Adverse selection

Choosing the right fund manager is a difficult task for investors, and the workbook treats getting it wrong as a risk in its own right — the first of the investor-level risks, ahead of illiquidity and cash management.

The mechanism is information asymmetry. Fund PPMs sometimes make forward-looking statements, or show a manager track record that may not be an assurance of future performance. The investor cannot tell skill from luck from selective presentation, and the manager knows which of the three it is. The risk of adverse selection of a manager would mean either sub-optimal returns or moral hazards for investors.

The workbook puts the risk in two places, and they are worth separating.

At the investor level, it is about manager selection. Selection of the right type of AIF to associate with depends largely on the selection of the investment manager, and if that is not executed properly it leads to the risk of adverse selection. Manager selection is not a mechanical process — it requires industry experience and resources to conduct both research and due diligence. A telling signal: an informal process of appointing the investment manager may indicate that the fund is privately managed by the sponsor and manager, without aligning the interests of investors.

At the portfolio level, it reappears inside Category I AIFs. Because investments there are made early, there could be the risk of adverse selection, infant mortality and lack of step-up in value — the manager faces the same problem with start-ups that the investor faces with the manager.

The defences are the rest of the syllabus. Continuing interest is the structural one: the sponsor's locked-in capital provides skin in the game and removes one of the main sources of mis-alignment and moral hazard. Fund due diligence is the procedural one, with its five-year track record review and five-year disciplinary history check. The key man clause stops the fund making new investments if the people the investor selected are no longer devoting time to it. And alignment of interests across fee, waterfall, catch-up and clawback, competing or outside interests, governance and related-party transactions is the list an investor negotiates against.

Two first-time Category II managers, each raising Rs 300 crore, each showing a strong deck.

Ms Nair commits Rs 20 crore to Fund B, persuaded by the deck and by the presence of a large institution on the investor list.

Three years on, Fund B has drawn Rs 14 crore of her money, has a DPI of 0.1x, and one of its two senior partners has left to start his own fund. Her costs so far:

Management fee, 2% on Rs 20 crore committed x 3 years   Rs 1.20 crore
Share of set-up cost, 2% of commitment                  Rs 0.40 crore
Total paid                                              Rs 1.60 crore
Distributions received                                  Rs 0.14 crore

She cannot redeem — Category II AIFs are close-ended — and she cannot remove the manager without a 'for cause' finding of fraud, wilful misconduct or gross negligence, which is litigable and slow.

Two of the four rows in the table above were visible before she signed. The fee-waiver continuing interest is expressly not permitted; the missing key man clause was a negotiable term. That gap between what was knowable and what she knew is adverse selection.

Chapter 9 section 9.4.1 lists the risk of adverse selection as the first investor-level risk, and repeats it inside the underlying investment risks for Category I AIFs. Chapter 12 section 12.4 returns to it as the consequence of poor manager selection. Expect 'which of the following is an investor level risk' and a definition question that hinges on sub-optimal returns or moral hazard.

• It is an investor-level risk in the workbook's taxonomy, not a fund-level or governance risk — that classification is itself examinable.
• It is about selecting the manager, not about an investee company defaulting. The Category I flavour is the manager selecting the wrong start-up.
• Moral hazard is a consequence, not a synonym. So is sub-optimal return; the workbook offers both outcomes.
• A track record is not an assurance of future performance — the workbook says this in terms, and PPMs may carry forward-looking statements.
• Continuing interest is the structural mitigant, due diligence the procedural one. Neither eliminates the risk.
• An informal manager appointment process is a signal: it suggests a privately managed fund with no alignment to investors.