What am I?
“You can’t be all things to all people.”
Michael Porter
Recently, I met with an acquaintance to update him on the fund. He’s a sophisticated business owner so I was eager for his feedback, but his response took me by surprise. He said, “I’m not sure people really understand what it is that you do.” They may assume that I’m a financial planner or offer wealth management advice because those are familiar. Given Nebraska has only a handful of partnerships that buy public equities (I’m aware of four) describing awareness as ‘low’ would be generous. In truth, it’s borderline nonexistent.
He also suggested that people tend to have long-standing relationships with their advisors and aren’t looking to upset the apple cart. There’s a reason the affluent outsource their investing and vetting new options can be mentally taxing, especially when those they have seem to be working. Inertia is a powerful force, and my unique structure may hinder adoption. So, at the risk of over-explaining, I’d like to highlight what I think makes Epigram Capital Partners Fund I unique.
Epigram Capital exists to provide differentiated returns. Sometimes they will be better, sometimes worse, but ideally, always different. Many investors have decided that outperformance is a fool’s errand, stock picking a waste of time, and it’s better to minimize fees (which are controllable) than gamble on outperformance (which isn’t). Consequently, half of all capital is now invested passively. I believe strongly that active management can still add value, provided your manager is willing to stay small, ignore institutional orthodoxy and resist the urge to be all things to all people. Many aren’t, which may explain why outperformance has dwindled.
WHAT IS A PRIVATE INVESTMENT PARTNERSHIP?
Some hear the word private and assume the fund buys shares in private companies. Not so, every stock the fund owns you could buy yourself. Private means the partnership isn’t open to the general public, can’t be bought on Schwab and is limited to 99 partners all of whom have met me personally. To join the partnership, you must be a qualified client which the SEC defines as having an investable net worth in excess of $2.2 million, exclusive of your primary residence. If you pass those two tests, you may be eligible.
The modern investing partnership dates to 1946 and is a common vehicle for private equity, hedge funds and venture capital. They exist to allow investors to pool their capital, share profits and expenses and achieve outcomes not obtainable elsewhere. I chose this structure realizing it’s not for everyone, which is part of its appeal. I would rather be small and differentiated than large and mediocre. Here are the pros and cons as I see them.
PROS
TIME HORIZON: Most investors will concede that a long-term orientation yields better results, but their words and their actions often differ. As financial products have become easier to buy and sell, people no longer own funds, they rent them. The average holding period for a mutual fund has dwindled to two and a half years and for ETFs, it’s just five days. You’ve probably bought avocadoes with a longer shelf-life. A partnership requires substantial due diligence, won’t appeal to the fickle or flighty and intentionally discourages tourists.
DIFFERENTIATED: Most capital today is disintermediated meaning the person selecting your investments has little incentive to take performance risk. Outperformance requires periods of underperformance which threatens their job security. Consequently, they tend to recommend blue-chip managers with market-like returns, reducing the odds of lagging (or heaven forbid, the inverse). Partnerships have limited constraints and will only appeal to the entrepreneurial investor (my favorite kind).
FLEXIBILITY: Mutual funds offer daily liquidity, ETFs trade in real-time and both take all comers. The more liquid the product, the less discretion a manager has over when to buy and sell. Inflows often come when least advantageous, and the average investor usually underperforms the average fund. Partnerships offer flexibility around when to accept and deploy capital, and while this may not improve returns, it certainly can’t hurt.
ALIGNMENT: To foster alignment between the manager and his partners, partnerships often charge incentive fees. Most are familiar with management fees, which average about 1%. But if the client keeps 99% of the outperformance, why would a manager take performance risk? If he outperforms by 5%, he keeps five basis points (1% of 5%). If he underperforms by the same amount, he jeopardizes the entire fee stream. This asymmetry encourages indexation and explains why some managers spend more time gathering assets than managing them. The fund also has a highwater mark, meaning I can’t earn an incentive fee if I’ve lost you money. If there’s a better way to align our interests, I’ve yet to find it.
EFFICIENCY: Many pooled products (like mutual funds) are tax inefficient. If investors withdraw capital, the fund must sell holdings and realize gains to meet redemptions. This creates tax consequences for new investors regardless of how long they’ve held the fund, what I call redemption risk. One benefit of a partnership is that gains are allocated at the individual level and each investor has their own tax basis. Should the partnership be redeemed, there will be tax consequences but at least they’ll match your actual returns.
CONS
SMALL CAPS: The fund invests in small companies which make up less than 5% of the Russell 3000 and have consistently underperformed. Although the asset class has disappointed, small managers are more likely to outperform than their large cap brethren. If you’re going to pay for active management, it makes sense to do it where it can still add value.
UNCONSTRAINED: There are three things that can blow up a fund: leverage, options and shorting and my documents prohibit all three. But the fund has few constraints around what it can buy, position sizing or ability to hold cash. The fund typically holds 25-35 holdings, which is fairly concentrated and deliberately ignores the index which invites performance risk (which is kind of the point). When people ask about my risk tolerance, my typical reply is that the fund and its predecessor strategy have never had a down year before fees and outperformed in 29 out of 30 months when the Russell 2000 return was negative. But it does mean the fund could lag significantly, especially in up markets.
ANTI-SCALE: As a small cap manager, I chose a small asset class which limits the size of the fund and its economies of scale. I will likely never have a Chief Risk Officer or a team of analysts at my disposal. The investors I admire tend to be sole practitioners and I’ve found little to suggest that this yields inferior results.
LOW TRANSPARENCY: Most advisors offer separately managed accounts, which allows investors to see holdings in real time. Partnerships with less than $150 million in assets are not required to disclose holdings except once a year and then only positions that exceed 5% of assets. Because I value transparency, I’ve chosen to report the fund’s 10 largest holdings quarterly with a one-month lag, not because I’m secretive, but because more disclosure could impact returns.
EXPENSES: Most mutual funds pay expenses out of their management fee, while partnerships bill expenses directly to the partnership. They’re limited to services that benefit partners like research, fund administration, tax prep, legal and audit. As a new fund, I realized expenses would be under absorbed, so last year, I capped them at 1% of assets and reimbursed the fund over $14,000. As assets continue to grow, their drag will diminish. The upside is that these expenses are tax deductible, can lower your basis over time and offset realized gains.
That’s the gist of it. I created Epigram Capital Partners Fund I to deliver differentiated returns. I believe active management can still add value, provided you’re willing to take performance risk and ignore the benchmark (at least temporarily). The asset management industry has shown that trying to be all things to all people is the surest path to mediocrity, negating its value proposition along the way. Most assume that active management is dying because of fees, but the truth is it’s dying because it’s not active enough. I designed the fund hoping to preserve what’s best about active management; conviction, differentiation, and diversification. This means it will always appeal to the few rather than the many.
Thanks for reading,
Dan Walker