Active managers compete in an extremely tough arena, since markets tend to price assets accurately. Enormous sums of money deployed by highly motivated investors seek to exploit perceived mispricings at a moment’s notice. Winning at the game of active management requires great skill and, perhaps, more than a little good fortune. Serious investors consider carefully the certain results of low cost passive management before opting for the uncertain returns of high cost active management.
Significant costs raise the hurdle for active strategies. Identifying a portfolio that merely beats the market fails to define success, as managers must build portfolios that beat the market by a sufficient margin to cover management fees, transactions costs, and market impact. Because of the leakage of fees and costs from the system, a staggeringly large percentage of money invested in marketable securities falls short of producing index-like returns. Overcoming the costs of active management presents a formidable challenge.
In the context of an extraordinary complex, difficult investing environment, fiduciaries tend to be surprisingly accepting of active manager pitches. Institutions all too often pursue the glamorous, exciting (and ultimately costly) hope of market-beating strategies at the expense of the reliable, mundane certainty of passive management. Instead of examining critically the factors that drove past performance, investors frequently simply associate superior historical results with investment acumen.
Because of the nearly insurmountable hurdles in beating the market, prudent investors approach active strategies with great skepticism. Beginning with the presumption that markets price assets correctly places the burden of proof on the manager who promises risk-adjusted excess returns. Only when compelling evidence suggests that a strategy possesses clear potential to beat the market should investors abandon the passive alternative.
Active managers worth hiring possess personal attributes that create reasonable expectations of superior performance. In selecting external managers, investors must identify individuals committed to placing institutional client goals ahead of personal self-interest. Alignment of interests occurs most frequently in independent investment management firms run in an entrepreneurial fashion by energetic, intelligent, ethical professionals. Engaging investment advisors involves consequences beyond issues of financial returns, as fiduciaries entrust both the institution’s assets and reputation to the external management firm.
Even after identifying a promising investment management firm, the job remains uncompleted until the investor and advisor negotiate satisfactory deal terms. The fundamental goal in establishing contractual arrangements consists of aligning interests to encourage investment advisory agents to behave as institutional fiduciary principals. Slippage between what the investor wishes and what the advisor does imposes substantial costs on institutions, reducing the likelihood of meeting basic investment goals and objectives.
THE GAME OF ACTIVE MANAGEMENT
The thrill of the chase clouds objectivity in assessing active management opportunities. Playing the game provides psychic rewards, generating grist for the mill of cocktail party conversation. Keynes likens active investment to children’s entertainment: “For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs—a pastime in which he is the victor who says snap neither too soon nor too late, who passes the Old Maid to his neighbor before the game is over, who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated.”1 Fiduciaries must ensure that active management leads to higher expected portfolio returns, not just higher investment manager job satisfaction.
The willingness to believe that superior performance comes from intelligent hard work clouds clear judgment. The investment world worships success, deifying the market seer du jour. Instead of wondering whether a manager at the top of the performance charts made a series of lucky picks, observers presume that good results stem from skill. Conversely, in public perception, poor results follow from lack of ability. Market participants rarely wonder whether high returns came from accepting greater than market risk, or whether low returns resulted from lower than market risk. The investment community’s lack of skepticism regarding the source and character of superior returns causes strange characters to be elevated to market guru status.
Joe Granville
Of all the individuals who moved markets with their predictions, Joe Granville may be among the strangest. In the late 1970s and early 1980s, the technical analyst made a series of “on the money” predictions. Strikingly, on April 21, 1980 when the market fell to a two-year low of 759, Granville issued a buy signal, anticipating a powerful rally that took the average over 1000 within three months. In January 1981, Granville’s next major market call, a sell signal, prompted “waves of selling,” causing markets to decline sharply on record volume. The next day his picture appeared on the front page of the New York Times, while Washington Post headlines read “One Forecaster Spurs Hysteria—Markets Sink in Panic Selling.” Granville predicted he would win the Nobel Prize, crowing that he had “solved the 100-year enigma, calling every market top and bottom.”
Granville’s technically driven forecasts came replete with costumes and props. His routine included dressing as Moses to deliver the Ten Commandments of investing, dropping his trousers to read stock quotations from his boxers, and appearing on stage in a coffin filled with ticker tape.
Such antics did nothing to diminish his following. In late 1981, markets fell worldwide, sometimes in apparent response to Granville’s calls. According to Rhoda Bramner of Barron’s: “while Granville strutted across the investment stage, the market pretty much followed his bearish script.”2
Unfortunately for Granville, he missed the turn of the market in 1982. Stubborn bearishness kept his followers out of the early stages of one of history’s greatest bull markets. In a cruel twist of fate, Granville turned “wildly bullish” prior to the 1987 crash. As a result, a 1992 study by Hulbert’s Financial Digest concluded that Granville ranked last among an undistinguished group of investment newsletter writers, down 93 percent over the twelve-year period.
Joe Granville’s one-time prominence in the investment world provides evidence of the investing public’s association of superior returns with investment skill. Granville’s methodology relied on technical factors with absolutely no predictive power. Yet he moved markets, fooling large numbers of people into following his absurd predictions.
The Beardstown Ladies
In the early 1990s, the Beardstown Ladies captured the investing public’s attention. Based on an impressive historical record of beating the S&P 500 by 8.5 percent per year for the ten years ending in 1993, the matrons of Beardstown parlayed their success into a lucrative writing and lecturing career. Their first book, The Beardstown Ladies Common-Sense Investment Guide: How We Beat the Stock Market—And How You Can Too, sold more than 800,000 copies. The group followed with four more books, The Beardstown Ladies’ Pocketbook Guide to Picking Stocks; The Beardstown Ladies’ Guide to Smart Spending for Big Savings: How to Save for a Rainy Day Without Sacrificing Your Lifestyle; The Beardstown Ladies’ Stitch-in-Time Guide to Growing Your Nest Egg: Step-by-Step Planning for a Comfortable Future; and Cookin’ Up Profits on Wall Street. The Beardstown empire, which in addition to books included lectures, videos, and cassettes, rested on the public’s belief in the solid foundation of the Beardstown Ladies’ extraordinary investment success.
All of the hoopla surrounding the Beardstown Ladies met with relatively little skepticism. Assertions of superior performance provided prima facie evidence of the efficacy of their investment approach. No further analysis needed.
Unfortunately, the Beardstown Ladies possessed so little analytical ability that calculating investment returns challenged their capabilities. Because the investment club’s treasurer erred when using a computer program, she reported a two-year return as applying to a ten-year period. In fact, upon critical examination, the extended record of reported strong relative performance turned out to be worse than mediocre. Figures compiled by Price Waterhouse concluded that the Beardstown Ladies produced returns of only 9.1 percent per annum, falling short of the S&P 500 return by 5.8 percent per year and failing to meet previously reported results by a staggering 14.3 percent per year. In short, the investment record merits not even a modest magazine article.
The fundamental lesson from the Beardstown Ladies’ saga relates to the attitude investors take toward performance records. Markets price securities efficiently enough that when presented with a superior performance record, the initial reaction ought to be that strong performance most likely resulted from a series of favorable draws from the distribution of potential outcomes. Only when managers articulate a compelling, coherent investment philosophy should fiduciaries begin to consider the active management opportunity.
Jim Cramer
Jim Cramer deserves a prominent place in the pantheon of investment anti-heroes. Educated at Harvard College and Harvard Law School, Cramer squanders his extraordinary credentials and shamelessly promotes stunningly inappropriate investment advice to an all-too-gullible audience.
Cramer made a name as an unabashed cheerleader for tech stocks during the Internet bubble. He rationalized the purchase of absurdly valued securities by asserting that the professionals “got it wrong” and the public is “much, much smarter than you realize.”3 Near the peak of the market in January 2000, Cramer articulated six “commonsensical rules” that allow the “average individual” to “routinely beat the professionals.” Included in his list of rules were “buy stocks of companies you like,” “buy expensive stocks,” and “buy stocks that move in chunks.”4 Cramer’s inane rules proved perfectly timed to inflict the maximum damage to his readers’ portfolios.
Cramer never minces words. He described the “momentum/growth camp” as a group of investors that “would rather buy stocks that have both earnings and technical momentum, regardless of price. In other words, it doesn’t matter how expensive they are, as long as they execute.”5 Not content simply to promote an irresponsible momentum strategy amid a market bubble, Cramer took the then long-suffering value managers to task. He registered palpable contempt for the “value/contrarian camp,” contending that “denial is the basis of the value thesis.” He accused value investors of exhibiting “systematic blindness to all things tech,” chiding Warren Buffett for his “preposterous” preference for “Coke over Microsoft.”6
In February 2000, Cramer wrote about the arrogance of value mutual fund managers, lamenting that “[n]ot only do they have the guts to tell us that we are wrong to own our Ciscos and our Yahoo!s, they also insist that they are the only authority on what to buy.” Cramer asserted that value managers holding Philip Morris “should have to answer to their dereliction of duty” and added that “the worst are the managers who bought the Cokes and Pepsis…” He followed with a piece of advice for mutual fund investors in “growth-turned-value stories”: “Take control. Fire these guys.”7
Of course, Cramer’s advice missed the mark by a wide margin. In the year following the publication of his anti-value rant, Coke gained 10 percent, Pepsi, 36 percent and Philip Morris, a stunning 171 percent. Meanwhile, Cramer’s favorites collapsed, with Cisco down 57 percent and Yahoo! declining by a staggering 84 percent.
If Cramer’s early 2000 preference for Cisco and Yahoo! over Philip Morris and Coke laid waste to his adherents’ portfolios, his calls on the grocery business destroyed even more value. In February 2000, Cramer suggested that “the death knell for value investing may very well be sounding right now because of technological innovation.” He asserted that old economy grocer Albertsons was “being hit by a fundamental paradigm shift,” which “will only get worse as Urban Fetch, Kozmo and Webvan expand.”8 Cramer unequivocally placed his bet on Internet-era firms.
Nine months after Cramer’s prognostication, Fetch discontinued its consumer delivery business. Even though Kozmo never executed its hoped-for public offering (sparing Cramer’s readers an opportunity to lose money), the firm managed to muddle through until April 2000 when it ceased operations. Webvan, which boasted a market capitalization of more than $5 billion at the time of Cramer’s February 2000 call, filed for bankruptcy in July 2001. Meanwhile, Albertsons, the dinosaur doomed to extinction, posted profits of more than $500 million on nearly $38 billion of 2001 revenues. Ultimately, on May 30, 2006 Albertsons succumbed to a takeover by a group led by SuperValu. Scorekeepers note that from the time of Cramer’s misguided, top-of-the-market advice to the date of merger consummation, Albertsons returned an annualized 0.5 percent per annum, beating the S&P 500’s 0.2 percent per annum and trouncing the NASDAQ’s –9.1 percent per annum.
In spite of Jim Cramer’s massively misguided top-of-the-market advice, in March 2005, CNBC gave him his own TV show, Mad Money. On Mad Money, Cramer makes a mockery of the investment process, throwing chairs, shoving toy bears in meat grinders, wearing sombreros, and decapitating bobble-head dolls (made in his own likeness).9 Betwixt and between his sophomoric antics, Cramer throws out hundreds of stock recommendations. In fact, according to an August 2007 Barron’s article, a database covering six months of Cramer’s picks contained an astounding 3,458 stocks. Barron’s concludes that “the credible evidence suggests that the telestockmeister’s picks aren’t beating the market. Did you really expect more from a call-in host who makes 7,000 stock picks a year?” To make a dismal story worse, Cramer failed to beat the market in spite of a post-broadcast surge of an average of 2 percent for his picks. Barron’s negative assessment would be even more dire were transaction costs and taxes included.
