Said no one ever. The last thing other investors want is more competition. Every investor is now well versed in the paradox of skill. On Main Street, Congress might be the only institution with a lower approval rating than Wall Street. In this new world of winner take most, public asset managers won’t survive unless your assets under management (AUM) is larger than Amazon’s market cap, a private equity firm’s AUM better have as many zero’s as Phil Jackson has championship rings, and in venture capital, the glory days of Blitzscaling might be over, but only the Joker burns cash better than start-ups.
In a world awash with capital, first order thinking would lead an induvial to believe that starting a business has a higher likelihood of success than becoming an investor as money has to go somewhere and the FAANG stocks don’t have infinite growth ahead of them. But second order thinking leads one to believe that the world requires skilled investors to allocate that capital to new and existing businesses.
The economics of investment management scale beautifully, but investment returns tend to look like Emperor Palpatine in the economies of scale model. In public markets investing, as the amount of capital managed increases, a manger’s investment universe shrinks. A manager with a billion dollars to allocate can’t take meaningful positions in small-cap stocks. That manager would move the stock too much when building the position, and if the manager tried to exit the position it; could take months or years without being too much of an influence. These are all problems of liquidity.
Willingness to be different is more difficult as a larger manager due to the revenue model of most mutual fund managers. Under the assumption that a mutual fund manager is paid 1% of the AUM, she is more incentivized to grow AUM rather than generate above average returns. At the beginning of a manager’s career, performance will be the main driver of AUM growth. But once that manager’s AUM reaches a certain level, John Maynard Keynes becomes the guide.
“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” – John Maynard Keynes, The General Theory of Employment, Interest, and Money
The other issue investment managers’ face within a larger asset management company is a lack of patience with underperformance. Any manger with a differentiated process or philosophy is going to underperform at some point. Underperformance is difficult to sell, no matter how temporary in duration. With the lack of support from the sales force, and pressure from company management to reverse the trend, the investment manager will be pressured to change the portfolio in a way that will look more like the benchmark index.
All of these factors reinforce the “winner take most” investment management economy and a world where managers value assets over alpha. Charlie Ellis wrote,
“The optimal balance between the investment profession and the investment business needs always to favor the profession, because only in devotion to the disciplines of the profession can an organization have those shared values and culture that attracts unusually talented individual professionals.” – Will Business Success Spoil the Investment Management Profession?
Investors should look to remove the factors described above and become solopreneurs or start small firms. But this is not easy. If an investor chooses to go the route of less regulation, that investor can only market to accredited investors (aka rich people). The other option to create a fund that will be filed with the SEC, with total costs somewhere in the mid to high six figures. The requirements of institutional capital allocators make going down this route even more expensive. Dan McMurtire (aka @SuperMugatu) explains the difficult of starting a hedge fund in this video.
But it’s the small investors that are needed to find interesting investments in companies that the large asset managers won’t look at. Small/micro cap publicly traded stocks offer wonderful investment opportunities. The large asset managers won’t spend the time on them because the small amount of capital that can be invested won’t make a difference in their bottom line. The economics of a large asset management company require investments in companies that are large and liquid. But the economics of a solo professional investor allow him to not only generate alpha, but create a differentiated investment strategy. This strategy would also allow a skilled investor to be free of fee pressure as index funds are unlikely to be reliable alternatives to clients.
This strategy can be replicated in the world of private companies as well. Brent Beshore essentially bootstrapped his own private equity company (his firm invests in private companies but share very little with the typical private equity company) by finding attractive businesses that generate a lot of cash. Search Funds were in vogue during the latter half of the last decade and offer a wonderful opportunity for young investors to improve a small business as it transitions away from its baby-boomer founder.
Venture capital doesn’t have to try to compete with the likes of a16z or Benchmark. Because of the low cost of starting a company today (thank you AWS), a venture capitalist doesn’t need $10 million to be a seed investor. This allows a small team of private investors to network and try to find interesting entrepreneurs. The COVID-19 pandemic isn’t holding back entrepreneurs. Y-Combinator is seeing a 10-15% increase in applications for its summer program.
The opportunity for an increase in individual/small investors also allows for innovation in fee structure in the investment management industry. The management fee/percent of profits model fails to align the incentives of client and manager. It also tends to result in too many “heads I win, tails you lose” situations. I present one way to change the fee structure here. Permanent Equity has developed another fee structure for their private equity fund, described here.
The two main themes I explore with this blog are principle/agent issues and incentives. It’s almost impossible to remove the principle/agent problem entirely from the investment management industry, but reimagining the fee structure can help reduce the spread between the priorities of each party. This in turn creates the right incentives for the investment manager. While the strategies of a solo/small-team investment fund might not scale to a billion dollars, they protect the fund from the competition and fee compression of larger firms.
