Nicolai Tangen is the CEO of Norges Bank Investment Management, Norway's $1.4 trillion sovereign wealth fund.
I co-manage Blueprint Capital Management (www.blueprintcm.com) which is a MicroCap growth equity strategy focused primarily on the Technology and Consumer sectors. I launched my fund almost two years ago and, over time, have fielded many inquiries, both general and specific, regarding the initial setup, preferred structure, and actual
I co-manage Blueprint Capital Management (www.blueprintcm.com) which is a MicroCap growth equity strategy focused primarily on the Technology and Consumer sectors. I launched my fund almost two years ago and, over time, have fielded many inquiries, both general and specific, regarding the initial setup, preferred structure, and actual investment procedures we have put in place to manage our client assets for the long-term. This blog may serve useful to others considering starting their own investment management business, and I hope you find it useful as an instructive tool.
The Basics – Investment Philosophy and Expectations
First off, one needs to develop a sound philosophy for their strategy. This relates to what you believe in and how, exactly, you plan to execute on those beliefs. We have a detailed presentation book that covers these topics, and many others, upfront when talking to prospective clients. This openly lays out our business model, and helps set realistic expectations for the ongoing relationship. This may seem like obvious business strategy, but one would be surprised! We have seen some very unstructured business plans out there. An investment strategy should not be open-ended, as it will give too much leeway to destroy value over time. Money managers should have a clear focus and discipline to stay within their area of expertise or specialty. This will limit the undesired evolution of a manager that has been hired to pick MicroCaps from suddenly dabbling in convertible bonds or another strategy for which they were not hired. Our investors know what to expect. For example, we do not dabble in biotech or energy, and state this very clearly. If there are well-articulated expectations and parameters, then investors will clearly know when you have met them, or not. This enables trust and accountability on both sides of the relationship.
Portfolio Construction, Investment Process & Discipline
Having a framework, or “blueprint” is important to know how to build a house or run an investment portfolio. Having clear guidelines regarding portfolio construction, investment process and discipline are paramount. It will allow investors to better evaluate you, and it demonstrates that what you are doing is repeatable. We drive outsized returns based on taking concentrated bets across 12-15 MicroCap investments. We first get to know our companies very well using a repeatable process and a key tenet to this approach is accessibility to management. Without accessibility to the CEO or CFO, we will not invest with a company. It is a black and white deal breaker for us. Going deeper with each investment enables us to take more concentrated positions. I don’t see how a money manager can have a Portfolio Manager (PM) to Position ratio greater than 10 to 1. In other words, it takes time and resources to truly understand a company, gain an edge, and continue to monitor the investment. Blueprint has two PMs, and we don’t own more than 15 total names. This is very manageable from a bandwidth perspective. When a client asks, why should I invest with you? You must be able to outline why the strategy is different and where you derive an advantage. Our advantage is information… and yours should likely be the same as well. Clients will want to see a replicable plan with a performance track record reflecting good performance. A manager who strays from their core discipline will struggle with messaging the true direction of the strategy without such focus.
Discipline with position sizing, entry and exit points, and ongoing due diligence and risk management are all additional points to consider before taking steps forward. A simple structure likely makes the most sense. Concentrated also makes sense in micro cap as you take relatively larger investments in companies you feel have asymmetric risk reward. The bets can be bigger in micro caps because the reward should, in theory, be much greater when you are correct. Our goal is 3x reward relative to risk, at least, from our initial purchase. That being said, if something has 30% downside, we must therefore envision a realistic scenario where the investment could increase 90%. Based on that risk reward multiple, we determine a weighting within the portfolio. Most positions begin at 5% but more speculative and/or less liquid opportunities can start at 2.5%. Our best ideas frequently are bought up to 10% and can exceed that as they appreciate. This framework is a simple basis for constructing a portfolio. Managing risk and downside are critical, and often the sell-discipline is the hardest part of this business. We have put in place clear guidelines for this.
Structure: Limited Partnership (LP) vs. Separately Managed Accounts (SMA)
A topic that can be debated more so than any other is that which focuses on the more traditional LP hedge fund structure or attempting to build a fund using an SMA platform. In a post Bernie Madoff world, we feel it is imperative to offer clients separately managed accounts, but also full transparency. There are pros and cons to each of course.
LP: The LP structure is a very common approach to managing an investment strategy, often referred to as a hedge fund. However, as a startup it is fairly expensive out of the gate, and can have onerous ongoing service costs relating to legal, administration and auditing expenses. In the long run, this investment may make it easier to attract larger institutional clients and it may also provide greater ease when participating in private placements or other types of non-standard transactions. The downside of the LP structure is lack of real-time transparency and infrequent performance disclosure. One could also argue that your investors are taking hiding risk by sharing, or co-mingling their liquidity, which can have negative implications which were felt during the 2008 financial crisis.
