Three Books about Capital Allocation (Part One)

As the title indicates, this is the first of three postings on books which address the challenges of capital allocation.  Each one has a different perspective on that term — which is used in disparate ways in the investment world — and is written in a style unlike the others.

The book currently under review, The Climb to Investment Excellence, was written by Ana Marshall, chief investment officer of the Hewlett Foundation.  Its subtitle:  “A practitioner’s guide to building exceptional portfolios and teams.”

Marshall uses the analogy of mountain climbing throughout the book, which is structured as a series of moves from a base camp to the pinnacle.  Thematically:

Alpinism is similar to investing in that it is the interplay between the technical skills and endurance of the climber/investor and the conditions of the mountain/market that result in a successful summit.

Base camp

The preparations begin with setting up the right goals and structure “to maximize the probability of success.”  In the first two chapters, Marshall addresses investment objectives, constraints, risk tolerance, and time horizon, as well as creating the proper governance framework.

Marshall stresses that there is no one perfect approach.  Getting the staff, the investment committee, and the board on the same page is essential, knowing that circumstances may force unexpected changes in plans.

Also at the start, it is important to know the tools that will be used, so Marshall provides her perspectives on the attributes and applications of various public and private investment vehicles.  A few ideas from her that are worth referencing:

~ Hedge funds and real estate partnerships suffer from a common problem:  Investors use them in diverse ways and have divergent expectations.  Therefore it is essential that the purpose of those vehicles in the portfolio is clear and that there is an alignment with what the investment manager is attempting to deliver.

~ Regarding private equity buyouts, Marshall writes, “The goal is to create valuable companies that can flourish for decades after the GP exits the investment.”  It is hard to square that with how partnerships are actually structured and operated; decisions and actions are optimized for profitable exits, not for long-term sustainability.

~ “The closer the institution is to the theoretical or actual maximum illiquidity threshold, the greater the premium any [private] investment needs to have to earn a place in the portfolio.”

~ “Technical analysis can be useful as a trading tool.”

Up the slope

As Marshall moves to a series of “camps” progressing up the mountain, she deals with policy portfolios, benchmarks, and a variety of portfolio management and manager selection topics.

Policy portfolio.  Marshall argues against “a dogmatic interpretation of the efficient frontier,” preferring instead a “cloud of efficiency” that includes portfolio mixes that are close to the boundary of a mean-variance optimization but which incorporate subjective judgment.  The volatility used for private strategies in the analysis should reflect their inherent variability, not the stated historical numbers — and return projections should not include “hoped-for alpha generation.”

Active risk.  She thinks a diversified portfolio should be expected to have a tracking error of 2-3%, with the individual asset classes running 4-6% — and “a successful investment team aims to deliver a long-term information ratio of 0.50-0.75 or 100-200 bps above the benchmark alpha.”

Liquidity management.  Marshall:

While cash flow models have limitations, the sensitivity in the output from the models lies almost entirely in the behavior of distributions from the portfolio, and not in the pace of commitments.

Asset owners are experiencing this right now, with distributions lagging expectations, changing the liquidity profile of the portfolio overall and altering previous pacing plans.  (Also noted:  single-asset continuation funds and direct investments lead to increased difficulty in modeling distributions versus typical funds.)

Secondaries.  In addition to forced sales due to liquidity issues, over time there has been an increase in the active management of private holdings in the secondary market.  The book covers the trade-offs involved in such transactions, as well as operational considerations.

Manager selection.  This section starts with a quote from John Krakauer’s Into Thin Air, in which he says that half of those at a Mount Everest base camp are “clinically delusional.”  The analogy is to the investment managers who are “eternal optimists, and, perhaps delusional” when it comes to their ability to add value.  (It is also true that some doing due diligence may believe that they are properly prepared to evaluate managers when they aren’t.)

Marshall wants to find A-rated teams with A-rated opportunity sets, and places heavy emphasis on organizational analysis:

Through the process, the CIO and team should come to understand how the managing partners at the GP make decisions, admit mistakes, recruit and develop talent, and align incentives to promote a healthy culture.

There are comments on various aspects of the due diligence and selection processes, with reminders that there are a range of choices in implementation.  Here are some worthwhile excerpts:

It is impossible from the outside to know everything about an investment firm or predict how the partners will act when things go south (in markets there are always challenging periods).

