Goldman Sachs: In search of ‘managerial alpha’

Private equity firms should direct as much energy in maximising the potential of their teams, cultures and business-of-the-business as they do in generating investment alpha, if they want to secure a competitive edge for the next decade, suggests Goldman Sachs’ Chris Kojima

This article is sponsored by Goldman Sachs

Chris Kojima

“Investors in private equity managers face the challenge of finding the great, while avoiding the bad, in a space with high performance dispersion and imperfect information,” observes Chris Kojima, global head of Goldman Sachs’ Alternative Investments & Manager Selection Group.

“That challenge isn’t new. But what has evolved is the complexity of the investment manager’s business. So today we’re not only searching for the ability to generate strong investment performance, we’re looking for the underlying ingredients, the pre-conditions for success, in what is an increasingly sophisticated and competitive industry. Distinct from the investment alpha, you might call this the ‘managerial alpha’.”

The AIMS Group currently manages over $200 billion in open-architecture assets, over $60 billion of which is in strategies in the private markets. It accesses opportunities in four different ways: as a primary investor; as a secondaries investor; as a co-investor; and as an investor in GP management companies.

Over its 20-year history, the AIMS Group has met with over 10,000 private equity managers, and today ranks as one of the leading investors in private markets.

Broadly speaking, what are the elements you’re looking for in today’s private equity managers?
Our specific questions and analyses are always informed by the manager’s strategy and the current environment, and therefore they change depending on context. But there are some over-arching principles which drive our approach.

We’re deeply focused on the manager’s ability to create value, in processes that are repeatable, mindful of the future economic environment. When assessing a new manager today, LPs are being asked to commit capital well into the 2020s, perhaps into the 2030s. We have to consider the harsh realities of what you might describe as ‘alpha decay’, this sense that the things that make you special are impermanent, particularly at a time when disruption is accelerating and competition is more intense. So we need to ask whether today’s manager – even if successful in the 2000s and 2010s – is well-positioned to succeed into the next decade.

We’re also inclined to regard most private equity firms not as impersonal permanent institutions, but instead as collections of people – human investors, led by human managers, in human teams which age and evolve. Strong personalities emerge from these talent pools. Teams expand and contract, with internal rhythms which change as new leaders emerge. So we see managers more as living ‘eco-systems’, filled with natural energy, ambition, rivalry, fragility and potential.

The question for LPs evaluating all of this is how to assess whether this eco-system is healthy and thriving. Unfortunately, this is the sort of inquiry which sometimes seems ‘soft’, less objective than ‘hard’ performance data. But understanding this human element is essential. A strong culture won’t guarantee success, but its presence improves the probability that strong investment performance will follow, and its absence is likely to erode the organisation eventually from within.

How much can you rely on track record?
As a signal to predict future outcomes, we’ve found that historical track records in private equity are really an incomplete signal. A manager’s track record generally represents a combination of yesterday’s competitive landscape, yesterday’s economic environment, and yesterday’s investment team. We all recognise these components, but we sometimes under-appreciate the timeframe over which our ‘continuity assumptions’ are made. To say that the last fund’s track record – assembled over some four-to-eight years of sourcing and investing and harvesting – sensibly predicts the next fund’s performance is to suggest that the competitive, economic and team circumstances will each persist in the same perfect balance, across a decade.

Historical track records are certainly not irrelevant, but we don’t see them as conclusions. Instead, they can provide clues, providing insight to LPs in asking the right questions. Diligence time is finite, and LPs need to efficiently hone in on the right issues.

What does your investment process emphasise today, as you look for the best firms of the 2020s?
Many of our analyses have remained consistent across the decades we’ve been investing, but there are certainly some notes of emphasis today.

We look for how managers are adapting to the operational complexity underpinning value creation today. This speaks to their need to work fast, effectively starting the deal evaluation process already on second base, with detailed pre-mapping of the target space, 100-day plans pre-composed, and roll-up acquisitions pre-identified. Today’s valuation levels demand a daunting degree of confidence in execution, when yesterday’s upside case is effectively today’s base case.

We look for signs of collaboration, where deal teams are encouraged to live outside the high walls of their deal-team silos. Within some managers, we see deliberate efforts to convene resident experts to develop shared macroeconomic perspectives, geopolitical outlooks and capital markets insights – intelligence which makes the whole greater than the sum of parts.

We observe clever collaborations between underlying portfolio companies and their executives, recurring idea-generation engagements not just between CEOs, but also between functional leaders in human capital, engineering, sales and marketing, and technologists.

We look for some advanced thinking about data and disruption. At some level, every deal is a technology deal, in the sense that the impact of new technology, insights from data science and the possibilities of AI all have the potential to shape every industry at every point in the value chain.

