Asset Managers Are from Mars, Investors Are from Venus (Part 2 – A Space-Walk Down to Earth)

In the first part of this post, I wrote about how differently asset managers and investors react to stressfull situations, with the retreat to the cave of the ones contrasting with the need for increased communication and transparency of the others.

(Lateral thought: it will be interesting to look at how robo-asset managers will deal with market stress and the consequent requests of investors…)

In this second part, I will focus on the referenced major second differentiation trait describing the fundamental psychological differences between asset managers and investors.

  • It appears that asset managers and investors are surprised to find out how their counterparty “keep score”, or how widely their scoring methods differ.

Given the strength of the evidence, I will refer to the private equity industry – but the argument holds, with the due adjustments, for all other asset classes.

In private equity, there seems to be quite a bit of communication breakdown with respect to score-keeping…

Broadly speaking, asset managers (or the GPs, the General Partners in the industry’s jargon) favor the Internal Rate of Return (IRR) methodology – that is the yardstick that they use to select and benchmark their investments. The IRR works well for the asset managers as it allows to deal with the different cash flows of any transaction in isolation.

So, for example, asset managers could report an IRR performance of 6.7% about a certain fund (details could be available upon request).

This score, per se, is not sufficient to investors. How do they know whether this number is good or not? Usually investors look at the performance of a major comparable index to have a sense of how much a “simple reference” investment would have yielded over a comparable period.

Ok, but what’s the period? Ah, the IRR doesn’t not have a time framework comparable to that used to frame the return of the S&P 500 (that is the actual calendar).

So the asset managers have come up with a solution – the public market equivalent (PME) methodology. They assume that the money is invested and divested with the same pace of the private equity transaction being benchmarked and then compare the total amount.

Using the PME, investors should be reassured – it looks they earned in private equity 14% more than investing in the S&P….

In reality, investors still don’t know how much money and for how long the 6.7% represents. Do investors have received the equivalent of a 6.7% coupon? And for how long?

The reality is that asset managers from Mars and investors from Venus still need to meet “down to Earth”.

A useful return must be unambiguously representative of the actual money being produced by a transaction. I have that number, after 10 years, considering the NAV at par: it is USD 15.8 million – versus the initial availabilities of USD 10 million.

Is that 6.7% over 10 years? No, this is 4.7%, i.e. this is the rate or return that makes 10 million become 15.8 after 10 years.

The difference seems to be lost in translation.

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A space-walk down to Earth should not be about changing the IRR, that is the tool/language that asset managers utilize to manage efficiently their investments.

It is a matter of incentives – the IRR rewards the limited use of capital and the speed of execution.

In fact, it is also in the investors’ best interest that the asset managers maintain the mindset intact, maximizing the result.

But investors need to know how much money they have (or can expect to have) to pay the bills.

The bills are the investors’ goals, hence the relevant incentives that cannot and should not be modified. It’s true for individuals, pension schemes, endowments, foundations, etc.

Therefore, a space-walk down to Earth is about building an efficient translation framework to bridge the communication gap between Venus and Mars – keeping the relevant languages, incentives and constraints intact.

XTAL has been building the innovative “Duration adjusted Return” (DaRC) translation engine, that is increasingly attracting investors and asset managers interest and has recently been granted an additional patent.

Ground control to Major Tom, what’s the duration up there?

Ground control, here’s Major Tom. Adjust duration from 5.8 to 10 and connect Venus to Mars.

(Originally published on Pulse: https://www.linkedin.com/pulse/asset-managers-from-mars-investors-venus-part-2-saccone-cfa?trk=hp-feed-article-title-publish)

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