Aside from Cramer’s unsurprising inability to choose thousands of stock market winners in any given year, he seems to have admitted to market manipulation when he ran a hedge fund in the late 1990s. In a December 23, 2006 interview with Wall Street Confidential, Cramer flat out said “…a lot of times when I was short at my hedge fund…I would create a level of activity beforehand that could drive the futures.” He further noted that “it doesn’t take much money….” In the interview he goes on to describe ways to manipulate the prices of individual stocks.10 According to Barron’s, Cramer later “said he’d only been talking hypothetically.”11 Surely the Harvard-educated Cramer, who served a stint as editor in chief of the Harvard Crimson, knows that there is nothing hypothetical in the clause “when I was short at my hedge fund.” Does Jim Cramer need a lesson in the subjunctive?
Joe Granville, the Beardstown Ladies, and Jim Cramer provide compelling evidence that market participants frequently and uncritically accept simple prominence as proof of sound underlying investment strategy. The falls from grace suffered by Joe Granville and the Beardstown Ladies (and perhaps a future fall from grace for Jim Cramer) should encourage investors to adopt skeptical attitudes when evaluating active management opportunities.
PERSONAL CHARACTERISTICS
Real estate investors invoke the mantra “location, location, location.” Sensible investors seeking to engage an active manager focus on “people, people, people.” Nothing matters more than working with high quality partners.
Integrity tops the list of qualifications. Aside from the fact that moral behavior represents a fundamentally important standard for human interaction, working with ethical advisors increases the likelihood of investment success. Choosing external advisors of high integrity reduces the gap between the actions of the advisors and the interests of an institutional fund.
Inevitable differences exist between the interests of an endowment and an outside money manager. The more profound issues might include differences in financial goals, time horizon, tax status, and various forms of business risk. Regardless of the structure of contractual arrangements, external advisors tend to respond to personal incentives. Employing individuals with high moral standards reduces the severity of conflicts of interest, as ethical managers consider seriously the goals of the institutional client when resolving conflicts.
Loyalty plays an important part in investment management relationships, allowing longer term thinking to dominate decision making. In the best of circumstances, the interdependence of institutional investors and external advisors creates a spirit of partnership, enhancing opportunities to create successful, lasting relationships.
Loyalty flows both ways. Investors owe external advisors the opportunity to pursue investment activities within a reasonable time frame. Firing a poorly performing manager simply to remove an embarrassing line item from a quarterly investment report fails to meet the test of reasonableness. Likewise, an investment advisor abandoning reliable partners simply to pursue a lower cost source of capital follows a short-sighted strategy.
Obviously, loyalty does not require permanent maintenance of the status quo. Relationships between fiduciaries and external managers come to an end for a variety of compelling reasons. Far too frequently, however, investors abandon good partners for trivial reasons, imposing unnecessary costs and needlessly disrupting portfolio management activities. Investment advisors and institutional fund managers operating with a presumption of loyalty enhance opportunities for long-term success.
Top-notch managers invest with a passion, working to beat the market with a nearly obsessive focus. Many extraordinary investors spend an enormous amount of time investigating investment opportunities, working long after rational professionals would have concluded a job well done. Great investors tend to have a “screw loose,” pursuing the game not for profit, but for sport. Markets fascinate successful investors.
The best investors care about risk. Diligence and hard work take an investment manager only so far, as even the most carefully researched decisions ultimately face the vicissitudes of market forces. Because so much lies beyond a portfolio manager’s control, superior investors seek to know as much as can be known, limiting uncertainty to the irreducible minimum. Well-researched investment ideas tend to be the least risky, since, as Yale’s great economist Irving Fisher observed, “risk varies inversely with knowledge.”12
Money provides an obvious motivation, bringing enormous wealth to successful investment advisors. Yet money managers seeking to maximize income constitute a poor group from which to choose. Profit maximizing business plans involve unbridled asset growth and unimaginative benchmark hugging strategies, factors at odds with investment success. Appealing money managers limit assets under management and make aggressive, unconventional security choices, incurring substantial risks for their money management business with the hope of generating superior investment returns.
Warren Buffett produced his own set of desirable money manager characteristics in a March 2007 announcement of the search for his successor as Berkshire Hathaway’s chief investment officer:
Picking the right person(s) will not be an easy task. It’s not hard, of course, to find smart people, among them individuals who have impressive investment records. But there is far more to successful long-term investing than brains and performance that has recently been good.
Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions.
Temperament is also important. Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior is vital to long-term investment success. I’ve seen a lot of very smart people who have lacked these virtues.
Finally, we have a special problem to consider: our ability to keep the person we hire. Being able to list Berkshire on a resume would materially enhance the marketability of an investment manager. We will need, therefore, to be sure we can retain our choice, even though he or she could leave and make much more money elsewhere.13
Even Warren Buffett worries about losing a colleague to a better economic opportunity!
Due diligence on the principals of an investment management organization provides critical input into the manager selection process. Spending time with manager candidates, both in business and social settings, allows assessment of whether the manager exhibits characteristics of a good partner. Questioning individuals on manager-supplied reference lists confirms or negates impressions gathered in the due diligence process. Contacting people not included on an official reference list, including past and present colleagues, competitors, and others, provides opportunities to evaluate the quality of a prospective manager’s business dealings and integrity level.
In the intensely competitive investment management arena, only a small percentage of managers overcome the enormous burden of fees to post market-beating records. Identifying members of the small group that will prove to be successful requires an intense focus on personal characteristics. Only the best of the best will succeed.
ORGANIZATIONAL CHARACTERISTICS
The right people tend to create the right organization, reinforcing the centrality of selecting strong partners. However, finding great people, while necessary, marks only a starting point in the search for a money manager, for strong people in a poorly structured organization face the markets with a significant, unnecessary handicap. In a world rich with alternatives, compromising on structural issues makes little sense.
Attractive investment management organizations encourage decisions directed toward creating investment returns, not toward generating fee income. Such principal-oriented advisors tend to be small, entrepreneurial, and independent.
Size and Client Base
Appropriate size depends on the nature of the investment opportunity. In general, smaller tends to be better. Market size matters little when trading highly liquid securities such as U.S. Treasury bonds and large-capitalization domestic equities. Of course, such markets provide few opportunities to generate excess returns. Interesting active management situations reside in smaller, less liquid markets, requiring managers to exercise discipline in limiting assets under management.
Constraints related to the number of clients limit rational firm growth as severely as do constraints related to asset size. While routine communication might be conducted through broad-based mailings or by client service personnel, informed clients inevitably require meaningful amounts of an investment principal’s time and energy. An investment advisor opting for less involved, less burdensome clients makes a potentially serious mistake. First, high quality clients occasionally provide useful input into the investment process. Second, in the event that the firm experiences an explicable stretch of poor performance, high quality clients continue to support the manager’s activities. Less sophisticated clients control unreliable money, oftentimes exhibiting pro-cyclical tendencies, buying high, selling low, and introducing instability into the investment management operation.
A strong client base creates advantages for both the investment advisor and the clients themselves. If a money management firm’s client roster contains “weak hands,” temporary poor relative performance might cause substantial asset withdrawals. Such withdrawals harm other clients directly, in the case of transactions costs spread among participants in commingled funds, and indirectly, in the case of client defections leading to poor firm morale.
In contrast, intelligently supportive clients contribute financial and emotional support to investment managers experiencing a rough stretch of performance. By adding assets to an underperforming manager’s account, the client stands to profit from a future reversal of fortune, while the manager benefits from the client’s vote of confidence.
Entrepreneurial Attitude
Small, independent firms operate on the opposite end of the spectrum from large subsidiaries of financial services conglomerates. Appropriate firm size and sensible ownership structures contribute to superior investment results. The tendency of smaller, principal-oriented firms to behave in an entrepreneurial fashion provides critical context to the investment management process. Entrepreneurial environments emphasize people, putting them ahead of bureaucracy and structure. By placing people first, investment organizations increase chances for success.
In entrepreneurial organizations, individuals drive decisions, placing great importance on selecting partners with attractive behavioral characteristics. Great people provide the core of a strong entrepreneurial operation, according to venture capitalist Len Baker, because they “execute better, respond better to surprise, and attract other great people.” He suggests that managers “be out there, be obsessive, and be bottom up.”14
Entrepreneurial capitalism rests on three driving forces: innovation, ownership, and adaptation. Each characteristic contributes to successful money management organizations.
Innovation
According to Schumpeter, innovators “see things which only subsequently prove to be true.”15 By building an investment process that promotes foresight, investment advisors lay the groundwork for success. Excess returns stem from out-of-the-mainstream positions that subsequently achieve recognition, often in startling surprise to ordinary market observers. By identifying the unexpected consequence before the fact, successful investment managers realize superior returns from exploiting superior insights. Without creative portfolio choices, investment managers face dismal prospects, since the old combination represents the consensus view. Market efficiency drives returns on market-like portfolios to the average, causing conventional portfolios with conventional ideas to produce conventional results, a poor outcome for active investment managers.
In efforts to innovate, entrepreneurs encourage experimentation, accepting occasional shortfalls as the price paid for potential gains. Repeated failure precedes success in many entrepreneurial endeavors, requiring an organizational culture that encourages experimentation and accepts mistakes. By explicitly permitting failure, but holding down its costs, investment organizations create an environment allowing managers to construct truly novel, high-potential investment portfolios.
Ownership
Financial and psychic ownership leads to superior results. Strong investment management firms reward contributions monetarily while engaging the hearts and minds of staff members. Widely distributed ownership enhances organizational stability, facilitating long-term thinking. Carefully structured financial incentives elicit appropriate behavior from investment personnel, discouraging fee-driven activity and encouraging return-generating behavior. Psychic ownership provides a powerful complement to financial rewards. By causing investors to “buy in” to the process, interests of manager and client come together.
Adaptation
Adaptation involves careful selection, amplifying the strong and eliminating the weak. In choosing a portfolio of attractive positions from a large universe of potential opportunities, successful investors express unusual insights ahead of the herd. Strong ideas command meaningful portions of assets, magnifying the impact of high conviction positions, while weak positions disappear. When circumstances change, managers reconfigure portfolios to reflect new realities. Not only does adaptation influence the tactics of security selection, but as markets evolve, adaptation may lead to new investment strategies. If inefficiencies disappear in a particular niche, the entrepreneur leaves the unattractive market and seeks new mispricings to exploit. Both tactically and strategically, adaptation plays an important role in money management.
Contrast the flexibility of entrepreneurial organizations with bureaucracies. Bureaucratic structures deal effectively with repetitive, regular, slow-to-change environments. Control-oriented processes emphasize structure, subordinating the role of people. Bureaucracies employ conventional wisdom and seek consensus, punishing failure quickly and ruthlessly. By pursuing safety and avoiding controversy, bureaucratic structures systematically screen out the market opportunities likely to yield superior returns. Bureaucracies deal poorly with constantly changing market environments and fail to address even elementary active investment management problems.
Many bureaucratic functionaries pursue investment with “name brand” money managers, reducing career risk by choosing widely recognized firms blessed by an external consultant. Large, process-driven entities that produce consistent results provide a safe haven for the timid client. Well-respected firms develop franchises, using their good name to attract and retain assets. In the realm of marketable investments, the franchise provides no benefit to the portfolio management process. The value of the franchise lies solely in the comfort level provided to clients.
Comfortable investment decisions fail to generate exciting results. Discomfort represents a necessary, albeit not sufficient, condition of success. Because entrepreneurial firms tend to be newer and smaller, track records may be harder to define and interpret. Less process-driven strategies depend heavily on individuals, reducing the fiduciary’s ability to rely on the franchise for results. While backing an entrepreneurial group takes more courage than serving up a “name brand” recommendation, investment success may require backing managers without standard institutional credentials.