Some managers have resident domain expertise in digital strategy and data science, based within their firms but deployed to underlying portfolio companies. Others have resources dedicated to specific functions, like inventory management, sales and marketing, demand-curve and consumer-preference research, and optimised product pricing. But we’ve found that managers are only now beginning to consider aiming the data spotlight on themselves, considering how the current investment processes might be sharpened.

Perhaps most critical for the 2020s, we’re looking for an intense and skillful appreciation for the importance of innovation. This isn’t just in how the GP thinks about managing a given portfolio company. It’s also in the way the GP thinks about evolving its investment process, about how alpha generation might change in the future. This kind of thinking requires a perspective broader than a single deal, and a time horizon longer than the current investment period.

Many private equity firms have been growing dramatically, whether in fund size or in strategy extensions. How do you think about this kind of growth?
Many investors historically have been uncomfortable with the idea of manager’s growth, asking sensible questions like whether the firm is just asset gathering, or incentivised primarily by management fees, becoming distracted, or losing discipline. To be sure, private equity firms can find themselves in new neighbourhoods for which they’re ill-prepared, and can certainly struggle from surprises coming from overly ambitious expansions.

But if we believe that these firms are living ecosystems populated by real people, then we need to accept that the organisation needs to grow. A firm with low ambitions and low expectations, interested only in maintaining status quo, is unlikely to attract new talent, retain key producers, or inspire new leaders to emerge. It can be as damaging for an organisation to aim too low, as it is for it to reach too high.

In your view, how are the best private equity firms managing this growth dynamic?
We think the answer lies in the skill with which the firm is managed. This is quite different than asking about investment skill. Here, we’re focusing on managerial skill, what you might call the ‘business of the business’. This is about corporate strategy, LP capital management, new product development, human capital management and operational efficiency. In good times, when great investment performance washes over the entire organisation, it’s easy to forgive shortcomings in the business. But when investment performance is challenged, or when internal and external constituents are restless or frustrated, operational weakness is easier to spot, especially when it has been allowed to compound over time.

As competition and technology disrupt, or even erode, the production of ‘investment alpha’, we think this ‘managerial alpha’ is rising in importance, distinguishing the great managers from the average. Of course, managerial skill alone can’t make mediocre investors great, but it can increase the probability that great investment performance happens.

How do you detect the presence or absence of this managerial skill?
Our starting point is recognising that managerial skill isn’t evenly distributed across every investor making managerial decisions, just as investment skill isn’t evenly distributed across people making investment decisions. The best investor might very well be the best manager, just as the best doctor might be the best choice to run the hospital, but this coincidence isn’t always the case. But whether undertaken by different leaders or assumed by the same leaders wearing multiple hats, we’ve found it essential that the firm acknowledges a clear distinction between management functions and investing functions, demanding high standards for each.

We then ask a number of important questions. How skilled is the management team in growing its existing business, re-investing in its LP relationships and designing solutions for LPs for the next decade? How thoughtful is the management team in considering new business lines, seeding new ventures and diversifying into new revenue streams?

It can be tempting to explore business-line extensions that happen to be in fashion – internet investing in the late 1990s, credit market extensions post-2008, or anything sounding like data science today. It takes a special blend of discipline and vision to distinguish wise from unwise expansions. We’ve found that managers who truly capitalise on their growth potential have a clear-eyed understanding of their investment capabilities, and can spot natural and logical places where the team’s talent can be scaled and where it cannot.

We’re especially interested in how business leaders manage important firm-wide functions which represent the organisation’s critical infrastructure. We consider things like human capital management, cross-strategy compliance and legal, communications strategy, physical real estate, the technology and cybersecurity platform.

When well managed, these wide-ranging activities are like oxygen across the organisation, supporting daily operations and promoting real confidence for further growth. When poorly managed, these are the things which distract the entire organisation, disrupting momentum and arresting entrepreneurialism.

How do you assess ‘softer’ elements, such as team culture?
We’ve found it critical to find evidence that the team cares about its future, beyond its current programme. The typical GP-LP engagement is highly transactional, anchored on an examination of the current fund. But narrowing our focus only to this current fund, even if this is the only vehicle in which we might invest, misses the point. Unlike a permanent institution, a collection of humans – each with different ambitions, time frames and risk appetites – is unlikely to remain perfectly stable, focused and motivated if they believe they’re in the last round.

The best way to address this human dynamic is to look for signs that the team is in it for the long haul. While there are several indicators of such commitment, there are two particularly useful areas to explore. One question is whether people are contributing to some internal ‘public good’, something bigger than the current deal or current fund, something which has a current cost in money or time or expediency, but which will benefit constituents beyond the current team.

A second question we explore is how the firm’s leader considers his or her eventual succession. In the industry today, the firm’s leader is often its founder, and so generational transitions are more complicated given this unique position. We’re focused on investing with teams whose best days are in front of them, and in leaders who aim to leave the organisation in better shape than they found it.