Family offices – beware of hiring managers who are friends, performance could suffer

Endowments and foundations who hire managers due to the influence of business connections end up disappointed, according to newly-published academic research. It’s likely to be happening for family offices as well. 

It has found that returns generated by connected managers lag their rivals by a cumulative 1.12 % over three years. 

Family offices who draw too heavily on their connections – which is fairly typical in the sector – are unlikely to have done any better

The research said: “While relationships are conducive to asset gathering, they do not appear to generate commensurate benefits for plan sponsors via higher gross returns or lower fees.” 

Managers chosen for their past performance have performed nearly as badly. This suggests sponsors do not have as much expertise in manager selection as they believe, possibly because their approach is too simplistic.  Family offices who draw too heavily on their connections – which is fairly typical in the sector – are unlikely to have done any better.

The research said: “Sponsors have no discernable selection ability.”

The research – Choosing Investment Managers– was carried out by Amit Goyal of the University of Lausanne; Sunil Wahal of the WP Carey School of Business and Deniz Yavuz of the Krannert School of Management. 

The Goyal paper tested 7,000 mandate decisions by foundations, endowments and pension schemes who delegated $1.6 trillion to 775 bond and equity managers between 2002 and 2017.

It looked at relationships between managers and sponsors using data provided by advisory firm Relationship Science.  Goyal found that managers linked to sponsors through, say, past employment and directorships were 15% to 30% more likely to be hired than those who were unconnected. 

According to Goyal: “If connections convey information, one would expect sponsors to discriminate among managers with whom they have connections and generate higher post-hiring performance. They do not.”

Nor do connected managers offer a fee discount to their clients: “The gains to trade are asymmetrically shared between managers and sponsors.”

German advisory firm Sonean has carried out research which shows that the relationship between individuals also has a detrimental impact on business decisions.

In 2015, it researched Europe’s fifty largest companies and discovered 121 non-executive directors classified as “independent”. Of these, 44% were socially tied to their executive management.

According to Sonean: “When an independent director is part of a clique driven by homophily, independence will be compromised. Homophily then leads to less heterogeneity/diversity which ultimately affects innovation, and consequently performance.”

Sonean believes that it is crucial to comprehend social networks to get a handle on governance issues.

“This helps to spot conflicts of interest; discipline market participants and promote accountability. Greater transparency ultimately leads to less undesirable outcomes.”

Investment consultants tend to be leery of past performance and connectivity, preferring to concentrate on a manager’s skill, stability, strategy, and relevance.

However, the Goyal paper has discovered that consultants are also influenced by their personal connections to managers, who stand to gain additional business as a result.