Unfortunately, once-attractive investment partners sometimes mature into unattractive bureaucracies. Schumpeter’s concept of creative destruction takes hold, as organizations evolve from small entrepreneurial “craft shops” to large enterprises with characteristics that undermine the premise that supported forming the firm in the first place. As the organization grows, mutation “…incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.”16 Institutional acceptability threatens the very characteristics that made the firm interesting in the first place. As time and size erode the entrepreneurial enthusiasm that brought initial success to the firm, the fund manager needs to reject the old partners and seek new partners to provide superior management capabilities. The process of creative destruction, which Schumpeter concludes is “the essential fact about capitalism,” poses challenges for investment management organizations.17
Investment Guerrillas
Miles Morland, formerly general partner of Blakeney Management, captured the essence of the strengths of an entrepreneurial investment management organization in a letter describing why he did not proceed with a contemplated joint venture involving a much larger financial services conglomerate. Blakeney manages assets in Africa and the Middle East.
I am afraid we are not going to go ahead with our merger…. Blakeney is a small group of guerrillas. Our success comes from our ability to fight and forage in places too small and too risky for people with more to lose. That is also what makes it such an exhilarating place to work. We are focused completely on getting and doing business with no thought for our supply lines or on whose territory we are trespassing. [Your firm] is a big and powerful uniformed army. Thanks to you it has retained its entrepreneurial spirit more than any other large American firm but that is like saying that the parachute troops are more entrepreneurial than the tank battalions. Big firms by their nature need disciplines and chains of command. Their sheer size means that when they venture overseas they build complex relationships with other powers in other lands who speak the same language….
Guerrillas cannot be integrated into the regular army without losing what it is that makes them effective. All the professionals at Blakeney have previously been officers in the regular army and have deserted to join the guerrillas. It is the thought that you personally are a guerrilla at heart that has made us go on with the negotiations despite the warning signs. If we ask ourselves how will this deal help us do more and better business, and how will it make our lives more interesting and more fun, we cannot find an answer. Everything points in the opposite direction. This is no criticism of [your firm] or the excellent people we have gotten to know there. It is the reality of forming an affiliation with someone as big as you. Even if we don’t have to put on uniforms we will have to run our business in a way that acknowledges the rules that are imposed on you and when we go foraging for business we will have to respect your existing alliances. We are rustlers by nature not herders. We want to make lightning raids in Zimbabwe and Ghana and Egypt while your partners…are holding meetings to decide…about how and where they are going to deploy their mighty troops. When they arrive we hope they will find a few of the local cattle are missing.
…I hope we can continue to do things together. All this only started because of the respect I have for you personally. I bear the blame for not realizing sooner what the implications of the deal were. At the end of the day, we might have been the majority shareholder and you the minority one, but if a majority mouse lies down with a minority elephant it is not the elephant who is going to end up as a pancake.
By selecting investment managers with an entrepreneurial orientation, fiduciaries improve the chances for investment success. Large, multiproduct, process-driven firms face the daunting hurdle of overcoming bureaucratic obstacles. Small, focused, independent firms with excellent people provide the highest likelihood of identifying the contrarian path to excellent investment results.
Independent Organizations
Investors increase the degree of coincidence of interests with fund managers by choosing to work with focused, independent firms. Particularly severe conflicts between investor goals and money manager actions arise in “financial supermarkets”—large, bureaucratic organizations that offer a variety of investment management options. Employees at financial conglomerates turn over at substantially greater rates than at independent firms. Compensation explains part of the reason. The investment management subsidiary’s revenues flow to the financial supermarket, which takes some as profit and returns some as salary to the subsidiary’s principals. Successful portfolio managers employed by supermarkets have the option of simply moving across the street, opening up shop, and garnering 100 percent of the revenues associated with their efforts. The profit objective of the financial supermarket creates instability at the investment management subsidiary, opening a gap between the interests of the firm and the client. A desire for independence explains another part of the reason for high employee turnover. The opportunity to operate without interference from bureaucrats intent on serving corporate interests appeals to the best investment minds. Ill-informed, outside intervention in the decision-making process, however well-intentioned, creates the potential for suboptimal outcomes and provides incentive to establish an independent firm. A final motivation comes from a sense of ownership. Owner operators simply work harder and better than rank-and-file employees. Small, independent, entrepreneurial organizations provide greater coincidence of interest between firm and client.
Investment focus improves the chances of satisfying client objectives. A narrow product line forces managers to live and die by investment results, creating an enormous incentive to produce superior returns. In contrast, a firm with a broad product line anticipates that hoped-for gains on winning products more than offset inevitable losses on losing strategies, reducing the cost of any single product failure. Even worse, in seeking steady streams of income, financial supermarket managers fashion broadly diversified portfolios, tracking market benchmarks closely enough to avoid termination and too closely to achieve excellence. Investors prefer that fund managers place all their eggs in one basket, and watch that basket with great care. By selecting concentrated, focused managers, investors increase chances for success.
In pursuing stable flows of revenues, financial conglomerates seek income growth at the expense of investment performance. Investment managers soon recognize that rewards come primarily from attracting new cash flows, not generating superior investment returns. Since size is the enemy of performance, asset gatherers win at their clients’ expense.
Public ownership of an investment management organization introduces another set of issues for the firm’s clients. While the goals of a privately held financial supermarket differ materially from the interests of the money management clients, in the case of a publicly owned money manager the introduction of outside shareholders further exacerbates the conflicts of interest. The most obvious, and perhaps the most severe, problem concerns the conflict of interest between money management clients and external shareholders.
Fortress Investment Group
When an independent investment management firm files to go public, the offering documents contain clues regarding the consequences for owners of the firm, their clients, and the public shareholders-to-be. But, offering documents frequently fail to address head-on the fundamental conflict that arises from introducing public shareholders into the mix. In the context of a private firm, the investment manager accepts the responsibility to provide superior investment results to clients that entrust assets to the investment manager’s care. In the context of a public firm, the investment manager retains the responsibility to serve the clients’ interests and adds a responsibility to public shareholders. The interests of the clients and the public shareholders often conflict.
The public offering of shares in the Fortress Investment Group, a $26 billion manager of private equity partnerships, hedge funds, and publicly traded alternative investment vehicles, highlights the issues confronting a publicly traded firm’s clients. Take the case of dividends. The November 2006 registration statement proudly notes that “unlike many publicly traded asset managers, we intend to pay out a significant portion…of our annual distributable earnings in the form of quarterly dividends.”18 Substantial dividends clearly benefit shareholders. In contrast, investors in Fortress’s asset management products suffer from the firm’s dividend policy.
Consider the source of funds for dividend payments. The most reliable income stream comes from the management fees that Fortress charges for asset management services. Higher fees and increased assets under management benefit the public shareholder. Neither higher fees nor increased assets benefit the clients of the Fortress funds. In fact, both factors produce lower investment returns. To add insult to injury, some portion of the fees paid by Fortress’s clients go not to the principals making the investment decisions, but to faceless public shareholders. The issue of dividend payments highlights the conflict between clients and shareholders.
In an attempt to justify the public offering, the offering statement includes a helpful section entitled “Why We Are Going Public,” that contains the headers People, Permanence, Capital, and Currency. With respect to “People,” Fortress suggests that publicly traded shares would “increase our ability to provide financial incentives to our existing and future employees.”19 The Fortress statement ignores the obvious fact that public shareholders claim a portion of the funds that otherwise would have been available for distribution to the firm’s investment professionals. A public offering diminishes the size of the compensation pool, making Fortress’s claim disingenuous at best.
Regarding “Permanence,” Fortress expects to benefit from an increase in the proportion of capital that institutions and individuals allocate to the firm. No evidence exists that capital providers prefer publicly traded firms to privately held firms. In fact, if capital providers seek high risk-adjusted returns, the fundamentals support the opposite conclusion.
As to “Capital” and “Currency”, Fortress suggests that publicly traded shares facilitate the firm’s ability to grow, create new investment products, and finance future strategic acquisitions. Increases in assets and numbers of products may well benefit Fortress principals and public shareholders, but do nothing to serve the interests of the clients of Fortress funds.
Strangely absent from the list of reasons to go public is “Greed.” Just prior to the IPO, on December 18, 2006 the Fortress principals (five in number) sold 15 percent of the firm to Japanese securities firm Nomura “for approximately $888 million, all of the proceeds of which went to the Principals.”20 Moreover, between September 30, 2006 and the consummation of the IPO, the Fortress S-1 registration statement noted that “we distributed $528.5 million to our principals.”21 In addition, careful readers who make it to Chapter 4 of the offering circular note that shortly prior to the initial public offering, the principals of Fortress entered into a $750 million credit agreement, which provided funds for refinancing a prior $175 million credit facility and for “investment in various existing and new Fortress Funds, and to make a one-time $250 million distribution of capital to our principals.”22 Finally, in a tangle of complexity that only a lawyer could love, the registration statement describes a “tax receivable agreement,” which might produce payments to the principals that “could be material in amount.”23
Between the $888 million Nomura windfall, the $528.5 million of pre-IPO distributions, and the $250 million loan distribution, the five principals of Fortress cashed in to the tune of $1,666.5 million. Finding the three elements of the Fortress principals’ paydays required careful reading of pages and pages of legalistic prose in the company’s disclosure documents. In a straightforward world, the section entitled “Why We Are Going Public” would contain one header, “Greed,” that transparently outlined the $1.7 billion of payments to the fortunate few.
The Fortress IPO clearly benefits the senior principals of the firm and just as clearly imposes costs on both the junior Fortress professionals and the firm’s clients. By giving a piece of the pie to outside shareholders and by cashing out themselves, the senior principals leave far less to compensate their subordinates. By introducing a responsibility to serve the interests of public shareholders, Fortress creates a conflict with their fiduciary obligation to clients. Public offerings of money management firms benefit the few at the expense of many.
United Asset Management
United Asset Management (UAM), a once-acquisitive conglomerate of investment advisors, illustrates the problems with external ownership of investment managers. At the end of 1998, with equity interests in forty-five firms and managing in excess of $200 billion, UAM ranked among the world’s largest owners of investment management firms. While the firm boasted an impressive level of assets under management, UAM operated with a fundamentally flawed strategy.
The UAM investment manager roster included a number of well-known, highly regarded groups, including Acadian Asset Management and Murray Johnstone Limited. While superior historical performance created UAM manager reputations, their acquisition by UAM dimmed prospects for future excess returns. The emphasis on asset gathering, loss of entrepreneurial drive, and diversion of revenues to passive shareholders created conditions that led to investment mediocrity.
Even though UAM’s 1997 annual report lists the name, address, and investment strategy of each of the firm’s affiliated managers, no performance data appear. Net client withdrawals of $16.0 billion in 1997, representing 9.4 percent of assets at the beginning of the year, pointed to the conclusion that managers produced generally unsatisfactory performance. The few textual references to investment performance do little to confuse the annual report’s clear message: manager rewards stem from increasing assets under management, not from generating superior investment returns.
Board chairman Norton Reamer addresses the leakage of assets by identifying “improving our firms’ net client cash flow [as] our top priority in 1998….”24 The report later outlines incentive programs to reach the goal, “which is clearly a function of improved client service and retention as well as product development and marketing.” Where is the reference to investment returns? The annual report indicates that new acquisitions will “concentrate on firms with the highest growth potential,” not on firms most likely to provide superior performance.
In spite of a roaring bull market, UAM failed to increase “net client cash flow.” Throughout 1998, nearly $20 billion in assets left the money management firms under UAM’s umbrella. While UAM continued to articulate a goal of increasing assets through improved client servicing, the firm announced several investment-oriented initiatives designed to improve performance.
