-like return. Furthermore, the mass of money coming into the industry from larger institutional investors, (whom invest primarily in large established funds) is enormous, so just by keeping ‘moderate returns’, principals of large, established hedge funds feel assured that AUM will continue to grow and, as such, these managers are often reticent to trade aggressively. In stark contrast, smaller funds are constantly searching for higher performance, in order to attract larger amounts of capital.”***

In real life, in the world of private equity, venture capital, growth capital and hard, cash-flowing assets, this is especially true for small managers with less than $100 million under management.  If an oil well goes down in a small fund, it is more critical to the income of a small manager than it is to Exxon. 

Off and Under The Radar:

“Emerging funds and managers do not readily appear on investors’ radar screens, as they may not appear in the various fund databases that track funds. The managers of these funds can often be more flexible in their investment approaches and choice of instruments and markets, and are often characterized by their willingness and ability to employ new and innovative investment strategies exploiting new market inefficiencies. These factors can result in a competitive investment edge over their established peers, and be reflected in their relative out-performance. Academic and industry evidence tends to suggest that emerging hedge funds outperform more established ones.“ ***

" It is somewhat paradoxical that investors continue to fall for the allure of size and the false comfort of age ."** After all, no one is going to get fired for buying IBM.

Regarding flying under the radar. We have found it most beneficial for our returns and our partners that, in general, we are not well known as a routine source of capital. No one knows who our financial partners are. Personal experience has shown us many times that when Paul from Abilene steps up to purchase a property, the price is far more negotiable than when CB Richard Ellis or Trammel Crow make an offer.  

Closer Attention To Detail:

“Emerging managers are normally hungry for success and have a great incentive to demonstrate strong performance. They are able to seek out the smallest opportunities and inefficiencies in the market, and are less likely to demonstrate complacency from previously accumulated fees and/or wealth. Established managers generally need to place less reliance on generating a performance fee in order to operate their businesses profitably, whereas performance fees are vital for most emerging managers. Emerging managers typically invest a significant proportion of their net worth in the fund and/or the investment management firms, while at the same time suffering significant opportunity cost of often previously lucrative employment, therefore, providing a powerful incentive to perform.” ***

Also, smaller managers must keep a tight rein on cash-flows, pay closer attention to the details of daily management and be assured of their position in the investment because they cannot sell the asset tomorrow and recoup the investment.

Smaller Managers Significantly Outperform

“Recent research undertaken by PerTrac analyzed the returns from hedge funds over 10 years between January 1996 and July 2006. They concluded that the younger funds outperformed the larger funds, and did so with lower risk. Meaning, those funds with a two-year track record or less, returned 17.5% with volatility of 5.97% , compared to returns of 11.84% with volatility of 6.32% for older funds, ie, those funds with a four-year track record or more. In addition, overall size and age groupings, the youngest funds had:

(a) the highest absolute returns;

(b) the best risk-adjusted returns; and

(c) performed better on the downside, losing less than established funds."***

" The vast majority of outperformance is due to alpha, not beta, which confirms that higher risk taking does not explain the differential ."*

In the world of private equity, venture capital and hard, cash-flowing assets, this is very true because for a smaller manager to earn what they believe themselves to be worth, they must post higher returns, making their clients and themselves more money.

Take Advantage of Others Mistakes:

Small managers often have a different or contrarian view of the marketplace gleened from watching the big boys make mistakes and pass on or walk away from smaller opportunities.

When Columbus discovered America, no one thought that the new world existed and certainly did not understand its value.

One of the wealthiest people I knew growing up was the heir to a railroad fortune.  When the railroads were built in the West, few traditional investors believed they would ever make a profit.  At the time, traditional investors thought the end of the modern world stopped at the Mississippi River and that there were no profitable business opportunities in the West.

When Trammel Crow designed and built the Dallas Market Center, most traditional investors believed him to be crazy.  They thought he would never fill the facility to capacity.  The permanent space leased out in the first 18 months of operation and the largest marketplace in the South was born.  

Before Bill Gates bought the original Disk Operating System and sold it to IBM, many traditional investors (including the Chairman of IBM) believe that there was no future in personal computers.  In fact, the Chairman’s' words were something like this: "I believe the world wide demand for the personal computer to be ONE!"

