To what extent are investors aware of GPs managing, or gaming loss ratios, and how concerned should they be?
“One cause for concern is opportunity cost – the idea that a manager’s time is being spent in the wrong place. If a GP is focused on raising the multiple of a deal from 0.9x to 1.0x, when that same effort could take a successful deal from 2.0x to 2.5x, then that is clearly a misallocation of resources, which will negatively affect returns.
“Indeed, we find some evidence of that in aggregate. Perhaps more importantly, however, the prevalence of gaming means that loss ratios are simply not robust measures of risk at the fund level.”
Gregory Brown
“I don’t have evidence of gaming personally, but I can understand GPs’ motivations for doing so. GPs often feel loyalty to the management teams that they partner with. While the rational decision might be to choose not to dedicate additional resources to a particular investment, the impulse is sometimes driven by non-economic factors.
“As Gregory suggests, another motivation could be that even though you may end up with a higher IRR and multiple for the overall fund if you allow a business to be sold at 0.9x, it may look like a blemish on the track record. Certainly, there are managers that advertise their strategy as being low risk, and it makes for a powerful statement if those managers can demonstrate zero losses over the life of the firm.
“One final point is that there has been extensive research into behavioural psychology, which shows that people can make irrational decisions due to a sensitivity to cost. For example, if you were to buy a stock at US$100 a share and the price were to fall to US$95, you would probably wait until it went back to US$100 until you sold, even if it made more sense to get the US$95 and redeploy it into something with a better risk-reward profile. There is an irrational preoccupation with the price paid, even when it is irrelevant to the task of maximising portfolio value.”
John Haggerty
“What gets measured gets managed, and GPs are sophisticated financial animals who most certainly understand the levers that can reasonably be pulled to position their prospective funds in the most favourable light. This is why it is so important to adopt as longitudinal an analysis as possible of performance.
“However, any active management of loss ratios will ultimately manifest in reduced IRRs. Indeed, this research shows that poorly performing deals are held for an additional 12 months on average, which will bring down the IRR of the fund as a whole and could also potentially lower the overall fund-level MOIC, assuming attention is diverted from the rest of the portfolio. At the end of the day, it is difficult to hide from poor performance, even if some degree of loss ratio management is occurring.”
Michael Barzyk
“Different LPs have different objectives and risk profiles. From our perspective, risk management at the portfolio level is more important than managing losses line by line. Others may prioritise a zero-loss ratio, but if a manager can deliver a strong fund-level return while bearing a loss, as long as that loss is not explained by a failure at entry or the team not doing their job properly during the holding period, then that isn’t necessarily a problem.”
Jessica Sellam