The performance improvement initiatives evidently failed, as 1999 proved no more successful than 1998. UAM’s annual report noted that assets under management increased a scant $1.2 billion during the bull-market year; investment gains of $22.5 billion only slightly surpassed client outflows of $21.1 billion.*
On June 16, 2000, UAM threw in the towel, entering into an agreement to sell the firm to Old Mutual. The Wall Street Journal noted that the purchase price, which amounted to about 1.2 percent of assets under management, stood at the low end of the “going rate of 1%-to-5% of assets,” reflecting “some of the restructuring work that lies ahead.”25 Trevor Moss, a London-based securities analyst, observed that UAM had “about the same level of assets under management that it had about five years ago,” a dismal showing in the context of the U.S. equity market’s nearly threefold increase.26
UAM fizzled for a variety of reasons. External ownership of investment firms inevitably alters the institutional culture, diminishing the entrepreneurial spirit so critical to successful money management organizations. When senior professionals “cash out,” the single-minded focus on generating strong results dissipates, sapping the vitality of the firm. After the sale of a firm, junior professionals face a less rosy future. According to UAM disclosure documents, after a typical acquisition, only 50 percent to 70 percent of revenues remain with the investment management firm. The diversion of resources to passive external shareholders reduces the size of the pie available for distribution to investment professionals, creating instability. Employees of professional services firms with substantial outside ownership enjoy the option of moving across the street, setting up shop and garnering a greater share of the newly formed independent firm’s profits.
In October 2007, Old Mutual’s president and chief executive officer Scott Powers acknowledged the challenge of external ownership, noting that “[i]t’s taken us a while to figure out the right mix of short-term and long-term incentives.” Five years after the UAM purchase, Old Mutual “largely completed” the process of changing revenue sharing agreements into profit sharing arrangements, a step that reduces incentives to gather assets. In 2007, Powers articulated a longer term goal “to get equity into the hands of our affiliates.” While providing equity ownership to the principals of investment management subsidiaries moves the organizational structure in the right direction, the ultimate sharing of equity necessarily falls short of the 100 percent ownership characteristic of an independent investment manager.27
Pursuit of investment excellence in the context of a conglomerate of investment managers proves futile, as the goals of external owners fail to coincide with the aspirations of investors. Asset gathering creates diseconomies of scale for investors, decreasing the possibility of achieving superior performance. The transformation of senior managers from owners to employees creates changes in firm culture that disadvantage investors. Finally, compensation for external shareholders impairs the money management firm’s ability to pay portfolio managers at competitive levels, leading to turnover among personnel and posing risks to investor assets. Significant external ownership of asset management firms creates barriers to investment success.
Investment Banks and Investment Management
Conflicts of interest abound in the financial world, with large, complex organizations facing the widest range of issues. Investment banks frequently sponsor private equity funds, using access to proprietary deal flow as a selling point. Unfortunately, deals originated by the investment banking network come with built-in conflicts. When a company engages an investment bank to sell a division, alarm bells should ring when the banker suggests that the investment bank’s private equity fund purchase the division. Is the investment bank serving the interest of a good corporate client by paying a rich price for the division? Or, is the investment bank serving the interest of the private equity fund by paying a low price? Under such circumstances, fairness opinions notwithstanding, no fair price exists.
Less subtle conflicts permeate the process. Investment banks sometimes put themselves in untenable positions, advising companies at the same time as they provide financing. In August 2007, Lehman Brothers found itself horribly conflicted when its Home Depot Supply transaction floundered amid the LBO debt crunch. As reported in the International Herald Tribune, Lehman “advised Home Depot on the sale at the same time it was also providing financing to the buying group. Suddenly, Lehman was turning around and threatening to scuttle a deal it had advised one of its most important clients to accept.”28 Ultimately, Goldman Sachs replaced Lehman as an advisor and Lehman retraded the deal, obtaining more lucrative terms for its financing. Advisory and financing roles always conflict; the stresses of the LBO funding crisis brought the conflict into high relief.
After deals close, investment banks often continue to provide financial advisory and capital markets services to portfolio companies. In an unusual public description of the bonanza created by captive private equity funds, the December 14, 1990 Wall Street Journal detailed fees generated by Morgan Stanley’s investment in Burlington Industries.
Morgan Stanley and Burlington Industries
In 1987, Morgan Stanley’s leveraged buyout fund invested $46 million of equity in the $2.2 billion purchase of Burlington Industries. Over the next three years, the investment bank charged the company more than $120 million in fees for services ranging from underwriting to advising on divestitures. Because Morgan Stanley controlled the board of Burlington Industries, decisions regarding financing and divestitures were neither arm’s length nor exposed to market forces. At best, all transactions benefited the company, with Morgan Stanley compensated at market rates for services rendered. At worst, unnecessary transactions generated above-market fees, disadvantaging the company and Morgan Stanley fund investors. When a fund sponsor profits by charging advisory fees at the direct expense of investors, serious conflicts of interest ensue.
Noting that “nearly every time Burlington needed advice, Morgan Stanley turned on the meter,” Wall Street Journal reporter George Anders suggests that “the story of Burlington Industries raises troubling questions about Wall Street’s foray into merchant banking.”29 Fees generated by Morgan Stanley “for everything from underwriting Burlington’s high yield debt to overseeing a blizzard of divestitures” dwarf the equity investment made by the partners of Morgan Stanley in the Burlington transaction, providing handsome returns to the investment bank irrespective of the returns delivered to the firm’s private equity investors.30
Goldman Sachs and the Water Street Corporate Recovery Fund
Goldman Sachs created an even more extensive web of conflicts when in 1990 it established the Water Street Corporate Recovery Fund, a $783 million “vulture fund” set up to make concentrated investments in distressed securities. Hoping to be viewed as a savior of bankrupt companies, instead Goldman stirred up a hornet’s nest of conflicts.
One set of conflicts existed between Goldman’s financial restructuring advisory business and control investing in distressed situations. Investment banks generally rely on “Chinese walls” to contain sensitive data supplied by clients in the course of advisory assignments, keeping inside information away from securities analysts and traders. The term Chinese wall may be employed because such walls are easily removed at an assignment’s end. A cynic (or realist) might argue that paper-thin permeability more aptly describes Chinese walls. Because Goldman partner Mikael Salovaara both ran the Water Street Fund and continued to advise clients on restructuring, any shred of separation between the business disappeared, causing “traders at other firms (to joke) that Mr. Salovaara had a ‘Chinese wall’ in the middle of his brain.”31
The Water Street Fund investment in distressed bonds of toy-maker Tonka illustrates several strands of the web of conflicts. After accumulating a position in Tonka’s debt securities, Salovaara competed for an assignment to advise Mattel on a possible acquisition of Tonka, in the process, perhaps, picking up potentially valuable non-public information regarding the value and salability of Tonka’s bonds. Goldman’s advantage infuriated junk bond investors not privy to the information, causing several to complain publicly and to suggest they would reduce activity with Goldman’s trading desk.32
Ultimately, Tonka agreed to be acquired by Hasbro, creating yet another problem for Goldman. The Water Street Fund owned more than half of Tonka’s bonds, having acquired the position at less than 50 percent of face value.33 Even though Tonka’s board of directors wished to sell the company to Hasbro, Goldman played hardball, holding out for more money for the firm’s bond position. While such tactics raise few eyebrows in the rough and tumble world of distressed debt, some clients saw Goldman’s actions as inconsistent with the firm’s avowal to avoid any participation in hostile merger activity. Ultimately, the investment bank’s tactics worked, increasing payments received for the Tonka bond position by reducing the value of other participants’ Tonka and Hasbro shareholdings. Goldman’s investment returns came at great expense, tarnishing the firm’s reputation for putting clients first.
A final strand in the conflict web relates to Goldman’s junk bond trading activity. To avoid competition, the firm limited the high yield trading desk’s activity in bonds that interested the Water Street Fund. Goldman’s trading clients, already concerned about the firm’s possible informational advantages, faced market makers less able to take positions.
Goldman’s advisory conflict troubles went beyond the Tonka case. According to an article in the June 4, 1991 Wall Street Journal, “nine of twenty-one companies that the Water Street Fund selected for ‘restructuring’ are or were Goldman clients.”34 Perceptions mounted that Goldman invested the Water Street Fund with an unfair advantage.
Faced with a storm of controversy, Goldman shut down the fund in May 1991, several years ahead of schedule. Even though the Water Street Fund generated handsome returns during its abbreviated life, the fund’s enduring legacy may be its rich series of lessons on conflicts of interest.
Goldman Sachs and the Global Equity Opportunities Fund
In mid August 2007, Goldman Sachs faced unprecedented carnage in its hedge fund portfolio. The firm’s flagship $7.5 billion Global Alpha Fund, managed by Mark Carhart and Raymond Iwanowski, posted a stunning year-to-date decline of 27 percent.35 The lower profile North American Equity Opportunities Fund dropped 25 percent in the first seven and a half months of the year. And, for good measure, the Global Equity Opportunities Fund lost a stunning 30 percent of its value in the second week of August alone.36 In aggregate, the net value of the three funds managed by Carhart and Iwanowski declined by an impressive $4.7 billion during the first eight months of the calendar year.
Goldman had no skin in the game. The firm’s chief financial officer David Viniar characterized Goldman’s investments as “nothing substantial; very immaterial, if at all.” Goldman simply collected fees for mismanaging the hedge funds; the losses belonged to the firm’s investors. Yet, presented with an extreme market dislocation, Goldman chose to become a principal.
In response to the dramatic price declines, Goldman Sachs arranged a $3 billion injection into the Global Equity Opportunities Fund, of which approximately $2 billion came from Goldman Sachs itself. On a conference call explaining the move, David Viniar asserted the infusion of capital benefited Goldman Sachs and “the current investors in the fund, giving them the firepower to take advantage of the opportunities in the market today.” In reality, Goldman used the bulk of the infusion to play defense. The fund managers employed the cash contribution to bring the fund’s leverage down from an irresponsible level of approximately 6 to 1 to a still high (but more defensible) level of around 3.5 to 1.37
Goldman’s move raises a number of questions. If, indeed, the move benefited existing clients by reducing leverage and providing firepower, why did Goldman choose to benefit only clients of the Global Equity Opportunities Fund? What of the fiduciary responsibility of Goldman Sachs to clients invested in the Global Alpha Fund and the North American Equity Opportunities Fund? Goldman Sachs’s David Viniar noted that the fund managers were reducing risk and reducing leverage in both Global Alpha and North American Equity Opportunities. Why should Global Equity Opportunities receive a so-called benefit from Goldman in the form of a cash contribution that presumably allowed low-cost deleveraging, while the unfavored funds faced the market-related costs of selling assets in a hostile trading environment?
The timing of Goldman’s investment raises questions about the firm’s favored access to what senior management characterized as “a good investment opportunity.” Instead of providing the opportunity to existing clients of the Global Equity Opportunities Fund, Goldman took the lion’s share for itself and reached out to a select group of investors for the rest, ultimately raising $1 billion from the likes of Eli Broad, C.V. Starr (Maurice “Hank” Greenberg), and Perry Capital.38 As a fiduciary for the investors in Global Equity Opportunities Fund, should not Goldman first offer the chance to take advantage of the fund’s opportunities to the existing investors?
Viewed from another perspective, Goldman’s investment in Global Equity Opportunities might actually harm the fund’s clients, in contrast to the benefit that Goldman claims. Goldman and the firm’s favored co-investors enjoyed the opportunity to invest $3 billion in the Global Equity Opportunities Fund at net asset value on the day of their choosing. Goldman got a sweet deal. Had the $3 billion been invested in the securities that comprise the fund, the market impact of the sizable trades would no doubt force prices up, increasing Goldman’s cost basis. Instead, by using the contributed assets to reduce leverage, Goldman bought in at a price that otherwise would have been impossible to achieve. Existing investors suffered dilution of their position.
Finally, Goldman Sachs provided the cherry-picking investors better deal terms than those accorded the existing Global Equity Opportunities Fund investors. In an analyst conference call, Goldman Sachs president and co-chief operating officer Gary Cohen noted that the firm’s cash infusion put Goldman in an “equal position to all the existing investors.” In fact, the new money pays no management fee, pays a reduced carry of 10 percent, and benefits from a hurdle rate of 10 percent. Because Goldman and the other favored investors received preferential terms on their investment, their actions certainly disadvantaged the existing fund investors.
