Are You Ready When an LP Says No to a Sector?

You’re deep into an initial due diligence meeting with a promising LP – a pension fund, an endowment, a family office with a values mandate – and somewhere between the portfolio construction discussion and the risk questions, they ask a tricky question: “What would your track record look like without defense stocks?”

Most managers don’t have a clean answer.

The Trend Is Not Going Away

Values-based and ESG-adjacent screening has moved from niche to mainstream among institutional allocators. Aerospace and defense, fossil fuels, tobacco, firearms – the excluded sectors vary by LP, but the expectation that managers can model exclusions on demand is becoming standard practice. What was once a question from socially-conscious investors is now showing up in DDQs from pensions, and especially university endowments with investment policies that predate the manager relationship.

The uncomfortable reality for many managers is that they’re encountering this question for the first time during active due diligence, when the stakes are already high.

The Analytical Challenge

The instinct is to treat sector exclusions as a simple subtraction problem. Remove the defense names, rerun the numbers, present the result. That instinct is reductive at best, and sophisticated allocators will know it immediately.

Stripping positions out of a historical portfolio without reallocating the exposure produces a meaningless back-test. A fund that held 20% of its portfolio in aerospace and defense names isn’t comparable (on a risk-adjusted or any other basis) to one that simply deleted those positions and held cash. The benchmark relationship changes, the volatility profile changes, the active share calculation changes.

What a rigorous exclusion back-test actually requires is pro-rata reallocation: the capital invested in excluded names needs to be redistributed across remaining holdings in proportion to their weights, for every period in the back-test. Only then does the comparison mean something. Your methodology needs to be defensible, because allocators will ask how you did it.

What It Looks Like in Practice

We recently worked with a fund that needed to model the exclusion of its entire aerospace and defense book — roughly 20% of the portfolio — to satisfy a prospective LP’s investment policy.

The analysis required identifying every A&D position held over the relevant back-test period, applying pro-rata reallocation of that exposure across remaining holdings at each point in time, and recalculating the full return series. The output was a side-by-side comparison showing how the fund would have performed under the exclusion policy, with the methodology clearly documented.

The Pitfalls Worth Knowing

Three things tend to undermine exclusion back-tests when managers put them together quickly.

The first is survivorship bias in the exclusion list. If you’re removing names based on their current sector classification, you may be applying that classification retroactively to periods when the company was classified differently, or when it didn’t exist yet. The exclusion list needs to be time-stamped.

The second is benchmark mismatch. If your benchmark still holds the excluded names (and most standard indices do), your back-tested active share, tracking error, and relative return figures will all shift in ways that require explanation.

The third is the distinction between removing a sector and never having invested in it. A pro-rata reallocation back-test shows what would have happened if you’d held your non-excluded positions at higher weights. It doesn’t show what a manager who never touched defense would have built. That’s a subtler point, but worth making explicitly in how you present the analysis.

The Case for Getting Ahead

The managers who handle exclusion requests well have one thing in common: they’ve thought about it before the question arrives. They know which sectors are most commonly excluded by the LP types they’re targeting. They’ve modeled the most likely so the analysis exists before the meeting request does. If the question does come, they can hand over a clean, documented back-test right away.

That level of preparation signals that you understand your investors, that you’ve anticipated their constraints, and that working with you won’t create friction in their compliance process. For institutional allocators, operational maturity is part of the investment case, not a separate evaluation.

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Kevin Becker is a Co-Founder and CEO of Kiski. Connect with him on LinkedIn here.

*Any views expressed in this article are those of the author(s) and do not necessarily represent those of EFSI.