In a previous post, we looked at the challenges in assessing a sponsor’s track record, and regulatory and industry approaches to promoting consistent and accurate prior performance information. Today, we’ll discuss strategies for how to interpret sponsor track record information, including what factors can change the apparent meaning of what the sponsor presents.
As a member of FactRight’s sponsor/operational due diligence review team, I can tell you that certain issues come up again and again in our assessments of prior performance, which I’ll explore in this post. They underscore that proper analysis of track record is as much of a qualitative endeavor as it is a quantitative one.
How sponsors frame their prior performance pitch
As we previously disclosed, even under the most stringently designed disclosure regimes, sponsors have discretion in how they can present prior performance. So you have to pay attention to how the sponsor may be “finessing” its presentation.
One potentially obvious but important item to be aware of is that the time period that the sponsor selects for its stated performance can make a significant difference. For instance, a fund tracking the S&P 500 could state performance of (4.24%) for the year ending December 31, 2018 or 0.88% for the 12-month period ending January 31, 2019, a pickup of just over 5%. A request of fund documents and financial statements can verify when performance of a previous fund really began and ended.
Make sure to ask if the sponsor’s prior performance presentation is complete, not just a representation of its profitable programs. And perhaps most critically of all, understand how performance numbers are calculated. Assume that the sponsor will use the metric that looks the most favorable. Will that be total return, average annual return, internal rate of return, or something else? Does the metric represent the return of the earliest investor? The last investor? The average weighted return of all investors? Can you verify that the data supplied is net of any sales load and fees, were there any early investor discounts, and to what extent do the results reflect the reinvestment of dividends or other earnings? Examine the back-up calculations to answer these questions.
Whose prior performance is it anyway?
One must keep in mind that fund managers raising their first fund may, given a lack prior performance data, be tempted to leverage a track record from their work at a prior firm. Investment advisers, particularly registered investment advisers, must be aware that they are subject to limitations under the Investment Advisers Act with respect to the presentation and portability of performance data. The SEC generally takes the position that an investment advisory firm’s performance data belongs to the firm, not the investment professional.
However, generally, an investment manager is not prohibited in showing past performance of funds managed at a prior firm as part of a performance track record as long as it is accompanied by appropriate disclosures about where the performance took place, the person’s specific role in achieving that performance and the investments managed at the predecessor firm are similar to the investments currently under management. This can be clarified with the appropriate questions to the sponsor when reviewing their presentation and/or a call to their previous place of employment.
We’d expect new sponsors to have experience managing programs for friends and family before launching a program with similar investment objectives in the retail channel, and performance of those programs is important to examine. However, understand that friend and family program performance can only tell you so much. An early sponsor program is likely to have a different fee structure than what will be offered to retail investors. Thus, even if the manager achieves the same level of “investment success” with managed assets, retail investors may experience lower returns due to higher fees. Retail programs may be burdened with a higher cost or longer timeframe to obtain equity capital than what was needed to solicit close associates. Additionally, tactics that were effective on previously smaller scales may not fully translate into larger retail offerings.
What market conditions can and can’t tell you about prior performance
A real estate firm launched relatively shortly after the Great Recession may have generated positive results for investors, no doubt aided by the run-up in values created by the recovery. Perhaps this demonstrates the manager’s ability to take advantage of market opportunities, but we would expect a relatively easier time in accomplishing investment objectives during the past five years than, say, over the next five.
What is sponsor principals’ track record through various stages of the market cycle?
After all, investment performance during downturns can be more telling about a manager’s ability than performance during periods of rising tides. Ask the sponsor to describe their worst investment. In our experience, hearing about how a manager hit it out of the ballpark on a particular investment can be useful but understanding how a manager struggled with a bad investment can be even better. This will not only give you insights as to how they’ll more effectively manage assets or programs next time adverse conditions present themselves, but also what lengths they were willing to go to support their investors.
And that, in our opinion, is as much of a critical aspect of track record as what the numbers say.