The Missing Key to Optimal Investment Performance - Part 2
Polywood - Wausau, WI
Mismatched Timing Incentives
One common error in manager evaluation is selecting a manager whose timing incentives are misaligned. Consider Manager B, who delivered outstanding returns in 2020 and early 2021. He decides to launch an opportunistic fund to purchase the distressed assets of Manager A and others in similar positions. Given his history of excellent returns, Manager B secures commitments of hundreds of millions of dollars, earning fees while searching for opportunities. His investors give him three years to deploy their capital, after which he can only earn on what he has deployed.
By 2022 and 2023, Manager A is not motivated to sell at a compelling price because he refinanced at historically low interest rates in 2020 and doesn't face his loan coming due until 2025. As 2024 approaches, Manager B must return the capital if he doesn't buy something, so he deploys the capital before his time expires rather than waiting for market conditions to fully develop. While this action may be contrary to what investors would prefer, it aligns with the incentives established by the investors when they hired Manager B.
Misaligned Duration Incentive
Timeframes can also be misaligned between investors and managers regarding the duration of underlying investments. Consider an investor with a 7-10 year investment horizon. This investor is interested in receiving a steady income stream during their investment period and a maximum gain on their capital when it is returned. The optimal way to achieve this from a risk/return perspective is to invest in properties with a tenant having 10 or more years of lease term. This approach provides income stream certainty during the hold period and allows repricing to market at the exit time to capture full appreciation in the property.
Now, let's revisit Manager B. He takes two to three years to deploy the capital he has raised but will not simply wait to sell those properties to raise more capital. Once one fund is largely deployed, he will begin raising capital for a new fund. When raising capital for his funds, it is important to demonstrate that his existing investments have performed well. This means that the risk horizon for his investments is one to two years, the period over which the investment needs to perform optimally. Because of this, Manager B may prefer to keep the lease term to one to two years so that he can mark the property to a higher market value in time to support his new capital raise. In doing so, he optimizes total returns within his duration timeframe but at the expense of unnecessary risk in the investor's timeframe.
Stay tuned for the next part of this blog series where we talk about financial incentives and how they can go wrong...
Dan Andrews
CEO