Allocator Interview: Building a Bullpen of Micro and Small Cap Managers

My name is Alexander Plum and I lead business development efforts for SumZero’s allocator cohort. It’s my pleasure to be joined by Chris Tessin CFA, Managing Partner and CIO, Dennis Jensen CFA, Founding Partner and the Director of Research, as well as Doug Porter CFA and Matt Nieman CFA, both Senior Analysts and Portfolio Managers at Seattle-based multi-manager investment advisor, Acuitas Investments.

As the Acuitas team speaks with hundreds of managers annually, our goal is to provide both funds and fellow allocators with a look inside their approach. For some background, Acuitas manages approximately $575m in assets in multi-manager strategies across private funds, SMAs, and mutual funds – the majority of which have a US micro cap and non-US small/micro cap focus.

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ALEXANDER PLUM (AP), SUMZERO : Chris, Dennis, Doug, and Matt, thank you very much for your time. We appreciate you opening up for this Q&A and for being a long-time, active member of our Cap Intro offering. Let’s get right into what Acuitas does best. You’re a multi-manager that focuses on micro and small cap investment managers. Can you discuss the genesis of this focus?

CHRIS TESSIN (CT): Thank you, Alex. We appreciate and always welcome the opportunity to chat. SumZero’s cap intro offering has helped our team connect with a number of interesting funds and it’s great having resources such as SumZero to help allocators and funds initiate a dialogue.

Regarding our focus as an investment firm, Acuitas was founded with the goal of finding great investment managers in the least efficient asset classes. We’re always trying to solve a simple problem: How do sophisticated investors gain access to the least efficient corners of the equity markets? Many simply don’t have the time for what would be a small, but still important allocation. When we consider that small/micro cap are some of the richest corners of the market for active management, the simple answer was to provide investors with dedicated research and investment expertise within this underrepresented space.

There is an inherent problem in money management. Managers have an incentive to gather assets, but a large asset base is often the enemy of investment performance. As a result, we don’t see large organizations offering limited capacity products and most investors are biased against smaller products, despite the fact that they often post better returns. Additionally, few investors start in this business with the goal of staying small, but we think those that do stay small have an advantage. We believe that by being experts on the small/micro corners of the investment universe we can provide significant value for clients.

AP: Matt, in October 2019, you wrote about a “challenging active [management] environment”, but the setting has since changed a bit. As Acuitas recently stated that micro/small cap investing is not a “riskless trade” and the current environment is now providing an opportunity for active managers to “get paid for assessing risk”, can you elaborate on these ideas?

MATT NIEMAN (MN): It’s no secret that capital markets – and the world – have been flipped upside down in recent months as we all battle through the COVID pandemic. As micro and small cap specialists, we recognize that the naturally higher beta in these areas of the equity markets presents risks. During extreme risk-off environments this can be quite painful for investors, as the Russell Micro cap Index fell more than 40% in under a month. Many active managers struggled during the drawdown as the indiscriminate nature of the selling caused individual company fundamentals to have minimal impact on stock performance.

The key question is: Where does this leave us now? We feel that this is one of the most lucrative environments for active management we’ve seen in our careers. The sell-off has brought small and micro cap equity valuations to historically attractive levels, and many individual stocks have sold off in a manner that’s completely disconnected from what the economic reality would indicate. To be clear, a number of companies will go out of business as a result of COVID. The opportunity for active managers lies in companies that are able to emerge from this crisis in a position of strength, after being unfairly punished during the selloff. Active managers who are adept at opportunistically sifting through the universe of oversold companies should add meaningful value and when this skill is coupled with sharp portfolio management, it definitely catches our attention. Frankly, this is the most excited we’ve been about the active opportunity since the launch of Acuitas.

AP: Dennis and Doug, through your careers you’ve covered the entire market cap spectrum from mega caps to micro caps. What do you enjoy most about focusing on smaller market cap strategies?

DENNIS JENSEN (DJ): Above everything else, the ability to generate more attractive alpha in micro cap markets makes focusing on the space more fun, and more importantly, improves our ability to deliver returns for clients. Additionally, I really enjoy finding unique, skilled managers that are motivated to operate in capacity-constrained asset classes because they care more about delivering investment results than they do managing as much money as possible.

DOUG PORTER (DP): Given the size of the stock universe and dearth of coverage by institutional investors, managers in this part of the market have a much greater opportunity to develop an informational edge. This edge can be generated by sifting through data, communicating with management, one’s individual perspective, or via the regimen of the investment decision making process. From our vantage point, the hunt for managers who can develop this edge and deliver attractive returns is incredibly exciting.

The small/micro cap manager universe is similar in dynamic to the underlying stock universe - large and disparate. Most often, the undiscovered “gem” managers operate in obscurity far longer than similarly capable large cap managers. Those who are discovered often grow past a reasonable level of capacity, which impacts future returns. Few can maintain the edge over the long run when at or near capacity and as a result, there is a constant hunt for the next star manager.

