Vetting investment partners, time-tested heuristics

In 2022, 11% of GPs with +$1 billion in assets under management attracted 72% of all LP capital in private markets (Pitchbook, 2022). Most blue-chip firms are predisposed to scale bias. Once they reach a certain critical mass, investing in lower-middle market or more esoteric strategies often becomes economically unviable.

Traditional private market access channels that advise LPs, such as private banks, wealth managers, etc., tend to mirror this bias, leaning towards large, scalable funds due to their expansive client base and, in some cases, pressure from shareholders. Institutional allocators (endowments, pensions, etc.) are often similarly scale seeking—but for reasons related to resource constraints and a lack of flexibility/nimbleness.

Fiduciary responsibilities may be, at least ostensibly, achieved based on ‘buying IBM’—i.e., long term track records of past performance and lower dispersion of outcomes, the classic brand safety net. Advisers typically don’t get fired for recommending blue-chip funds and can have little incentive to expend resources finding lesser correlated sources of excess return.  

The pursuit of growth and scale, then, often creates a self-perpetuating cycle of product bias. More of the same. Therein lies the tension between investment performance and asset gathering (incentives).

“Time and size constraints, meaning an investor has an economic interest in deploying a large amount of capital in a short period of time, tend to have a negative correlation with performance. Just follow the incentives.” – Michael Leffell

The resulting market structure has a supply/demand imbalance in capital formation, which we think is ultimately a beacon signaling potential for excess return among the ~89% of GPs seeking capital for smaller funds and less competitive opportunities. 

Such investments, intuitively, also tend to have a much wider dispersion in performance outcomes. And the market is hyper-fragmented, teeming with over 28,000 of these smaller GPs. Thoughtful, streamlined filtering is therefore critical—this is where we focus resources to source what we believe are the likely outperformers.

Over the past decade+, we have identified several heuristics that tend to correlate with positive outcomes through a blend of empirical analyses and pattern matching.

We strongly believe this (non-exhaustive) list helps us avoid fishing expeditions in fruitless waters, while mitigating non-obvious risks.

The first is skin-in-the-game. A significant personal investment and/or the engagement of personal networks for capital is a strong conviction signal. It entrenches switching costs and can plant a subconscious risk controller in the mind of the GP. Based on industry trends, it’s vital to understand the capital at risk for key individuals in the GP as opposed to firms that syndicate GP ownership.

Demonstrable industry expertise, a variable in measuring competitive advantage, centers on the GP's sector-specific experience and execution track record. Deep industry knowledge can confer significant advantages, from spotting high-potential opportunities to deftly handling sector-specific risks. A significant percentage of small GP’s are small for a reason—they lack the specific expertise to execute—and thus might be investing your capital as an ‘experiment’. 

Sourcing edge. We assess a GP's ability to source and win off-market (or limited auction) deals. The pressure to invest a fund quickly to raise the next larger fund can be fueled by greed. And acquiring assets via an auction process by offering the highest price is certainly not a recipe for success.

Key partner relationship duration, a perhaps less conventional variable, provides insights into the stability of the team. Partners with long-standing, pre-existing relationships often display a more cohesive strategic vision, providing a buffer against the risks posed by potential corporate breakups.

Integrity, character, and intellectual honesty. Seemingly obvious, we know. GPs that are transparent about their mistakes and talk about losses (not just winners), are most often strong candidates for long-term partnerships. Everyone makes mistakes—take accountability, learn, and move on.

Combining these heuristics, and other systematic due diligence procedures, will position investors to find opportunities that have attractive risk/return asymmetry.

Investing is as much art as it is science. And the ultimate goal is to find asset categories where the investment universe is sufficiently large, but capital flows are scarce, creating ample opportunity to capitalize on inefficiencies. 

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This material is solely for informational purposes and should not be viewed as a current or past recommendation or an offer to sell or the solicitation to buy securities or adopt any investment strategy. The opinions expressed herein represent the current, good faith views of the author(s) at the time of publication and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this article has been developed internally and/or obtained from sources believed to be reliable; however, 10 East does not guarantee the accuracy, adequacy or completeness of such information. Predictions, opinions, and other information contained in this article are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and 10 East assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward-looking statements. Individual investor portfolios must be constructed based on the investor’s financial resources, investment goals, risk tolerance, investment time horizon, tax situation and other relevant factors. Investors should seek advice from their investment, legal, tax and/or other advisers to review their specific information. Asset allocation does not guarantee a profit or protection from losses in a declining market. Investments in securities involves significant risk and has the potential for complete loss.