Since the cost of being wrong is higher, the hurdle for adding a new private manager and underwriting a follow-on commitment to an existing manager is higher in private assets than in public asset classes.

While checklists can be useful in ensuring all diligence items are covered, if an investor is focused on getting items checked off they may not be listening to the manager for clues that perhaps contradict key areas deemed important by the organization.

Successful investment teams have designed due diligence processes that hold themselves to the same exacting standards they expect their managers to complete before they invest the organization’s capital.

(The last point reflects an effective pushback in a situation where an asset manager is not providing information that a person doing due diligence is seeking.  A researcher being rebuffed should ask, “Would the members of your team settle for inadequate disclosure when investing our money?”)

The chapter on manager selection closes with Marshall’s thoughts about examining the biases that can creep into a portfolio and “knowing when to quit” a manager — with examples that illustrate when “the evolution of the firm or the opportunity set may be reason enough to walk away.”

Manager relationships.  At several points throughout the book Marshall references (and reverences) relationships with investment managers, especially those in the private arena where, when Hewlett considers a new manager, they assume they “are making a decision for three funding cycles.”

Hewlett uses the term “partner” to indicate the kinds of relationships they would like, and it seeks to earn the trust and respect of those providers so that it can continue to get access to managers and is a first call for opportunities even if its size may not warrant that.  It wants to be “a reliable source of capital.”  All of that makes sense.

However, for asset owners, including Hewlett, the power in the relationship in terms of access and sizing (and pricing) is in the hands of the general partners, so it can be difficult to walk the line between relationship building and impartial analysis.  In that regard, finding out that “feedback from several GPs” is an element in the performance reviews of the members of the Hewlett investment team makes one wonder as to whether the balance is tipped too far in one direction.

Relationships, courage, and trust

The last part of the book, “The Summit in View,” focuses “on the importance of relationships, and the role of courage and trust.”  There are thoughts about culture, structure, needed skills, decision making process, leadership, compensation/incentives, and performance reviews as they relate to the creation and nurturing of an outstanding investment team.

Also covered are relationships with an investment committee and board of directors (connecting back to the groundwork laid in the governance section), fellow investors, and asset managers.  Finally, there is a chapter on “Managing the Self.”  Marshall stresses the need for a clear investment philosophy, as well as the technical skills appropriate for a given role and the qualities of curiosity, creativity, confidence, compounding knowledge, and connecting the dots.

Using the book

As with much communication in the investment realm, books like this face the challenge of meeting the needs of people with different levels of expertise and interest.  In the prologue, Marshall writes, “This book is a handbook to help anyone with a fiduciary responsibility for overseeing or managing significant sums of capital.”  That would include people who are members of governing bodies and those who are actively involved on investment teams.

For those in the second group, who are already familiar with the material, the book serves as a way to compare practices and perspectives, and to look for areas of difference that can be debated and investigated as a part of continual improvement efforts.

Its most natural audience will be those in governance roles, who can benefit from the breadth of topics covered in an accessible fashion.  There are a number of good exhibits that frame individual topics and pose questions for fiduciaries to consider.  The one shortcoming is that the glossary is very skimpy, leaving out many definitions of terms used in the book that would be helpful for those who are early in their governance responsibilities and don’t have a lot of investment experience.

Occasionally the mountain climbing analogies seem forced.  And, while the elements for the management of an investment function are well covered, thinking of them as stages in a linear progression to the summit raises questions about the order in which the topics appear.  That’s especially true for the closing chapters about people and creating an organization that makes good decisions.  Marshall places those topics at the end as an indication of their importance in reaching the top of the mountain, but they could also have appeared at the beginning, to convey that without them as a foundation you would be bound to fail somewhere along the way.

Successful investing

In the prologue, Marshall writes, “Being successful in investing requires a mix of theory, practice, and luck.”  She provides a nice mix of the first two, as well as a number of examples of the vagaries that arise in an uncertain, complex system.  Preparation and discipline are essential, but so are humility and adaptability.

Her general philosophy is well summarized in a list she includes in the book of the characteristics of successful investors.

 

The complete series may be found here.

Visit the archives for more essays in the Asset Owner and Due Diligence categories.