Many of the smartest geologists I have known in my life cut their teeth working for major companies, but became independently wealthy when the company they worked for decided that a discovery they had made was not worth their time or an area of production was "too small" for the company to pursue.

Better Customer Service:

“Who has ever experienced better service from a large organization compared with a small one?”**

Because investor assets are more important to a small manager, it is guaranteed that you will get better service, better reporting, and more consistent attention from a small fund manager than a large asset manager.  The good small fund managers are meticulous about their monthly reports and financials and generally very communicative with their investor partners.

More Flexible:

Regarding small AUM managers: " They are better at exploiting niche opportunities, especially in new under-developed and under-researched markets, and quick to implement investment ideas. They also tend to have a greater ability of using new and innovative investments.” ***

It has been our experience that small fund managers have more market experience and widely more efficient and pointed due diligence and therefore can be more flexible in the approach to the widely variable aspects of hard-asset investing.   

No Cumbersome Decision Making Process

“Emerging managers typically display strong motivation in the knowledge that they stand to benefit from being an owner of the business. "***

Small firms don't have as much internal politics to overcome.  By not having to convince a large investment committee with each member having their own set and different agenda, smaller managers can execute investment programs more quickly and with greater efficiency.  This fact alone allows them to take advantage of opportunities uncovered by their research.  We have found this to be exceptionally profitable in the world of private deals where, once a deal is presented to us, our due diligence and decision making process is extremely short, allowing us to capture as much as a 10% discount on our purchase price, just by closing quickly with CASH!

Illiquidity Means Opportunity:

“ Newer hedge funds are almost always set up to exploit perceived pricing inefficiencies in ‘newly popularized’, smaller markets. However, as time passes and competition makes these smaller markets more efficient, returns are eroded. …Some extremely good early-stage track records attest to the fact that it can still take a considerable amount of time (again, usually measured in years rather than months) before such inefficiencies disappear. This gives the best early-stage managers (in a variety of different strategies) sometimes several years to generate above-average returns before returns in the sector are driven down by greater players and competition.”***

We have found this particularly true in the growth capital marketplace where small operators and owners often desperately need capital to grow, retire, or fund a management buyout. This allows us to create significant high yielding programs from illiquid opportunities, often for years before the rest of the world catches on to the profitability.  

An example of this was a purchase we made in our last oil and gas fund. An operator needed cash and was willing to take a 10% discount on the asking price if we could close quickly. We did our due diligence and closed the transaction on some great assets within 2 weeks. These assets returned the purchase price within 36 months and continue to cash-flow into the portfolio 8 years later.

The Kansas Effect:

What is commonly known as the Kansas Effect is alive and well today.  The Kansas Effect can be described as finding opportunity in areas that others have forgotten or are too lazy to execute, OR, in areas where the fund is so large that it cannot afford to execute.  We make our living by uncovering opportunities that others, especially large Fund managers, have not seen or cannot spare the time to research.

An example of this opportunity set resides in the overlooked Texas, Oklahoma panhandle today. Horizontal drilling has opened new opportunities in the overlooked area of the US.

Another example, the initial investment in a small furniture company in Nebraska is one of the investments that started Warren Buffet on the road to success and a strategy that is still his claim to fame today.  He researches opportunities that others have discounted and provides capital to exploit what he finds.  

One of most important questions you can ask a small fund manager is "where have you been lately and what did you learn".  The answers will amaze you.

If you would like to discuss your investment programs or ideas, give me a call.  We are open to new programs and ideas continuously.  

Thanks for reading,

Paul Anthony Thomas, Principal

Custom Private Equity

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Abilene, Texas

 (c) Copyright 2016 - Paul Anthony Thomas, Abilene, Texas

SOURCES CITED:

*Source: SMALLER HEDGE FUND MANAGERS OUTPERFORM: A STUDY OF NEARLY 3,000 EQUITY LONG/SHORT HEDGE FUNDS, All About Alpha, Feb 18, 2013   http://hvst.co/2bQAN7f 

**Source: Emerging Hedge Fund Managers Outperform Older Funds , By Peter Urbani,   http://hvst.co/2bQABoB 

***Source: "Early Stage Investing: Why Emerging Hedge Fund Outperform in the Hedge Fund Life Cycle."  by John E. Dunn III, http://hvst.co/2bQAFV8