In any event, Goldman picked an opportune time to make its commitment to the Global Equity Opportunities Fund. Bloomberg reported that in the week following the cash infusion, the fund rose 12 percent. A September 20th AP release noted that Goldman’s investment had appreciated 16 percent in little more than a month. At least in the short run, Goldman made out well. Global Equity Opportunities Fund clients shared in the rebound, but by dint of Goldman’s investment, in an attenuated fashion. Presented with an attractive investment opportunity, Goldman became a principal, riding roughshod over the interests of the firm’s hedge fund clients and enriching itself in the process.
While investors cannot avoid conflicts entirely, fewer differences in interest exist when investing with independent investment management organizations. Avoiding affiliates and subsidiaries of financial services firms does little to reduce the rich set of investment manager alternatives.
DEAL STRUCTURE
Appropriate deal terms play an important role in producing satisfactory investment results. After identifying an attractive investment management firm, investors face the issue of evaluating (or negotiating) compensation arrangements. The degree of efficiency in asset pricing determines in part the nature of the compensation scheme, with passive management of efficiently priced securities demanding different treatment from active exploitation of anomalously priced assets. All aspects of investment management fee structures contain potential for conflict between the interests of investors and investment managers, forcing fiduciaries to pay close attention to explicit and implicit incentives embodied in management contracts.
Co-investment
Co-investment provides a powerful means of aligning fiduciary and fund manager interests. To the extent that a manager becomes a principal, issues regarding agency behavior diminish. Unfortunately, along with substantial co-investment, issues arise regarding possible differences in goals between mortal, taxpaying money managers and immortal, tax-exempt institutional investors. That said, co-investment reduces the incentive for investment advisors to profit at the expense of clients.
While any level of co-investment encourages fund managers to act like principals, the larger the personal commitment of funds the greater the focus on generating superior investment returns. Managers cease to benefit from attracting new capital at the point where the return diminution on the manager’s personal stake caused by increasing assets under management exceeds the opportunity costs of fees foregone by limiting asset growth. Because the easily measured level of fees foregone generally eclipses the fuzzy estimate of size-induced performance drag, only the wealthiest managers confront a clear trade-off favoring asset growth limitations. Even though the numbers might favor asset-gathering strategies for most managers, substantial levels of co-investment send strong signals to investors regarding the principal orientation of fund managers. The idea that a fund manager believes strongly enough in the investment product to put a substantial personal stake in the fund suggests that the manager shares the investor’s orientation.
Investment of personal assets side-by-side with client capital creates a powerful alignment of interests. While profit participations focus manager attention on the investor goal of generating handsome investment returns, a profit sharing arrangement in which managers share only in gains creates an option that encourages risk-seeking behavior. By making a substantial co-investment, managers participate directly in gains and losses, leading to more balanced assessment of investment opportunities. To realize the hoped-for behavioral outcome, the co-investment commitment must be large relative to the manager’s net worth, even though the amount might be modest in absolute terms. When writing a check representing a material portion of personal assets, the investment manager steps into the role of a principal.
While co-investment generally improves the investor’s position by aligning investment interests, differences in goals bear careful scrutiny. Taxpaying fund managers in partnership with tax-exempt institutional investors face different after-tax return scenarios. Mortal decision makers operate with shorter time horizons than appropriate for an enduring organization’s permanent funds. Individuals with large fund investments frequently desire greater diversification than required by most institutions, which hold an already well-diversified collection of assets. Even though differences in tax status, time horizon, and risk tolerance drive wedges between the interests of individual fund managers and the goals of institutional investors, the benefits of substantial co-investment far outweigh the likely costs.
Compensation Arrangements for Marketable Securities
The character of sensible compensation arrangements for investment managers varies with the degree of efficiency in asset pricing. Passive management of government bonds demands fee arrangements different from those appropriate for active management of private equity. For most asset classes investors face well-entrenched fee arrangements, ranging from asset-based fees for relatively efficiently priced marketable securities to a combination of asset-based fees and incentive payments for less efficiently priced asset types. Because marketplace practices frequently deviate from ideal compensation structures, price-taking investors generally take the pragmatic approach of choosing the best option from a set of bad alternatives.
Passive Strategies
Passive asset management differs fundamentally from active asset management. Size, the enemy of active investors, works in favor of index fund managers. For example, passive funds with large numbers of investors and sizable pools of assets frequently offer crossing opportunities, in which some portion of exiting investor demand for funds matches entering investor supply of funds, allowing nearly costless exit from and entrance to the investment pool.* Scale improves tracking of benchmarks, as large size facilitates full replication of the investment universe, reducing the need for tracking-error-inducing sampling procedures. Experience shows that funds with billions of dollars track benchmarks with little or no slippage.
Barclays Global Investors, one of the world’s largest index fund managers, offers a wide variety of products designed to mirror various marketable security benchmarks, segregated into distinct pools for different types of investors. The largest pool of assets, designed to track the S&P 500, contained $127 billion on December 31, 2006. Before fees the fund returned 8.46 percent for the trailing ten years relative to 8.42 percent for the S&P 500 index. The much smaller bond pool, with $1.6 billion on December 31, 2006, showed similarly impressive results, with ten-year returns of 6.33 percent relative to 6.26 percent for the Lehman Brothers Government Corporate Index.
The commodity-like nature of passive investing commands commodity-like compensation. Index fund managers compete with the alternative of internally managed passive portfolios, forcing fees to a paltry two basis points per year for large accounts.** By choosing passive alternatives for efficiently priced assets, investors expect predictable results at a bargain price.
While strong arguments support passive management for all marketable securities, two factors argue strongly for passive management of bond portfolios in particular. First, to satisfy the deflation hedging role of fixed income, investors must hold long-term, high quality, noncallable bonds, suggesting the creation of stable duration government bond portfolios. Second, the extraordinary efficiency in the pricing of government bonds makes active security selection decisions a costly exercise in futility. The need for a stable maturity structure and the futility of individual security bets require that investors manage bond portfolios passively.
While domestic equity investors enjoy more flexibility in structuring portfolios than bond investors, the difficulty of identifying material mispricings in the stock market, particularly among large-capitalization securities, leads many investors to index common stocks. By avoiding high fees and substantial transactions costs, index funds provide long-term results that represent a formidable hurdle for investors hoping to outperform. Yet, in spite of the clear difficulties in producing risk-adjusted excess returns, most investors pursue active management strategies.
Active Strategies
Careful active investors pay close attention to fee arrangements, recognizing that fees represent a substantial obstacle to market-beating performance. Active managers of marketable securities generally receive asset-based fees in exchange for portfolio management services. On one level, interests coincide. To the extent that a manager increases assets through superior investment performance, both the manager and the investor win as the manager’s income increases and the investor’s return pleases. On other levels, interests conflict. The manager may pursue a “staying in business” strategy to protect fee income by closet indexing, holding a market-like portfolio unlikely to produce results that would lead to termination. Perhaps even more damaging, the manager may conclude that gathering assets provides greater fee income than generating superior returns.
In growing assets, managers simply respond to economic incentives. With asset-based fees, income increases as assets under management increase. Frequently, managers find it easier to add assets by attracting new accounts than by creating excess returns. With distressingly few exceptions, fund managers aggressively pursue marketing activities, attempting to gather as many assets as possible. Retaining assets requires avoiding disastrous performance, causing money managers to create market-like portfolios that all but eliminate the chance for superior performance. Investment management represents, at best, a secondary consideration for most institutional fund managers.
Creating appropriate deal structures allows investors to mitigate many of the conflicts inherent in the investment advisory relationship. Sensible fee arrangements contain two elements: base compensation that covers reimbursement of reasonable overhead costs and incentive compensation that rewards a manager’s value added. The incentive compensation, or profits interest, represents a share of the returns generated in excess of a benchmark appropriate to the investment activity. For example, large-capitalization domestic marketable equity managers might be rewarded for returns generated in excess of the S&P 500, while foreign equity managers might receive a profits interest in returns above the Morgan Stanley Capital International EAFE Index. Fair deal structures, rare in the investment management arena, encourage appropriate behavior on the part of money managers.
Unfortunately, the overwhelming majority of marketable security managers employ asset-based fee schemes, causing market gains or losses and portfolio inflows or outflows to overwhelm the impact of manager skill. Even though a number of managers offer superficially attractive incentive compensation arrangements, three factors diminish the appeal of most schemes. First, the vast bulk of marketable security funds generate profits primarily from asset-based fees, encouraging managers to emphasize increasing asset totals. In other words, even when firms offer incentive arrangements, those incentive arrangements fail to influence fund manager behavior because investment firms continue to rely on fee income expressed as a percentage of assets under management. Second, investment managers tend to offer terms on incentive schemes that involve modest levels of risk to the firm’s existing income flows. Instead of taking a “blank slate” approach that sets baseline fees at a level that covers reasonable overhead, money managers try to structure incentive arrangements that ensure continued income flows even with mediocre performance, protecting the profit margins implicit in existing fee structures. Finally, investors choosing between a traditional asset-based fee and an alternative incentive-oriented structure encounter cognitive dissonance, as the performance expectations implicit in hiring an active manager cause expected costs of incentive compensation to exceed anticipated payments from a traditional asset-based fee arrangement. While the concept of incentive compensation structures for active managers of marketable securities carries a great deal of theoretical appeal, the limitations of real-world arrangements reduce the effectiveness of incentive schemes in causing fund managers to behave as principals.
Investment management fees, whether asset-based or incentive-oriented, represent a heavily scrutinized term in most contract negotiations, with investors seeking the lowest possible fee burden along with a “most-favored-client” clause ensuring advantageous treatment in the future. Beneath the open, honest discussion concerning marketable equity fee arrangements lie hidden soft dollar payments, representing old-fashioned kickbacks designed to increase investment advisor cash flow at the direct expense of investor clients.
Soft Dollars
The history of soft dollars provides a worrisome tale. Prior to May 1, 1975, Wall Street operated under a system of fixed commissions that set rates far above the costs of executing trades. Competitive forces caused brokerage firms to circumvent the fixed prices, by providing rebates to favored customers in the form of soft dollars. Soft dollars, in essence a kickback from broker to trader, funded the purchase of both investment-related and noninvestment-related goods and services.
Think about the implications of soft-dollar trades for investors. Paying inflated commissions to trade securities, for whatever purpose, reduces investment returns. The reduction in return comes straight from the investor’s pocket. The benefit, in the form of goods and services, accrues directly to the fund manager. Because the costs of soft-dollar goods and services would otherwise have come from the fund’s management fee, soft dollars represent nothing other than a well-disguised increase in management fees. Wall Street benefits at the investor’s expense.
A T. Rowe Price disclosure document, dated March 1, 2004, describes the soft-dollar game. “[U]nder certain conditions, higher brokerage commissions may be paid in return for brokerage and research services…. [S]uch services may include computers and related hardware. T. Rowe Price also allocates brokerage for research services which are available for cash…. [T]he expenses of T. Rowe Price could be materially increased if it attempted to generate additional information through its own staff. To the extent that research services of value are provided by brokers or dealers, T. Rowe Price is relieved of expenses it might otherwise bear.” Investors learn of T. Rowe Price’s soft-dollar policies through carefully constructed, legally correct prose buried on Chapter 4 of an infrequently read disclosure document. Even though T. Rowe Price presumably satisfies legal requirements with its disclosure, the firm compromises investor interests with its soft-dollar usage.
After May Day 1975, when the SEC abolished the system of fixed commissions, the raison d’être for soft dollars vanished. Price competition would set brokerage commission rates. Under-the-table kickbacks could disappear. Unfortunately for investors, fund managers realized that soft dollars transferred research-related expenses from their account (management fee income) to the investors’ account (trading expenses). As a result, the money management industry enthusiastically defended the use of soft dollars.
