Emerging solutions for due diligence in emerging markets
Are we missing out on potential alpha due to inadequate research and due diligence? Kamal Suppal, Chief Investment Auditor at Emerging Markets Alternatives, shares his thoughts on how investing in specialised due diligence resources can help investors gain a head start in the race for alpha in emerging markets.
Most investors would probably agree that tectonic changes are sweeping across economics, politics, business and capital markets. We are in a rapidly changing world that investment portfolios must continue chasing elusive returns to bridge gaping funding shortfalls and/or meet spending targets.
One could probably have gotten away with old practices of allocating predominantly to large managers with big infrastructures, when the developed world offered a slew of opportunities and “emerging markets” was a fringe allocation. As emerging markets have evolved and are no longer a monolithic block, premiums for growth, complexity, inefficiency and illiquidity abound across asset classes and the liquidity spectrum. Therefore, in a new era of lower-for-longer growth and yields, it is more compelling than ever for developed-world investors to look beyond their backyards to capture as many idiosyncratic sources of potential alpha as possible. Allocating to GPs in the emerging world who can operate in real time with local expertise, networks, etc. is probably the first step to a viable solution in the new normal, more than safety bets on “comfort managers” sitting in London or NY.
However, venturing into niche opportunities in emerging and frontier markets is a tall order. It warrants specialised research and due diligence beyond just screens, filters and boiler-plate DDQs, to understand key drivers of return, inherent risks, and associated risk premiums. To add, local nuances to strategy execution, operational risks, ESG considerations, valuation practices, etc. assume greater significance in fully understanding GPs who might appear different, culturally and business-wise.
Building in-house specialist resources for asset-owners is a challenge against operating budgets and their internal governance. Their consultants’ plight is no different when many face shrinking operating margins and business succession issues, constraining them from attracting investment talent. Thus, they often resort to telling local EM managers that they are “too small” (to scale across their clientele and get more bang for their time and resources). This also frustrates investors who expect their advisors to go into niches where they cannot, especially if they have an appetite but not the means.
Is it prudent then to let a nugget of potential alpha flee from under our noses just because it fails to attract adequate due diligence resources or lacks someone’s stamp of approval?
An unbundling of investment research and advisory dollars to pay for best of independent research ideas and due diligence, is the need of the hour for savvy professional trustees to gain an instant head-start.
“Democratising” institutional manager research and due diligence becomes compelling to bridge the current intellectual gap in the institutional marketplace, by clinically examining non-mainstream opportunities as in emerging markets. Democratisation of research and due diligence in a new investing era is also an echo of the newly introduced MiFid II rules that call for separation of investment research from execution. The latter in this context is analogous to implementing an asset allocation plan designed by traditional investment consulting. A growing crop of independent investment auditors — each specialty shop with its own forte, e.g. venture, macro, infrastructure, private equity, emerging markets, etc. — conduct an independent 360-degree evaluation of a manager customised to the related investment opportunity. This is quite different from accessing just “buy-lists” of consultants. This is akin to seeking independent reviews of financial auditors, independent valuators, third-party administrators and now even ESG consultants.
Once asset owners have defined their targeted “opportunities”, (e.g. capitalise on innovation, exploit distress situations or illiquidity, profit from volatility, etc.) through strategic/tactical asset allocation plans, they should be open to managers big or small, liquid or illiquid, across geographies and capital structures, who can execute well within their opportunity set. This opens a vast array of opportunities outside of just managers on consultants’ “buy-lists” that often pose adverse selection bias.
LPs need to cogently assimilate more than what emerging market GPs might pitch or what most LPs can decipher on their own with their limited resources to make informed decisions.
An unbundling of investment research and advisory dollars to pay for best of independent research ideas and due diligence, is the need of the hour for savvy professional trustees to gain an instant head-start. For those asset allocators confined to traditional ways, this might seem a utopian fantasy; for those progressive-minded, reoriented to navigate a new investment world, specialist independent investment auditors are on the horizon. This would allow investment trustees to take more ownership of their own investment decisions and support their convictions as exemplified by many an endowment, corporate pension and insurance company plan sponsor.
For any reason, if LPs find it difficult to seek independent specialised due diligence resources for needs as complex as emerging markets but nonetheless value engaging with a “GP, pre-examined clinically” by an independent specialist, GPs can take the lead by going through a proactive vetting process (as with a rating agency e.g. S&P, Moody’s, etc.) with an investment auditor before approaching LPs.
Either way, LPs need to cogently assimilate more than what emerging market GPs might pitch or what most LPs can decipher on their own with their limited resources to make informed decisions. Researching emerging markets for potential alpha in a new investment paradigm deserves a new solution.
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Under the spotlight: Kamal Suppal
Kamal Suppal, CFA is Chief Investment Auditor of Boston-based Emerging Markets Alternatives, an independent investment audit firm specialising in the research and due diligence of alternative strategies in emerging markets.