Adverse selection occurs in any market where one party has more information about the quality of a good or service than the other party. In the context of investment platforms, adverse selection can result in lower-quality projects being funded, resulting in lower returns for investors.
Startup investor Julian Shapiro has written about this problem, saying, “the enemy of returns in venture is adverse selection.” The same issue can occur on investment platforms that act as marketing or placement agents for funds, as some platforms are compensated for the placement of funds on their platform, which could have negative implications for fund quality.
Further, investment platforms that act as “funding of last resort” can also create a downward spiral of adverse selection. When companies turn to these platforms, it can signal that the company is not able to raise money from more traditional sources.
In another example, research from HBS found that “co-investments underperform the corresponding funds with which they co-invest due to an apparent adverse selection of transactions available to these investors.”
Solving adverse selection
To mitigate the problem of adverse selection on investment platforms, it is crucial to consider the following:
- The quality of projects being funded: Does the platform have a screening process to ensure that only high-quality projects are being funded?
- The compensation structure: Is the platform compensated in a way that could incentivize lower-quality projects?
- The reputation of the platform: Is the platform known for high-quality investments?
By considering these factors, platforms can work to mitigate the problem of adverse selection and ensure that only high-quality investments are being offered.
Gridline’s approach
Gridline takes a proactive approach to mitigating adverse selection on its platform. The company is focused on top-quartile, professionally managed funds and has a rigorous manager selection process. Gridline also ensures that its compensation structure does not incentivize lower-quality projects.
Gridline’s investment team has over 20 years of experience running private market portfolios for top endowments and family offices. One member was the CIO of a $13 billion family office, while the other ran UTIMCO (one of the largest endowments in the US). This experience has given them a deep understanding of the private markets and how to identify high-quality managers and projects.
Gridline begins its manager selection process with a comprehensive market analysis, drawing on various sources, including third-party data providers, contacts within the Investment Manager’s network of fund managers, and other limited partners. This analysis is used to identify funds deemed worthy of further consideration based on a set of quantitative screening tools.
The screening tools review past performance and compare it to a customized peer group of funds with similar investment styles (e.g., sector, stage, strategy). This allows Gridline to better understand the strategy’s risks, the consistency of management’s investment approach, and whether outperformance may be sustainable over a long time horizon.
Once a fund has been identified as worthy of further consideration, Gridline engages with the manager to better understand the fund’s strategy and investment thesis. This process allows Gridline to select managers that it believes display preferential access to investments (e.g., strong sourcing & networks), exhibit superior portfolio management skills (i.e., through exit), have a strong track record of success, anticipate market movements, and have a deep conviction in their thesis & strategy to “deliver alpha.”
By taking this proactive and thoughtful approach to manager selection, Gridline can mitigate the problem of adverse selection and ensure that its investors have access to high-quality investment opportunities.