Instead of banning soft dollars, in 1975 Congress created a safe harbor for their use under Section 28(e) of the Securities Exchange Act of 1934. Perverting a piece of legislation originally designed to protect the investing public, Congress bowed to pressure from Wall Street and explicitly allowed fund managers to deplete investor assets, legitimizing soft dollars by instructing the SEC to define appropriate use. Why do market participants tolerate the inefficiencies involved in paying inflated prices for trading securities and then receiving rebates in the form of goods and services? The answer lies in the lack of transparency of the process, which allows money managers to profit in an opaque manner. Were the soft-dollar charges as transparent as the highly visible management fees, the investment management industry would have no use for soft dollars.
When the Securities and Exchange Commission examined the soft-dollar issue in the mid 1980s, the commission not only missed an opportunity to eliminate the scourge of soft dollars, it actually expanded the epidemic. In wonderfully bureaucratic prose, the SEC noted that its 1986 release addressed “[i]ndustry difficulty in applying the restrictive standards” on soft-dollar usage by “adopting a broader definition of ‘brokerage and research services.’” In other words, if the restrictions bind, loosen the constraints. The SEC’s 1986 soft-dollar regulations favored the advisor over the advisee.
SEC Chairman Arthur Levitt described soft dollar conflicts in a February 15, 1995 Wall Street Journal article: “Soft-dollar arrangements can create substantial conflicts of interest between an advisor and its clients. For example, advisors may cause their clients to pay excessive commission rates, or may overtrade their clients’ accounts simply to satisfy soft-dollar obligations. Soft-dollar arrangements may also result in inferior executions when advisors direct trades to the wrong broker to satisfy a soft-dollar obligation.”39
To ameliorate conflicts surrounding brokerage activity, in February 1995, the SEC proposed a new rule under the Investment Advisors Act of 1940 that would require investment managers to disclose the services they receive for brokerage commissions. The report would list the twenty brokers to which the advisor directed the largest amounts of commissions during the previous year, the top three execution-only brokers, the aggregate amount of commissions directed by the advisor to each broker, and the average commission rate paid to each broker. The disclosure would permit a client to assess the costs and benefits of the soft-dollar services that the advisor receives, and, consequently, whether the client should attempt to limit the advisor’s use of soft-dollar brokers. Unfortunately, no action resulted from the 1995 SEC rule proposal.
In spite of Chairman Levitt’s public concerns about soft dollars, the SEC again failed to protect mutual-fund investors in 1998. The regulator’s Inspection Report dryly notes “the widespread use of soft dollars,” as “almost all advisors obtain products and services other than pure execution from broker-dealers and use client commissions to pay for those products and services.” The report recognizes that “advisors using soft dollars face a conflict of interest between their need to obtain research and their clients’ interest in paying the lowest commission rate available and obtaining the best possible execution.” The report details instance after instance of questionable use and outright abuse of soft dollars, including payment “for office rent and equipment, cellular phone services and personal expenses, employee salaries, marketing expenses, legal fees, hotels and car rental costs.” Wall Street’s definition of research bears little correspondence to Merriam-Webster’s.
In spite of the fundamental, irreconcilable conflict of interest in soft-dollar use and in spite of the long litany of soft-dollar abuse, the 1998 Inspection Report concludes only that the SEC “should reiterate and provide additional guidance, consider adopting recordkeeping requirements, require more meaningful disclosure and encourage firms to adopt internal controls.” Instead of protecting investor interests, the SEC defended Wall Street’s gravy train.
While the substance of the 1998 Inspection Report argued for abolition, the SEC wimped out. Faced with a concerted lobbying effort by interested parties—including investment managers, Wall Street firms, and the normally sensible trade association of research analysts—and a lack of pressure from individual investors, the self-styled “investor’s advocate” opted to tighten regulation instead of taking the high road of total eradication. A cynic might argue that the SEC acts on highly visible, easy-to-understand investor protection issues, while allowing low-profile, difficult-to-comprehend abuses to remain.
One of the most outrageous “legitimate” uses of soft dollars involves payoffs made by investment advisors to consulting firms. According to the 1998 SEC report, performance attribution services constitute “a significant portion of the total commission dollars used in soft dollar transactions.”40 Obviously, any competent investment manager develops internal capabilities to understand sources of investment returns, creating evaluation mechanisms specific to the firm’s particular approach to markets. Purchasing performance attribution from consultants serves simply to line the pockets of the consulting firm at the expense of the investment manager’s clients. Presumably, the consulting firm receiving the payoff places the investment management firm in a favored position when making manager recommendations. While investment advisors may wish to improve their standing by purchasing useless information from consulting firms, using client assets for the purpose turns inanity to ignominy.
Some investment managers need so much assistance in evaluating performance that they purchase reports from a variety of consultants. The SEC study cites a large institutional advisor that “directed $882,000 in client commissions to pay for 13 separate performance analyses.” According to a report in Pensions and Investments, J&W Seligman & Co., a money management firm with $24.3 billion under management, engaged seven consulting firms to provide performance attribution reports, using client assets to fund the purchase through soft dollars.41 By paying substantial sums to Callan Associates ($79,000), Evaluation Associates ($100,000), Frank Russell ($26,789), Madison Portfolio Consultants ($17,500), SEI Corporation ($10,000), Wellesley Group ($52,500), and Yanni-Bilkey Investment Consulting ($25,000), J&W Seligman no doubt expects favorable treatment in the next search conducted by the compromised consultants. Payoffs dishonor everyone involved.
Beyond the “legitimate” use of soft dollars to “curry favor with the consultant in his rankings and recommendations of advisors,” nearly 30 percent of investment advisors employ soft dollars for “non-research products and services.” The purchases, which fall outside of the safe harbor, include use of soft dollars for office rent, equipment, marketing expenses, phone services, and salaries. The SEC observed that “virtually all of the advisors that obtained non research products and services had failed to provide meaningful disclosure of such practices to their clients.”42 Aside from using an illegitimate source of funds for legitimate business expenses, many advisors stepped over another line by diverting funds for personal use, including purchase of travel, entertainment, theatre tickets, limousine services, interior design, Internet website design and construction, and computer hardware and software. In the most flagrant abuse of soft dollars, investment advisors defrauded clients by directing “funds ostensibly for verbal ‘regional research’ and ‘strategic planning’ to family members of the advisor’s principal,” by transferring soft dollars through a daisy chain of companies controlled by the advisor’s president, and by paying “round trip airfare to Hong Kong for the principal’s son.” Even though soft dollars did not cause the theft, the opacity of the arrangement facilitated the crimes.
Some clients benefit from a different aspect of the current system of commission-related activity, taking advantage of the murky character of directed brokerage. With directed brokerage, plan sponsors cause trades to be executed by specified brokers, paying higher than market commission rates. A portion of the above-market rate flows back to the plan sponsor in the form of cash rebates or investment-related goods and services. Two factors drive directed-brokerage activity—directed-brokerage investors gain an advantage at the expense of clients not directing brokerage, and fund sponsors use rebates from directed brokerage to purchase goods and services unavailable through normal procurement channels.
Investment advisors commonly aggregate trades for a number of separate account clients, allocating shares to accounts on a pro rata basis. If one client requests that brokerage be directed to a particular securities firm, in order to receive a cash rebate, that client accrues an unfair benefit relative to other clients. In fact, the client who “steps out” of the aggregated trade likely benefits implicitly from all of the brokerage conducted by the investment advisor at the designated firm. Such arrangements exist only as long as they remain hidden from view. If disclosed, disadvantaged clients would demand fair and equitable treatment.
Some investors, particularly in political or corporate environments, fail to obtain sufficient direct support for investment management operations. To augment direct appropriations, investments staff sometimes employ directed-brokerage and soft-dollar programs, generating resources outside regular appropriations or operational channels.
Appearing before a Department of Labor Working Group on Soft Dollars and Commission Recapture, the former director of the New Jersey Division of Investment openly testified that “he utilizes soft dollars to pay for needed administrative expenses,” since “he does not receive sufficient funding from the New Jersey State Legislature.” In fact, the former director urged that “the current interpretation of ‘research’ should be expanded to include travel and hotel expenses.”43
Soft dollars provide a convenient mechanism for the New Jersey Division of Investment to circumvent constraints imposed by the state legislature, allowing the investment operation to thwart the intent of New Jersey’s elected representatives.
In April 2007, SEC Chairman Christopher Cox added his voice to the chorus calling for soft-dollar reform. In a speech to the Mutual Fund Directors Forum, Cox asserted that:
Soft dollars can serve as an incentive for fund managers to disregard their best execution obligations, and also to trade portfolio securities inappropriately in order to earn credits for research and brokerage. Soft dollars also represent a lot of investors’ hard cash, even though it isn’t reported that way. The total of soft dollars runs into the billions each year for all investment funds in the United States.
An agency focused on ensuring full disclosure to investors has to be very concerned about this, because soft dollars make it more difficult for investors to understand what’s going on with their money. Hard dollars eventually end up being reported as part of the management fee the fund charges its investors. But soft dollars provide a way for funds to lower their apparent fees—even though, in the end, investors pay for the expense anyway.
The very concept of soft dollars may be at odds with clarity in describing fees and costs to investors. The 30-year-old statutory safe harbor, in Section 28(e) of the Exchange Act, was probably thought to be a useful legislative compromise when it was packaged with the abolition of fixed commissions. But surely in enacting Section 28(e) Congress meant to promote competition in research, not to create conflicts of interest by permitting commission dollars to be spent in ways that benefit investment managers instead of their investor clients.44
In May 2007, SEC Chairman Cox called for repeal or substantial revision of the safe harbor that protects soft-dollar arrangements between broker dealers and money managers. Cox noted the current system produced a “witch’s brew of hidden fees, conflicts of interest and complexity in application that is at odds with investors’ best interests.”45
While the SEC attempts to reform soft-dollar practices, the question remains—why do soft dollars exist? Powerful market participants in the brokerage community benefit from the inherent murkiness of soft-dollar transactions. Third party providers of soft-dollar-eligible goods and services maintain a strong vested interest in supporting the current system. Investment advisors employing soft dollars increase net income by transferring a portion of investment management costs to clients.
Soft-dollar activity flies in the face of reasonable governance. Investment advisors employ soft dollars to pay off consulting firms and increase investment management revenues, relying on the technique’s opacity to hide from view. Fund managers incur frictional costs to pursue initiatives with directed commissions for which “hard” dollars are unavailable, frustrating the intentions of fund fiduciaries. Soft dollars and directed brokerage, the slimy underbelly of the brokerage world, ought to be banned.
Compensation Arrangements for Nontraditional Assets
Fee arrangements in the nontraditional asset arena typically include some form of profits interest. In spite of important limitations, when compared to typical marketable security deal terms, alternative asset deal structures better align interests of fund managers and fund providers, as the profits interest focuses manager attention on generating investment gains. Large co-investment by managers provides the strongest force for creating parallel interests, causing the manager to share in investment losses as well as in investment gains. Forcing managers to pay attention to the downside of an investment mitigates concerns about the one-way nature of profit sharing options.
Without substantial levels of co-investment, deal structures in the alternative arena encourage investment managers to expose investor assets to risk, as the managers typically receive compensation in the form of an option-like profits interest. Facing a “heads I win, tails you lose” arrangement, managers respond by adopting an agent’s perspective, focusing on achieving personal gains that may or may not correspond to generating risk-adjusted investment returns for the providers of capital.
A particularly troublesome problem results from granting investment managers a profits interest without specifying an appropriate benchmark or hurdle rate. By paying 20 percent of gains after return of capital, investors give asset managers a windfall in the form of a profit participation in market-generated gains over which the manager exercises no control. In creating structures without a reasonable measure of the opportunity cost of funds, investors diminish the likelihood of realizing superior risk-adjusted returns.
Alternative asset compensation arrangements consist of fee income, generally calculated on portfolio value or committed capital, and incentive schemes, generally calculated as a portion of investment gains. In the rarely achieved ideal world, fees offset ordinary costs of pursuing the investment business, while profits interests create incentives for adding value to the process. All too frequently, fees exceed the level required to cover costs, becoming a profit center, and profit participations cover more than value added, rewarding (or penalizing) managers for results beyond their control.