AP: Related to the above question, do you notice that micro/small cap managers have traits or processes that are different from those investing in large caps?

DJ: One of the more critical differences we see for global micro cap and small cap managers is on the idea generation front. These managers, particularly those outside the U.S., need more focus and creativity when it comes to idea generation. It takes a unique mindset to identify and research companies that are not on what we call the “institutional radar screen”. The companies typically lack sell side coverage, don’t have great investor relations departments, and have heavy insider or local investor ownership. There’s little institutional competition following these stocks and managers need a process that’s tailored to uncovering these opportunities. Ultimately, if skilled professionals are willing to dig to uncover interesting small companies they can create an informational advantage and potentially generate better returns.

AP: Dennis, a clear process to discover new opportunities makes a lot of sense and I’m sure in many cases this is easier said than done. Matt, you’ve mentioned that the way a strategy physically trades its holdings is also of utmost importance. Tell us more about that.

MN: A firm’s trading effort often plays a larger role in the success of a micro/small cap strategy than a larger cap peer. As Dennis noted, finding names that are not on the “radar” can be a meaningful source of value add, however being able to successfully navigate the smallest end of the market cap spectrum presents unique liquidity and trading challenges. Many of the smallest names are not included in popular small cap ETFs, have no sell side coverage, and are consistently screened out by other investors on size and/or liquidity metrics. These elements all contribute to the lack of liquidity and also cause pricing inefficiencies. During our research process we spend a significant amount of time assessing a manager’s trading practices. We’ll often query historical transactions to learn how trades were executed and liquidity was sourced. From there, we assess the trading effort in the context of the manager’s investment process to assess fit and recognize if there is potential for implementation slippage. We always ask ourselves, “How integral is the trading component of the strategy to its overall success?” This element of our manager evaluation effort is also closely tied to our assessment of product capacity - as a smaller asset base makes it significantly easier to deal in the less liquid tail of micro cap. While a best-in-class trading effort is not required for managers to win, those that are able to strike the right balance between maintaining strong trading execution, being opportunistic and nimble with sourcing liquidity, and setting prudent capacity limits have an advantage over peers.

AP: Funds often ask me, “Is it an analyst or the CIO of the firm that’s viewing my materials?”. My answer, in so many words is, “It depends.” Can you shed some light on the structure of your team and responsibilities of the members?

CT: That’s an important distinction for us, Alex. There is no fund that goes through our process without review from every member of the team. We are a culture built on collaboration and while we each have unique areas of strength and focus, ultimately working together and holding each other accountable results in better investment outcomes.

DJ: In Acuitas’s case our team is very flat. To give some additional color, all four senior members of our team have explicit areas of coverage, but we work together throughout the process on all high interest managers and portfolio decisions. Each investment professional is empowered and encouraged to identify interesting new managers and move them through our investment process. If a new manager looks promising the entire team is increasingly engaged in the process, participating in both internal and external meetings. Ultimately, when the lead analyst would like to add the strategy to our “Bullpen” the investment committee meets for a full discussion about the strategy’s strengths and weakness, to challenge the investment thesis, and to compare the manager to our existing managers. Once a manager is in the Bullpen it’s available for use in client portfolios. Chris is the lead PM on most of our portfolios and makes the final decision, along with the respective portfolio’s co-PM.

AP: Due to capacity constraints within the micro/small cap space, many funds have relatively low AUM figures and may be considered “under-the-radar”. How do you and the team most efficiently source new manager relationships? What tools or best practices do you use?

DP: Broadly, we aim to utilize investors with tremendous experience in micro and small cap and a well-defined, repeatable investment approach. To source these managers, we use quantitative and qualitative methods, separately and in tandem. In some instances, the product exists and is available in a consultant database. After reviewing the investment approach and assessing how assets compare to our estimate of capacity, we’ll reach out to the manager to learn more.

As you may expect, we also use our contact network within the industry to find new opportunities. Due to our history in the market and reputation as an early allocator, we field a lot of in-bound inquiries. In some cases, investment firms are in the early stages of developing a product concept or are unofficially in search of seed capital. In other cases, we’ll approach a team who we believe has an approach well suited for the space.

We supplement our idea generation with quantitative analysis of reported holdings to highlight managers who invest in the space, but do not advertise or have a dedicated product. For example, we’ve found quite a few US small cap managers with a successful history of investing in micro cap stocks and in some cases have seeded micro cap focused strategies with them.

AP: A few weeks ago, you mentioned Acuitas’s desire to speak to everyone. In other words, you’ll gladly speak with a fund before they’re “ready” or “institutionally viable”. Can you elaborate on this and perhaps underscore the fact that many relationships that ultimately resulted in funding took years to build?

