Recent high profile investor losses under score the importance of due diligence. As Compenswiss looks to mandate new private debt managers, chief investment strategist Frank Juliano talks through the importance of the due diligence processes at the Swiss pension fund.
Recent high-profile pension and sovereign wealth fund losses in collapsed crypto exchange FTX, or when Silicon Valley Bank suddenly hit the wall, have cast a spotlight on due diligence.
Whether competition for returns, more investments flowing into less regulated private markets and the speed investors are required to commit capital, or just a prolonged period of relative calm in financial markets since the GFC lulling investors into undervaluing its importance, hands-on due diligence is in danger of being replaced by a tick the box exercise. So warns Frank Juliano, chief investment strategist and member of the executive committee at Switzerland’s CHF39 billion ($43 billion) Compenswiss.
As the fund prepares to bring new asset managers on-line in a boosted allocation to private debt, the process of checking that a new cohort of external mangers will deliver all they promise and the bone fide credentials of the team behind the strategy is front of mind.
“A simple questionnaire sent to managers is a recipe for disaster,” explains Juliano, who says the fund’s manager relationships (it has around 44 mandates with 27 managers) are partnerships not friendships, and for whom the value of due diligence is engrained from previous roles as head of portfolio management at Merrill Lynch and heading up hedge funds at Lomboard Odier.
The process
Compenswiss will only select managers with proven experience and expertise in a process that begins with reviewing all documents and references. The team get to know the firm and the people, especially the portfolio managers; the firm’s capabilities surrounding the investment and their risk management operation.
Once the strongest contenders have been selected (typically between 12-15 are shortlisted) each manager has a three-hour video conference with Juliano’s team. From this, between four to six go onto the next stage, an in-person visit and another 3-4 hours of onsite due diligence.
Of course, in person meetings don’t always flush out red flags. Famously, when executives at Sequoia Capital met FTX founder Sam Bankman-Fried in person he was playing video games and the firm still sunk $214 million into the exchange.
But it is this part of the process that Juliano feels is particularly crucial. Recalling a recent experience, he says on-site visits sometimes lead compenswiss to rethink manager selection.
“We thought we’d selected the final candidate but when we visited them, we decided to go with another. We discovered aspects to their strategy that were well described, but in reality, the manager was no doing what they said.”
Not being able to visit managers in-person meant compenswiss didn’t onboard any new managers during Covid.
A time it was also impossible to visit the managers it had in place and monitor strategies. Following selection, compenswiss meets managers at least quarterly – twice remotely, once at its Geneva headquarters and once on the manager’s own turf. Not being able to meet face-to-face was an increasing source of angst, he recalls. “I grew concerned about the pension fund’s ability to effectively monitor managers remotely.”
“We have strong partnerships with our managers, but they are not our friends,” he continues. “We are a good partner but at the same time we have to be bold enough so that when things don’t go well, we can take a tough stance and sort the issues.”
That could include a portfolio manager unexpectedly leaving the firm. In this case, compenswiss would immediately place the manager on watch. “When a manager changes course like this, a firm will quickly reassure and minimize the materiality of the departure. But for the next six months we make sure there is continuity, and we monitor them closely.”
Private debt
Juliano says that approval of the first wave of shortlisted private debt managers is currently in the investment committee process, awaiting sign off. compenswiss will likely relaunch an RFP in the next two years to increase the private debt segment again with a focus on diversifying across vintages and pushing the allocation to 3 per cent of assets under management over the next 3-5 years.
The move is a consequence of a combination of factors, he explains.
On one hand, building out the allocation to illiquid assets is due to compelling opportunities in private debt as fixed income as a whole becomes more attractive. After years in the doldrums, yield to maturities are more attractive and investment grade corporate bonds offer decent returns. A conservative risk profile means the fund has a large, diversified, fixed income allocation of 56 per cent. Equity accounts for 26 per cent of AUM, real assets 15 per cent and gold 3 per cent.
On the other, the move is due to an unexpected swelling of assets under management at the pension fund because of social security reforms. From 2017, assets under management were expected to steadily decrease as compenswiss entered run off mode. Now assets are expected to increase over the next 5-6 years by around $10 billion before they decrease again, offering a window to invest more in illiquid markets.
“The liquidation of assets has been significantly postponed and we can invest more in private assets to capture that illiquidity premium,” says Juliano.
As to what other illiquid assets will be added to the allocation remains under wraps. “We are exploring how comfortable we feel [with more illiquid assets] and determining what contributes more to the portfolio. There is room to go up more.”
Gold
Gold, an allocation that now replaces a broader commodities portfolio, has given the portfolio a recent sheen. Juliano likes gold because it is “anti-fragile” so that when inflation spikes it lends support. “Gold is a really good diversifier from a portfolio construction perspective,” he says, explaining that gold does best just after inflation has spiked and just before central banks start to hike rates. “When inflation surprises, the first reaction on gold is usually good.”
Over his tenure, Juliano has steadily increased internal investment capability at compenswiss with around half the portfolio run internally including most of the fixed income and local equity allocation. An 18-person team comprises eleven portfolio managers, and smaller teams involved in portfolio construction, ESG and manager selection.
The focus on internal management has driven costs lower. But in a counterbalance, onboarding costly strategies in private markets will see costs creep higher. Not only are private assets more expensive, due diligence requires that external managers have a strong commitment to resources, efficiency and good risk adjusted performance.
“People won’t work for us for free. You have to pay for what you get.”
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