There’s an old saying in finance that a relationship is worth a basis point, which is a fun, albeit nonsensical, way of saying that relationships in finance have value.
On the surface, this is obvious. Investment banks are highly profitable companies that exist to bridge investors with investment opportunities. Venture capitalists justify their exorbitant fees by pointing to their network as a competitive edge. Entrepreneurs move to Silicon Valley to increase their chances of getting funded.
And, anecdotes aside, Brian Uzzi’s seminal research shows that social capital has real economic value in financial markets. Further research has shown the correlation between better-networked VC firms with superior financial performance, through a sharing of knowledge, having access to better deal flow, and reducing risk. These studies are retrospective in nature and highlight the benefits of networks for investment performance.
And this, my friends, is why all of our investment models, financial theories, and portfolio construction tools use social capital and personal relationships as key inputs into the manner in which we make ... Actually, no. That’s not true. None of these tools include networks or relationships as a formal input or output. Mainstream models of finance and investment almost universally ignore social capital.
It turns out we’re very good at incorporating cash flows, or analyst forecasts, or really any quantifiable metric, into a pro-forma model of an investment — but we’re terrible at including the soft stuff, like how our relationships helped us develop an idea or source a deal. To be sure, the networks at play in this example often give us more comfort about an investment than the financial models, and yet we still don’t have any rigorous way of incorporating such criteria into a decision. Moreover, if an investment could create new relationships of value, how do you model that? Great investors build great networks, but I’ve never found a way to incorporate networks into investment models. And that’s why you end up with hokey heuristics like the one I used to start this article.
Because we have no reliable measurement of how social capital affects our investment performance, many Giants don’t manage their social capital at all. Their models don’t ascribe any real value to this, so they cede it to their service providers. This is something I complain about a lot. And it’s a good thing I do, because during one of my recent monologues on the subject a friend stopped me in my tracks by saying, “Ashby, calm down ... it’s just like dark energy.”
And he was right. It is just like dark energy.
Until the launch of the Hubble Space Telescope in the late 1990s, our models of how the universe works ignored dark energy and dark matter, despite making up 68% and 27% of the known universe, respectively. After Hubble, however, we learned that the universe can only be explained correctly — that is to say, modeled — by including dark energy and dark matter. Our models up to that point were fundamentally flawed. So, my friend’s point was pretty simple: Similar to the world of astrophysics before the discovery of dark energy, today’s financial models are still missing that “relational constant” which explains the value of networks in finance.
But even with that insight, we can’t wait for finance’s equivalent of the Hubble to occur. We need Giants to begin including social capital in their thinking today, as well as cultivating that capital just as deliberately as they would cultivate human or financial capital. Even better: Investors should consider a new C-level role that focuses explicitly on networking and relationships — Social Capital Manager (SCM).
This SCM role would seek to develop relationships with external parties, as well as to match people from inside their own institution with them. To be credible, the SCM would need to have intimate knowledge of the institution, a deep understanding of the industry and its value drivers, and a wide network of contacts from which to design and build opportunities. The SCM could also be responsible for overseeing external relationships with peer investors, and ensuring knowledge extracted from the network is managed in an efficient way.
If you think such a role sounds awesome, it is. And if you think it sounds fanciful, it isn’t. As I write this, I can think of a bunch of Giants around the world — New Zealand Super Fund, Ontario Teachers, CPPIB, University of California–Regents, OPTrust, Cbus Super, AusSuper, and a few others — that have already begun to implement components of a formal networking function that seeks to develop social capital.
These organizations, and their respective networking teams, are looking to source deals and generate privileged access and insights.
Why? They have come to realize that the true value delivered by most market intermediaries is simply a function of their network. There may be no reliable model to explain the value of this network to a pension fund board, but smart allocators are starting to recognize the “relational constant” in finance and are seeking to more aggressively tap into the dark energy of the financial and investment universe.