DJ: It’s our goal to keep as wide of a net as possible. We avoid narrowing our opportunity set through artificial constraints such as asset size and track record length. We want to get to know everyone that’s active in the global micro cap space, even if they aren’t ready for institutional money today, because someday they may be.

DP: It works in our favor because in our experience, perspective and conviction are best built over time. With a longer horizon, we can evaluate how the money manager and their peers handle different stages of the market cycle and how they use experience to improve or evolve. We believe in evaluating managers relative to their peers, which can only happen by keeping our net wide.

It’s also critical that we keep a deep “Bullpen” of managers that are approved for investment. We do that by continuously looking for interesting new investments. Throughout our sourcing, we avoid a demand-driven approach where idea generation is limited to only when there’s an immediate need. A demand-driven approach relies on a quick and often abbreviated analysis that lacks sufficient time to assess the manager and how they’ve evolved over time. Weaknesses of the past can be overlooked and the benefit of gaining insights from evaluating the manager over time, in real time, can be lost.

Our continuous search for managers also puts us in a position to opportunistically use interesting managers. It can be unpredictable when the timing might be right for a new manager opportunity. For example, there are cases where we’re interested in an investment team, but they may not be ready for an institutional mandate on the operations side. We want to have the investment work complete so that if they build out the operations infrastructure we are ready to invest. With this approach, in some cases we’ve followed a manager for many years before the right opportunity to work with them presents itself. In other instances we’ve been able to move quickly to take advantage of an investment opportunity. Regardless of time horizon, we believe it’s important to be in a constant state of evaluation with both current and potential funds.

AP: I’ve spoken to a number of funds that are anxious about fundraising because they can’t meet potential investors face to face. Due to the global pandemic, do you expect fundraising norms to change? Do you expect Acuitas to change its practices?

DJ: I’ll answer your question about Acuitas specifically first. We don’t expect our practices to change much. For the most part we’ll continue conducting our research, doing our analysis, and having discussions with managers much as we always have. In fact, we are in the process of making a few changes in client portfolios right now. The one exception is that onsite meetings with managers are an important component of our process. Onsite meetings help us get to know the key investors better, meet the full team, more fully understand compliance and operations functions, and develop a feel for the culture of the firm. For as long as travel is restricted we’ll continue to do our best to accomplish these components of our research remotely through conference calls.

Unfortunately, I do think fundraising will be impacted for the industry as a whole. Of course, the direct sales process will be much more difficult with conferences cancelled, travel restricted, and face to face meetings impossible. However, I’m equally concerned over the short run about the “freezing” of potential prospects’ activity caused by the volatility in the markets. I think many potential fund investors have turned their attention inward, focusing on what they currently own, their asset allocation decisions, and macroeconomic risks. Unfortunately, this has resulted in delays or cancellation of searches and manager allocations. I’m hoping that as we gain clearer visibility into COVID and its economic impact activity will loosen up before long.

AP: What do you see as the biggest barrier to success for managers focused on the small and micro cap spaces?

DJ: Managers in micro cap and small cap face many of the same challenges that all managers face, such as under-resourcing, product proliferation, or the key investors losing focus and delegating investment decisions to less senior professionals. However, the barrier to success specific to micro/small cap in our experience is excessive asset growth. As Doug discussed earlier, small and micro cap are both capacity constrained asset classes. As asset levels grow it impacts their ability to implement the process. Something has to give, whether it’s increasing transaction costs, lower turnover, holding more positions, or moving up the cap spectrum. We look to partner with managers with a low asset base that are in the “sweet spot” of their life cycle.

AP: We here at SumZero always like to close with the following question. What advice would you give to someone considering launching a new fund? What do you think is the most important thing these individuals can do to increase their chances of being a viable partner with an institution like Acuitas?

MN: In our view, the most important thing a new fund manager can do is to build a culture that is investment led, which means having an unwavering focus on the investment process and insulating the investment team from the numerous operational demands of running a firm. While we understand that fundraising and operations are important parts of the business, investment professionals that become too focused on raising assets and operational items can take their eye off the ball on the investment front. When this happens, the chance of sustained success diminishes meaningfully. On the flip side (re: operations/compliance), some of our clients are large public plans, and we can’t expose any of our clients to the risk of operational or compliance mistakes. The key is striking a balance where the success of these essential compliance and operational functions is achieved without compromising returns.

DJ: I agree with Matt 100%. The only thing I’ll add is from a business viability perspective. As we learned from our own experience starting Acuitas in 2011, raising assets in the investment industry can be a very tough game and the compliance and operational infrastructure needs have only raised the bar for starting new firms or funds. It’s important for new managers to either have a clear strategy for raising assets in the near-term, or be able to run very lean and have a long runway to operate the firm at a low asset base. As Matt noted, we certainly recognize that some of these points contradict one another! Maintaining the right balance between these competing factors requires discipline and we believe that managers that do so will be rewarded.

Download the Acuitas Investments Q&A Here