The Overstated Risk of Losing a Key Manager
One of the risks that prevents investors from hiring talented investment managers is the perception that the success of a strategy is too heavily dependent on one or two people—a concern expressed more ubiquitously via the “What happens if Joe gets hit by a bus?” question.
This so-called “key-person risk" is among the more exaggerated considerations when selecting an investment manager. Indeed, in many situations, this risk is something to be embraced, not shunned.
Key-person risk tends to receive more consideration than it deserves in part due to how simple it is to identify. It’s common for investment firms and investment products to be created around the distinct skillset of one or two people. Therefore, the most obvious and easily identifiable risk relates to what would happen in their absence.
Perhaps no clearer example exists today than Warren Buffett and Berkshire Hathaway. All of us see this risk and understand that Mr. Buffett’s absence could have a profound impact on the investment decisions Berkshire Hathaway makes in the future. But this example also underscores another point, which is that key-person risk need not preclude an otherwise profitable investment. If you avoided investing in Berkshire Hathaway because of fear that it relied too much on Mr. Buffett, or that he would retire, you would have suffered decades of regret.
Looking past the obvious, we also see powerful forces at work to promote stability in most star-manager situations, making disruptive “key-person events” less likely than one might assume. Just like with Berkshire Hathaway, talented investment managers often have significant economic and personal reasons to remain in their current role. These reasons stem from the fact that the key people are often founders, large equity owners in the business, and/or substantial participants in the firm’s economics. There can be more personal reasons as well—having their name on the door, a sense of obligation to those who have joined their team, or possessing such a deep passion for investing that retirement simply isn’t a consideration.
Of course, in situations where key people aren’t adequately incentivized, investors should rightfully focus on the prospective stability of the situation. Fortunately, understanding the economic forces that promote stability is as easy as having a few conversations with the appropriate people, albeit ones that may involve some awkwardly direct questions.
Another reason key-person situations appear relatively risky is that the risks of their alternative—non-key-person situations—are easier to underestimate. Investment processes that rely on the contributions of more than a couple crucial people are often more vulnerable to changes in composition, size, investment emphasis, and interpersonal dynamics because more people have an impact on the investment process. The complex interplay between such factors make it much more difficult to identify with any certainty the extent to which changes in any of these factors, even very subtle changes, are impacting the investment process and the resulting performance.
The truth is that analysis is more straightforward in key-person situations, where evaluation before or after an unforeseen event is highly focused on the one or two key people. If a proven star manager leaves his or her strategy, your next move would be relatively clear: you take your money and reinvest it elsewhere. The alternative is sorting through the more nuanced analysis of the relative contributions, synergies and interpersonal dynamics of a broader, more team-centric situation. Assuming the chances of departure are equal for any professional, investing in a well-oiled four-member investment team could be far more challenging to reconcile on the backend of potential disruption.
None of this suggests that key-person investment processes are inherently superior. In fact, they are almost certainly overrepresented in the tails of return distributions. On the positive side of the distribution, you will find truly unique talent, undiluted by the input of lesser investors. On the negative end, you will find portfolio managers mired in perverse investment behavior while lacking the mean-reverting influence of his or her broader team. The point is that if you do happen to discover one of these high-performers, you shouldn’t write him off solely due to a fear that he will drop out of the strategy.
Inconveniently, there is no optimal team structure in investment management. Instead, as always when choosing an active manager, one must consider the relative impact of a host of factors that impact the manager’s return proposition. In this context, key-person risk is relatively easy to evaluate, and in those situations where you are convinced you have found an exceptionally gifted investor in a stable environment, it is likely a risk worth taking. As further evidence, I would offer that in my 30 years in this industry, I have known of only one portfolio manager who was actually hit by a bus, and that individual survived just fine.
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