Fee Income
Reasonable fee income provides sufficient revenue to cover a firm’s overhead, allowing investors to run the business comfortably. Investment principals deserve fair salaries, nicely appointed offices, and sufficient resources to structure and manage the portfolio. Ideally, investors would discuss with fund managers the level of resources required to operate the firm, setting a budget sufficient to meet the agreed-upon needs. In practice, few firms take a budgeted approach to setting fees. Most firms maintain industry-standard fee percentages as fund sizes grow and generate enormous cash flows simply from raising ever larger funds.
Deal fees, paid to private fund managers upon consummation of an acquisition, serve to line the pockets of fund managers at the direct expense of investors. Typically found in the leveraged buyout arena, such fees motivate firms to do deals and provide an unnecessary addition to the more-than-generous compensation package represented by management fees and carried interests. Fees in excess of those required to run the business drive a wedge between the interests of investors and fund managers, subtly shifting the manager’s focus to maintaining fees at the expense of generating returns.
Profits Interests
Incentive compensation in the form of a share of gains generated by fund investments provides a powerful tool to motivate fund managers. A fair and effective arrangement splits the value added by the fund manager between the manager and the investor. Both parties deserve to share in incremental gains, since without the manager’s work there would be no value added, while without the investor’s capital there would be no deal. Achieving a hurdle rate that reflects the investor’s opportunity cost of capital represents the point at which a fund manager begins to add value. Unfortunately, in much of the private equity world, hurdles do not exist. By providing profits interests after return of capital, investors compensate fund managers inappropriately. Incentive compensation in the form of sharing value added causes managers to pursue the active investor’s goal of creating risk-adjusted excess returns.
A particularly egregious deal structure causes investors to pay incentive compensation to fund managers before the return of invested capital. Under some private equity arrangements, the investor’s capital account declines by the amount of management fees paid. If “gains” are calculated off of the reduced base, fund managers may receive a profits interest on a fund that fails to return investor capital. At the very least, fund managers ought to return investor capital before reaping the significant rewards of incentive compensation.
Fairness demands that investors earn hard hurdles before profit sharing begins. Hard hurdles represent rates of return that investors realize before fund managers participate in gains, with only profits above the hurdle rate subject to sharing. Soft hurdles, a popular marketing scheme, allow fund managers to “catch up” after exceeding the hurdle rate, providing little value for investors (except in the case where a manager produces truly miserable returns).
Identifying an appropriate hurdle rate poses a tricky problem, since alternative markets lack a ready benchmark such as the S&P 500 for marketable domestic equities. In the case of absolute return, the cost of funds as expressed by a one-year interest rate provides a reasonable starting point. Since absolute return managers generally take short duration positions, measuring investment success relative to short-term interest rates makes sense. In the case of real assets, where expected returns fall between bonds (representing a lower risk measure of an institution’s opportunity cost of funds) and stocks (representing a higher risk measure of opportunity cost), intermediate-term fixed income returns plus a small premium might give us an appropriate hurdle. When forming new funds, investors and fund managers revisit the question of an appropriate hurdle rate in light of changes in market conditions. For instance, as interest rates moved downward throughout the 1990s, appropriate real assets hurdle rates declined from high single digits to mid single digits.
In contrast to reasonable deal structures sometimes available to investors in absolute return and real assets, investors in venture capital and leveraged buyouts face generally unattractive partnership terms. By compensating private equity managers with 20 percent, 25 percent, or 30 percent of every dollar generated after return of capital, standard profit sharing arrangements fail to consider the opportunity cost of capital. At the very least, private managers ought to return a money market rate before collecting a profits interest. The long-term return on a marketable equity benchmark provides a hurdle rate more appropriate to the risk of private equity. In fact, the higher risk inherent in venture capital and leveraged buyout investments suggests using a multiple of long-term equity returns as a threshold for benchmarking private equity funds.
Risk-adjusted marketable security hurdle rates for private investments avoid the problem of compensating (or penalizing) fund managers for market moves that they cannot control. In the bull market of the 1980s and 1990s, buyout managers “earned” 20 percent of the profits on gains attributable to stock-market-induced valuation increases. In a reasonable world, investors might compensate private managers with a profits interest in returns exceeding some premium over long-run historical results from marketable equity investments, implying a mid-teens hurdle rate.
Fair incentive compensation schemes for alternative asset managers face nearly insurmountable obstacles. Under the current conditions of overwhelming demand for high quality groups, investors lack power to influence terms, facing the choice of accepting the standard deal or walking away. Investors hoping to encourage fund managers to behave as principals look to other aspects of deal structure.
Absolute Return Investment Vehicles
Absolute return managers, operating in a marketable securities environment, generally allow investors to withdraw assets and to make contributions on a reasonably frequent basis. Although partnership terms generally restrict the timing and size of inflows and outflows, stable investors face the possibility of incurring costs created by other investors’ cash moving in and out. Cash contributions to an existing partnership dilute the interest of existing investors. By buying into an existing commingled fund, new investors participate in an established portfolio without paying transactions costs to establish positions. Cash withdrawals pose the same free rider problem as departing monies fail to bear the full burden of trading costs required to raise the cash necessary to compensate departing investors.
A more significant problem arises when cash outflows disrupt a manager’s investment strategy. During the market panic in late 1998, many hedge fund managers worried about the magnitude of year-end withdrawals. The threat of potentially large withdrawals posed a dilemma, as on the one hand managers needed to prepare to accommodate departing investor demands while on the other hand asset sales at depressed prices harm the portfolio. The confluence of tough market conditions and concern regarding client withdrawals caused many managers to raise cash by selling assets trading at temporarily depressed prices, impairing results for the manager and steadfast investors alike.
Fund managers solve the free rider problem by allocating costs appropriately to entering and exiting investors. In the case of easily measured transactions costs, managers simply assess entry and exit fees, resulting in a fair allocation of costs. To meet the objective of distributing costs fairly, fees must be paid to the fund, not to the manager, as the fees offset costs incurred by the fund. More complicated procedures address the issue of allocating less predictable costs, particularly charges from transactions conducted in markets with poor liquidity. A rough approximation of fairness results from segregating new investor contributions, investing the funds, and contributing the resulting assets to the general portfolio at cost. Even though the package of securities purchased by the entering investor may not bear precisely the same level of transactions costs as would trades in existing portfolio securities, if the manager makes new purchases in markets similar to the existing holdings the new entrant bears a fair burden. Upon exit, the departing investor receives a pro rata share of the general portfolio in a segregated account, incurring the transactions costs associated with the liquidation process and insulating continuing investors from any adverse impact. By causing entering and exiting investors to absorb costs related to purchases and sales, fund managers avoid unfair treatment of existing investors. Most importantly, the process allows managers to invest assets without regard to concerns regarding extraordinary withdrawal requests, since departing investors simply receive the proceeds of their proportionate share of the fund.
Private Equity Investment Vehicles
Private equity managers best serve investor interests by focusing undivided attention on a single investment vehicle. With only one place to conduct business, managers avoid the inevitable conflicts that arise when managing multiple funds with non-coincident goals.
For example, if a buyout firm manages an equity pool and a mezzanine debt pool, tensions arise in pricing transactions. Better pricing on the mezzanine debt leads to worse results for the equity holders, and vice versa. Some firms attempt to deal with pricing issues by creating a formula for determining the terms of mezzanine finance. By pre-specifying the relationship between the mezzanine coupon level and U.S. Treasury rates, as well as pre-identifying the size of the equity kicker for the bondholders, fund managers hope to avoid the tricky issues involved in dividing expected returns between competing sets of investors.
Because dynamic market conditions constantly alter terms of trade for various investment tools, formulaic approaches inevitably fail to reflect the current market. If the formula determines worse-than-market terms for mezzanine debt, fund managers fail to discharge fiduciary duties to mezzanine investors. If the formula results in a better-than-market deal, equity investors suffer. The convenience of controlling a captive mezzanine fund comes at the cost of a serious conflict between the interests of lenders and owners. In the event of financial distress, problems become even more painfully obvious with some members of the firm wearing mezzanine hats and others wearing equity hats. If equity owners seek forbearance from lenders, fund managers find themselves in a hopelessly conflicted position. The best course for bondholders frequently differs from the path preferred by equity owners, posing a dilemma for even the best intentioned fund manager. In the case of bankruptcy, the problems worsen as interests clash in the zero-sum game of allocating value to debt and equity. By creating and managing multiple funds, managers invite exposure to the crossways pull of competing interests.
While debt and equity funds provide a dramatic example of tensions arising from management of multiple funds, complementary activities create similar types of issues. Criteria that determine which fund receives a particular transaction, carefully delineated in the fund offering documents, frequently fail to address subsequent realities, creating messy allocation issues for fund managers. Perhaps even more important, the fund manager faces the daily problem of deciding which particular activity will receive the manager’s time and attention. Because multiple funds contain different sets of investors with different interests, in choosing which activities to pursue the fund manager decides which set of investors to serve.
Fund manager investment outside of investment pools deserves careful scrutiny. Investment principals must avoid doing private deals for their own account, even if the transactions seem too small, too funky, or otherwise inappropriate for the institutional fund. Investors deserve the complete dedication of fund manager investment efforts. Undiluted focus of all professional energies on the management of a single investment pool forms an important starting point in serving investment client needs.
KKR’s Deal Structure Flaws
Poorly structured private investment deals often produce dramatically misaligned interests. The well known buyout firm, Kohlberg, Kravis, & Roberts (KKR), negotiated partnership terms in its 1993 fund that enriched the principals regardless of the results for the limited partners. Like managers of most private equity funds, KKR received a carried interest of 20 percent of the partnership’s profits. Unlike most funds, KKR did not aggregate investments when calculating the profits interest. That is, KKR collected 20 percent of the profits on successful deals, with no offset for losses incurred in failed transactions, creating an incentive to roll the dice. KKR owned a share of the profits of big wins, but suffered none of the pain of big losses. In essence, the deal structure encouraged the firm to take enormous risk by creating option-like payoffs for the general partners through use of extreme financial or operating leverage.
KKR’s agreement with the limited partners called for a management fee of 1.5 percent of assets, typical of leveraged buyout partnerships. Such management fees, designed to cover the cost of running a buyout fund’s business, became a profit center for KKR because of the enormous size of funds under supervision. Not satisfied with excessive management fees, KKR collected deal fees for consummating transactions, monitoring fees for managing positions and investment banking fees for subsequent capital market transactions. The overly generous management fees, deal fees, monitoring fees, and investment banking fees drive a wedge between the interests of the general partners (more is better) and the limited partners (less is more). Contrast this with the terms of Warren Buffett’s original partnership, in which he charged no management fee, believing that he should only profit if his co-investors profited!46
KKR’s August 1995 purchase of Bruno’s illustrates the misaligned interests. The $1.2 billion transaction, which included an equity investment of $250 million, involved the acquisition of a chain of supermarkets headquartered in Mississippi. KKR charged an acquisition fee of $15 million, which exceeded the general partners’ investment by a significant margin. Pro-rated management fees, charged on committed capital, amounted to $3.75 million on an annual basis. The monitoring fee consumed an additional $1 million annually. Moreover, in 1997 KKR charged Bruno’s investment banking fees of $800,000. In exchange for financing the purchase and paying tens of millions of dollars of fees, in February 1998, the limited partners lost their entire investment when Bruno’s declared bankruptcy, filing for Chapter XI.
Properly structured deals cause general partners and limited partners to share in both profits and losses. If a managing agent shares only in profits, incentives to take risk abound. Management fee income that covers only overhead forces investors to perform before receiving extraordinary profits. Fees above the basic overhead level represent an undeserved transfer from limited partners to general partners. The combination of high levels of fee income and option-like payoff structure allowed KKR to profit unreasonably on the Bruno’s deal, while the firm’s investors wrote off the transaction.
