The Flip Side to Capacity

Many investors have rules regarding the maximum weighting that their capital can comprise of a fund’s total assets. For example, if an investor wants to be no more than 50% of a fund’s assets (not including the investment to be made) then the most that investor could invest in a $100 million fund would be $50 million. One common explanation for such limitations is concerns about liquidity. If an investor is $50 million of $100 million fund and liquidates the sale of $50 million dollars could have a negative impact. However, the same is true for a $50 million liquidation in a $1 billion fund, as a $50 million trade will have the same market impact irrespective of fund size.

Admittedly, any impact would be more concentrated in a smaller fund, but this doesn’t necessarily make it significant. For many strategies, a $50 million purchase or sale would have little to no market impact. Rather than blanket limitations, investors should understand the strategy and its liquidity profile, and let that dictate how much of an investment the investor is comfortable making. Along those lines, we think an investor should focus on the following areas when conducting due diligence, no matter the size of the fund.

  • Investment Risk 
    An investor should attempt to gain a strong understanding of the strategy, the anomaly that it is exploiting, the reasons why this anomaly exists and should continue to exist, and the investment team’s capability in exploiting the anomaly. If the team can demonstrate that they’ve been successful in doing so, then fund size should play very little into the decision to invest. In fact, it is often smaller funds that are able to more nimbly take advantage of investment opportunities, so a more important consideration is whether a fund has grown too large.
  • Operational Risk 
    Is the firm capable of executing and scaling the strategy if it were to grow assets? Looking at a firm’s current infrastructure for research, modeling and trading is vitally important. This is especially true of a firm running a very small fund, as it may not have the experience or the infrastructure in place to scale up with a strategy as it grows.
  • Business Risk 
    A firm with a small fund may not be financially viable for long if the fund does not gain assets quickly. However, that risk is mitigated when the firm is diversified across its fund lineup. Also, a firm may be well capitalized even if it has a small asset base, providing time to grow a fund without the risk of shuttering the business. It is important to understand each firm’s individual situation when assessing business risk, as assets under management may not tell the whole story.

    In addition to firm viability, one must consider a fund’s viability. Is it likely that the fund will grow to a size where it is self-sustaining? How disruptive would it be to an investor if the fund were to shut down? These are valid questions any investor should contemplate when investing in a smaller fund.

Many would argue that the reason for limiting the size of the investment relative to the fund’s size is to minimize liquidity concerns. But rather than limiting the percentage amount you are willing to invest in a fund, it is probably a more effective strategy to have a strong comprehension of the fund; understanding its liquidity dynamics, as well as other vital due diligence considerations such as operational and business risks. Going through this process will allow an investor to be more dynamic in their decision making and not preclude them from strong investment opportunities based on arbitrary and possibly misguided rules.

Read our blog from last week, It’s March: Do you have a Championship Roster?