SMA: The SMA structure, most importantly, allows for complete real-time transparency. Each client owns their own account and can always see what is happening. There is nothing to hide. Each account can be viewed via the web in real time which we feel is incredibly valuable in a world where scandal sometimes makes the headlines more often than it should. The inability to participate in private placements can be a key limitation of this structure, and should be considered to the extent your investment philosophy warrants this type of flexibility. If all of your clients are accredited investors, this limitation becomes less relevant, but logistical hurdles remain. Liquidity is not commingled, and each investor can be liquidated individually.
Fees: Fixed vs. Performance
The topic of fees is an important one. There are asset gatherers and asset managers. We are the latter. My partner and I want to focus on two things: finding investment opportunities and taking measured risk to yield a commensurate investment return. Quite frankly, marketing and raising assets is a distraction, and our least favorite activity. The majority of asset gatherers do not have proper alignment of interests with their clients. Financial advisors are incentivized to wrap your account with a 50bps to 100bps (1.00%) annual fee. With that structure, the advisor does not win when you win and they do not lose when you lose. This is a structural flaw in compensation, and encourages time spent on marketing, rather than investing. When you think about your strategy and the assets you manage, you should 1) invest heavily alongside your clients, and 2) you should charge a performance fee so that you are incentivized to wake up early and make your clients money, and protect them from losses.
MicroCap strategies also command a pricing premium over large caps. MicroCap equities are not as liquid, do not attract larger institutions, and have yet to be found. This requires more work in the form of travel and resources. For that, you should charge a premium and when your performance reflects outsized returns, that premium is further justified. I would discourage future PM’s against a fixed only fee when managing MicroCaps and would suggest a hybrid approach that incorporates both a fixed (to help offset the cost of running your business) and a variable performance fee (which essentially pays you for your hard work).
Platform is very important with a few choices to weigh as you move forward. Start up managers do not have the same brokerage services at their disposal that larger funds do. In fact, an LP structure offers even more variety in the path towards setting up your fund appropriately. We have had a very positive experience using Interactive Brokers (IB), which incidentally was named Best Online Broker in 2014 by Barron’s.
IB has an amazing low cost platform for managers that works brilliantly for managing SMA’s across any number of clients, whether 5 or 500. The platform is essentially free, but IB primarily earns its revenue via transactions fees, which in our experience are the lowest in the SMA world. Competitors to IB’s SMA platform would include Schwab and Fidelity and several others. IB receives lower grades when comparing it to larger firms, in terms of web/user interface and client reporting. Clients overwhelmingly prefer to pay lower execution fees, in our conversations with them. We also produce custom monthly letters for our clients to augment what IB can offer.
When clients sign up with you as the money manager, they open an account directly with IB Brokers as they normally would any other brokerage account. The only difference is that you have discretionary investment authority as the advisor over their account. This means a few different things. One, you can only trade the account. Two, they can access their account any time they want. And three, any back office/administrative type action occurs directly with IB. As a result, there is no risk that your startup fund will have issues with audits, where money is held, allocation of shares via trading, etc. IB covers it all and all of our clients thoroughly enjoy the safety and benefits that such a relationship offers.
The norm in LP structures has typically been quarterly redemption with 90 days notice. Similar to our belief on transparency, we think this feature is out of date and that investors should be provided with greater liquidity where appropriate, and which should match the underlying strategy. An equity strategy can provide more attractive terms and thus should do so. We suggest managers seriously consider offering monthly liquidity on a rolling basis. The beauty of SMA’s is that accounting is less complex with assets held in each individual account. As a result, the risk with liquidity is simply moving assets from individual securities to cash. We offer monthly terms and as such position the portfolio accordingly to accommodate such requests. The reason one would not want to offer a shorter frequency is that 30 days provides ample time to maneuver the portfolio. However, if the markets were volatile and a large portion of the strategy decided to redeem, the 30 day window is a protective measure for all clients.
Effective and frequent communication cannot be understated. We have an open-door and completely transparent policy on what we own and why. Our investors can pick up the phone at any time and discuss their account or any of our holdings. We write very detailed monthly letters that discuss our actions, whether these are new positions or updates on existing ones. We are often complemented on these letters, and believe the time spent in preparing them go a very long way in client satisfaction and retention. Talk to your clients often. Sometimes you learn things that are really important, about them, their financial profile, and maybe you can help them in other ways that don’t relate to getting paid. Build a relationship based on mutual respect and trust, and it will pay off in good times and bad.
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Nicolai Tangen is the CEO of Norges Bank Investment Management, Norway's $1.4 trillion sovereign wealth fund.
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