Here's how to choose the right fund manager for the future

In constructing a future-ready investment portfolio in private markets, one of the most important decisions an investor can make is choosing a fund manager. A key element of manager selection is understanding his or her past track record. A research team, under the supervision of myself and Erin Cher, recently looked at this issue as part of a project exploring factors shaping the investment portfolio of 2040. It examined underlying qualitative and quantitative data based on a research project at the Milken Institute Asia Center, where CIOs of eight large sovereign wealth and pension funds granted exclusive interviews. In aggregate, the limited partnerships that contributed insights into this article manage $2.4 trillion of investments.

The findings of this study suggest that track record consistently features among investors' top criteria when selecting a manager. There is a dominant perception that track record is about quantitative metrics – rows on spreadsheets, historical fund portfolio performance information and quartile breakpoints – fuelled by a benchmark industry selling these data. However, feedback from the investors suggested that this static scientific-sounding approach often does not capture the full picture.

Narrowly focusing on historical numbers is ineffective, as the numbers may not hold up to scrutiny in an evolving economy and changing industries. In a changing world, how realistic is it to expect funds to continue the same investment strategy as they have for the past 20 or 30 years?

Fund managers, too, often play into this narrative. They tell investors that they will repeat familiar strategies, because they think this is what investors want to hear. The most sophisticated limited partnerships understand these dynamics and look for fund managers with the capability to execute a proposed strategy, rather than trying to replicate the past.

Each fund has only a low number of transactions, giving a small sample of data points on a manager’s performance. The handful of companies invested per fund are hardly sufficient to draw significant conclusions, and in a dynamic market the future is unlikely to look exactly like the past for good (and bad) performances.

Sophisticated investors know that a true understanding of track record goes beyond numbers. They always augment the numbers related to a manager's track record with qualitative analysis. Track record is about evidencing a manager’s talent. The points below could help the industry to adopt a more multidimensional approach. Ultimately, manager fundamentals, such as talent, investment philosophy and platform, are what actually give their track record its meaning. Quoting one investor: "We do not care how much money they earn, we care about how they earn their money.”

As more capital pours into private equity and as private markets mature, existing managers are expanding into new asset classes, industry sectors and strategies. Managers focused on consumer sectors may now broaden their remit to include healthcare enterprises; buyout investors may now look to invest in growth equity. From an organizational standpoint, managers may also restructure investment teams and operational teams to enhance their investment approach.

One investor, looking at 30 years of data on managers, pointed out that their skill-sets and sectors change over time. "Good managers change their strategy," the investor said. It's important to ask: does the manager have a proprietary platform and specific dealmakers that give them a competitive edge in this new sector?

Consider this scenario: after two highly successful funds in a bull market, a manager becomes highly sought after and decides to raise a huge third fund. This means a massive headcount and office expansion, and the fund will go from investing in 8-10 companies to 50-75. The fund is still helmed by the same two partners making all the decisions, and they argue they will repeat the same strategies and generate superior returns. Would you invest?

This was a real story shared by a seasoned private equity investor. Note that each fund must be considered on a case-by-case basis. In this case, the investor considered the manager to be weakening their fundamentals by spreading their attention too thinly across various product lines. Even as the fund became a hot commodity and other investors, encouraged by the firm's illustrious past performance, fought to get a piece of the fund, the investor did not invest. That third fund ended up being a failure. The discerning investor wants to pick the manager who can rise above his or her peers in a crisis.

Forefront on many investors' minds is the changes that will take place as the partners who have helmed some of today's most successful funds retire. As the key decision makers leave the firm, would you invest?

This, of course, is an open question and dependent on each investor's specific needs. Two considerations might be helpful in making this decision: junior analysts, and decision-making culture. If an investor is privileged with the experience to have worked with the current managing partners from the time they were analysts, that would be helpful in determining the manager's fundamentals. Furthermore, if the decision-making in the firm has been spread across many roles and people, it is possible that the departure of a pivotal partner will not significantly change the firm.

As one investor put it, "We like to test the junior members. We do not like to look at pitches." What really makes a difference is not individual numbers, but the underlying decision-making team and culture.

In the words of an experienced investor, “We’re looking for managers who will do well in the next 20 years, not the last 20 years.” It is essential to look past the historical data and examine a fund's competitive edge, from platform to talent. Track record is not really about the past – it is about the future.

This piece is from a blog series written by members of the Global Future Council on Investing exploring factors shaping the investment portfolio of 2040.