Responding to Growth Concerns from Investors
Raising capital can concern investors due to complications like style drift. In this article, we'll look at how to address these concerns.
As the manager of an emerging fund coming off a few good years, how do you answer this investor question: “I like your fund, and I want to allocate more capital, but can you handle it?” An emerging manager needs to quell the concerns of investors if they want to grow their asset base. Managing $100MM is very different than managing $4B.
Managers can pull three levers to handle asset growth:
- Move up the market cap spectrum
- Increase the number of positions
- Let liquidity deteriorate
We’ve previously discussed the challenge of the AUM growth, and our conclusions then were that liquidity deterioration is the least preferred method for handling asset growth. With that in mind, what is the best strategy? While we can’t predict with absolutely certainty whether a manager can handle asset growth, assuming that the most recent filings represent the current strategy of the fund, we can identify how sizing up a portfolio would affect liquidity and at which point a lever must be pulled.
Seawolf Capital and Bow Street
We examined the public filings of two small mangers, Seawolf Capital and Bow Street, and used the Novus platform to compile all data needed to evaluate how much capital these managers could take in without any change in their portfolio style (deploying new capital into their existing names) AND without giving up liquidity. All the data below comes from 13F public filings, aggregated through our public data product.
Here’s our methodology for this article: we collected the most recent filings, assumed the manager was 100% long, then sized up the portfolio from its current market value to various amounts, ceilinged at $4B. We assumed that the manager does not pull the first two levers, meaning they do not move up the market cap spectrum and do not deploy capital into more ideas. We assume they simply invest the additional capital in their existing names. First we’ll examine Seawolf Capital, founded by Atwood “Porter” Collins, formerly of FrontPoint Partners, filing $467MM in Q2 2015. Assuming they continue to implement the same portfolio going forward, we see how the liquidity profile changes at larger assets.
Based on current positions, around $700 MM the portfolio is no longer capable of liquidating in under 60 days. The green portion on the chart above is the part of the portfolio that must take between 60-90 days to liquidate. Once the portfolio reaches 1.5B, under 80% of the portfolio could be liquidated within 60 days, with over 20% in the illiquid >90 days bucket. At $4B almost 40% of the portfolio is illiquid. All of this information reveals that the current strategy could start to evolve around $700MM, but will have to change somewhere between $1B and $2B, when less than 80% of the portfolio could be liquidated under 90 days. Seawolf, as a smaller manager, will have to explain to potential investors how it plans to handle growth if it begins to move towards $1B, and must plan for asset growth sooner rather than later. Most likely they will need to pull one of their two available levers. It is important to note that not all style drift is bad, many managers do better in larger capitalization stocks and investors should perform attribution analysis by market capitalization bucket to understand where the skill is coming from.
Now we’ll examine an even smaller manager.
Bow Street, LLC, founded in 2011 by Akiva Katz and Howard Shainker, formerly of Brahman and Third Point respectively, publicly filed ~$203MM in market value. In comparison to Seawolf, Bow Street can maintain its current positions and strategy as they grow assets without as much concern.
Bow Street could liquidate their entire portfolio in under 60 days even at the $1B mark. Very illiquid positions don’t come into play until the $2B mark, and even at $4B, 88% of the portfolio can be liquidated under 60 days. This type of analysis is a simple, effective way for managers to understand the scalability of their current strategy. Managers should use their own private data to analyze and prove to investors that they can in fact handle more investment without shifting proven strategies. Preparing for exactly how their strategy will shift before the question of scaling is even presented proves to investors that the manager is maintaining due diligence.
Managers, and emerging managers in particular, should use their private data to evaluate their capacity for additional capital to soothe the anxiety of investors. We know most managers prefer to move up the market cap spectrum instead of reducing liquidity, but understanding when liquidity deteriorates indicates when a manager should consider moving up that spectrum, increasing positions, or consciously allow liquidity to decrease. This type of analysis benefits both investors and managers–managers can continue to discover ideal investments for their strategy, while investors can feel confident about additional allocations to their successful manager.
Methodology – AUM increase
We take public filings data from the Novus platform and extract all positions. First we take the current Market Value and assume 100% long, which becomes AUM. We then created theoretical AUM increases and divide the Potential by the Current. For example 550,000,000.00/467.245585.71 = 1.18. Just for reference purposes, call this the AUM Factor. We’ll come back to this.
|AUM Scenarios||AUM Factor|
|Current Market Value (AUM proxy)||$ 467,245,585.71|
|Potential AUMs||$ 550,000,000.00||1.18x|
Methodology – Liquidity
Assuming that 20% of the Average Daily Volume of the trailing 90 days is the max a manager can trade each day to exit a position, we multiply the .2 by the Average Daily Volume and get the amount that can be traded in one day. Take the ending quantity of shares of a position, in the case above, the quantity filed on Q2 2015, and divide it by the 1 day liquidity of that position. This is now the number of days it will take a manager to exit that position under this current market value or Current Liquidity (Days).
Now we take that AUM Factor from earlier and multiply the Current Liquidity (Days) by the AUM Factor for the corresponding value to generate a hypothetical Liquidity in days for each position at different values. The example below shows how GNW and RDN are slowly become less liquid as AUM increases.
|Current Liquidity||Hypothetical Liquidity|
|Symbol||Liquidity (Days) Current AUM||Liquidity (Days) at $550||Liquidity (Days) at $600||Liquidity (Days) at $650|
We have seven buckets 1 day, 1-5 days, 5 – 10 days, 10-30 days, 30-60 days, 60-90 days, and >90 days. This reflects how long it takes for a position to be exited based on our 20% of trailing 90 day ADV assumption earlier. We sum up the % of portfolio of each position based on each corresponding bucket.
|SeaWolf Liquidity||Current (as of 6/30) $467MM||$550MM||$600MM|
|1 – 5 days||22.01%||23.86%||24.72%|
|5 – 10 days||13.11%||8.60%||8.10%|
|10 – 30 days||22.78%||23.17%||23.67%|
|> 90 days||0.00%||0.00%||0.00%|
Once we have that, we know the % of portfolio in each bucket, and we can take this information and display in a chart for easier analysis of trends.
For more information on methodology, please contact Stephen Bennett at email@example.com.