Some aspects of the unusually egregious fee structure employed by KKR disappeared in 1996, when the firm raised a then-market-leading $5.7 billion fund. Pressured by substantial institutional investors, the buyout firm agreed to aggregate the results of all deals in the fund, offsetting deficits from losers before taking profits on winners. While KKR’s investors expect to benefit from the pooling of transaction results, the firm continues to benefit from extraordinary levels of fee income, ensuring general partner success regardless of limited partner investment results.
KKR’s fee income in 2006 illustrates the role of fees in the stunning transfer of wealth from limited partners to general partners. According to the July 3, 2007 preliminary S-1 filed with the SEC to facilitate KKR’s proposed IPO, in 2006 the firm received $67 million in monitoring fees and $273 million in transaction fees. Harvard Business School Professor Josh Lerner estimates that fund management fees in 2006 amounted to approximately $350 million.47 KKR’s senior professionals, who reportedly numbered twenty-five, collected an estimated $690 million in fees simply for showing up, turning on the lights, and going about their day-to-day business.
In spite of KKR’s 1996 removal of the deal-by-deal incentive compensation clause, investors generally exercise little influence over deal terms, as investment managers hew to an industry standard scale that provides higher levels of income at lower risk than would a fair compensation structure. Consider an environment where managers receive base fees to cover reasonable overhead and earn a portion of excess returns to provide incentive. Since a majority of market participants fail to beat a fair risk-adjusted benchmark, most fund managers would face a substantial decline in income under a fair deal structure.
Because profits interests begin to accrue after return of capital, private managers collect incentive compensation after investors receive a zero rate of return. If private managers received a profits interest in gains only above a risk-adjusted benchmark, based on historical results the overwhelming number of managers would fail to earn incentive compensation. Because the investment management industry receives compensation far in excess of levels justified by the degree of value created, investors encounter enormous resistance to institution of reasonable deal structures.
Unfortunately, when altering the terms of the trade, investors face the challenge of making industry-wide changes, since manager-by-manager change introduces the potential for instability. If a single private equity manager promoted a fair deal structure, compensation for that firm’s principals would fall far short of industry standards. Personnel at the firm could cross the street, work for a private fund operating under the unfair profit sharing regime, thereby increasing personal income dramatically. The innovative private fund, offering a fair deal, retains only those principals without other alternatives.
Investors find terms of trade in the private equity arena moving away from fairness. Fees on multibillion-dollar buyout funds generate tens of millions of dollars per annum, far in excess of amounts necessary to fund reasonable levels of partnership operating expenses. Buyout fund profits interests take 20 percent of returns created by the stock market’s upward bias, not to mention 20 percent of returns produced by highly leveraged capital structures. After adjusting for fees, profits interests, and the risk, no excess return remains for the overwhelming number of capital providers.
Venture capital investors fare little better. In the past, the venture community fell into a neat three-tier structure with Kleiner Perkins atop the hierarchy earning a 30 percent profits interest, a handful of superb firms receiving a 25 percent carry, and the rest of the industry taking home 20 percent of gains. The late 1990s Internet mania turned many solid venture capitalists into bull market geniuses, causing them to demand an increase in compensation from 20 percent of profits to 25 percent or even 30 percent. While a few making the move deserve inclusion in the elite ranks of the industry, most simply say “it’s the market” or “we need to do it for competitive reasons.” Such top-of-the-market increases in compensation persisted through the subsequent period of weak venture returns, creating a pattern of one-way ratcheting of deal terms against investor interests.
A recent study by two Wharton School academics, Andrew Metrick and Ayako Yasuda, produced some startling results regarding the relationship between fee income and profits interests. The authors examined detailed records of 238 funds raised between 1992 and 2006. Based on their modeling of the partnership characteristics, “about 60 percent of expected revenue comes from fixed-revenue components which are not sensitive to performance.”48 The conclusion that the majority of general partner compensation takes the form of fee income calls in question the basic private equity partnership structure.
Michael Jensen, professor emeritus at the Harvard Business School, expressed concerns about private equity compensation schemes in a September 2007 interview with the New York Times’s Gretchen Morgenson. Jensen, “the man whom many consider to be the intellectual father of private equity,” “deplores the newfangled fees that private equity firms are levying on their clients.” Jensen said, “I can predict without a shred of doubt that these fees are going to end up reducing the productivity of the model. And it creates another wedge between the outsiders and insiders, which is very, very serious. People are doing this out of some short-run focus on increasing revenues, and not paying attention to what the strengths of the model are.”49 Investors in private equity fare best with smaller, more entrepreneurial fund managers that benefit less from fees and more from profit participation.
Negotiating Change
While long established practices limit the ability of investors to negotiate fair deal terms, in the early 1990s the real estate industry presented an opportunity for radical restructuring. After recklessly throwing staggering amounts of capital into real estate in the 1980s, institutions withdrew almost completely from the market after the turn-of-the-decade collapse in prices. Those few investors interested in committing funds faced a host of unattractive investment management alternatives.
Large fee-driven advisors dominated institutional real estate activity in the 1980s. Firms such as AEW, Copley, Heitman, JMB, LaSalle, RREEF, and TCW amassed billions of dollars in assets, driven by the steady stream of acquisition fees, management fees, and disposition fees. Not surprisingly, the real estate advisory community adopted a laser-like focus on initiating, maintaining and enhancing flows of fee income, often neglecting even to consider the notion of generating investment returns for clients.
JMB’s Fee Bonanza
Headquartered in Chicago and named for Robert Judelson, Judd Malkin, and Neil Bluhm, JMB typified the fee orientation of the 1980s advisory crowd. Not content to collect flows of income based on the fair value of client assets, the firm went to extraordinary lengths to collect its fees even as portfolio assets withered in the 1990s real estate collapse.
Exhibiting nearly unbelievable greed, JMB retained underwater positions simply to collect fees from clients. In July 1986, the firm acquired Argyle Village Square, a retail property in Jacksonville, Florida, for $22 million as part of a portfolio of properties held in a commingled fund, Endowment and Foundation Realty—JMB II. Encumbered by a mortgage of $12.4 million, the property generated fees for JMB of 1.25 percent on the gross value of the asset, equivalent to nearly 2.3 percent on the original equity investment.
By 1992, Argyle Village Square declined in value to the extent that the property’s mortgage exceeded its market price. The anchor tenant, discount department store Zayre’s, vacated its space, dramatically impairing the property’s future prospects. Instead of turning the shopping center over to the lender, JMB held the asset on its books at zero equity value, continuing to collect fees from investors based on the gross value of the property. With a cash return of 1.1 percent (after debt service and before fees), Argyle Village Square’s fee of 1.25 percent exceeded the property’s income. To add injury to insult, JMB used investor cash flow from other assets to make up the difference, ensuring the continued flow of the full level of fees to the firm. In spite of repeated requests from investors to dispose of Argyle Village and stop the diversion of portfolio cash flow to pay fees, JMB retained the shopping center and piggily fed at the trough of investor assets.
In the “largest real estate acquisition ever,” JMB’s 1987 purchase of Cadillac Fairview, a collection of Canadian retailing properties, generated a fee bonanza for the firm on a stupendous scale.50 Continuing its practice of assessing fees on the gross value of transactions, JMB’s initial fee amounted to one percent of the C$6.8 billion deal, representing a load of 3.4 percent on original equity contributions of approximately C$2.0 billion. JMB included in the gross transaction value a portfolio of assets worth approximately C$560 million already under contract for sale, causing the firm to “earn” C$5.6 million for acquiring and immediately selling assets with absolutely no potential to benefit investors.
JMB’s “feeing” frenzy continued with annual asset management fees of 0.5 percent per year on gross fair market value (equivalent to 1.7 percent of initial equity), participation fees of 1.75 percent per year on cash flow and capital proceeds, and disposition fees of 1.0 percent on gross proceeds (with a parenthetical reminder in the Offering Memorandum that gross proceeds “includes indebtedness,” in case the investor forgot).
In addition to initial fees, annual fees, participation fees, and disposition fees, JMB retained the right to provide property management, leasing, insurance brokerage, and other services with compensation negotiated on an “arms-length” basis. Not satisfied with the staggering array of fee-generating opportunities, JMB contracted to receive incentive fees of 15 percent of profits after providing a 9 percent simple annual return to investors.
Unfortunately for JMB and its co-investors in Cadillac Fairview, in the tough environment of the early 1990s, the overpriced, overleveraged buyout suffered. Notwithstanding an additional 1992 equity contribution of C$700 million, by 1994 interests representing the C$2.7 billion of equity contributed by investors traded at 20 cents to 25 cents on the dollar. As pension investors from California, Massachusetts, Illinois, and Iowa watched the relentless decline in asset value, JMB continued to collect its management fees.
Responding to outrage over the real estate advisor’s insulation from the failure of the Canadian mega-deal, JMB voluntarily reduced its annual fee from $30 million to $25 million, while noting that the fee compensated the firm for advising Cadillac Fairview, not the investors! Judd Malkin highlighted the lack of coincidence of interest with his investors, observing that “[i]f I cut my fees by one-half, it still doesn’t change their return.”51
Succumbing to the inevitable consequence of too much debt and too little cash flow, in December 1994, Cadillac Fairview filed for protection from creditors in Canadian bankruptcy court. In spite of the failure of the company and massive losses by its investors, JMB aggressively sought to retain the gravy train, suing Cadillac Fairview for C$225 million, of which C$180 million represented the future stream of fees for advising the company on its Canadian properties. JMB settled the fee claim for C$22.5 million in 1995.
In spite of the massive failure of Cadillac Fairview and JMB’s outrageous treatment of investors, Neil Bluhm raised another institutional fund, Walton Street Capital, in 1997. The original fund paved the way for a series of funds, which as of 2007 boasted $3.5 billion of aggregate equity commitments. Bluhm’s asset-gathering ability and fee-charging acumen created a net worth sufficient to merit a rank of 215 on the 2006 Forbes’ list of the 400 wealthiest Americans.52
While JMB may represent the worst of the fee-driven excesses, in the 1980s all major real estate advisors focused on collecting fees, not generating investment returns. Institutions hoping to exploit real estate opportunities in the early 1990s faced a collection of discredited advisors operating with fundamentally flawed deal structures. Fortunately, an almost total withdrawal of capital from the real estate market provided substantial negotiating leverage to investors willing to commit funds to the cash-starved asset class.
The capital drought of the early 1990s placed investors and real estate fund managers on equal footing, allowing negotiation of fair deal terms. Providers of funds negotiated management fees sufficient to cover overhead, but insufficient to create a profit center. Investors obtained a hard hurdle, forcing managers to provide a fair return before earning a profits interest. In cases where real estate managers enjoyed a substantial net worth, general partner commitments to funds amounted to tens of millions of dollars, often exceeding the contributions made by many of the limited partners. When managers exhibited more modest means, recourse loans from the partnership provided funds for the manager’s co-investment.
The dearth of capital in the early 1990s created an unusual opportunity for investors to alter the compensation arrangements for real estate investing. Moving from the dysfunctional fee-driven agency structure of the 1980s to a well-aligned investment-return-oriented principal structure in the 1990s promoted the interests of investors and fund managers alike.
While the return of capital to real estate investing in the late 1990s eroded some of the deal structure gains, many managers chose to continue employing principal-oriented structures even when presented with rich fee-driven opportunities. Aside from purely economic considerations, the loyalty engendered by previous successful pursuit of mutually rewarding investment activities contributed materially to the decision to continue working with the existing structure. The dislocations in the real estate markets contributed to long lasting changes in institutional deal terms.
CONCLUSION
Market efficiency creates substantial hurdles for investors pursuing active management strategies, causing most to fail even to match results of market benchmarks. Although trying to beat the market proves tough and costly, fiduciaries frequently accept active manager claims at face value, attribute investment success to skill (not luck), and fail to adjust results for risk. In the face of active management obstacles, market players respond to the thrills and excitement generated by playing a game with scores tallied in the millions, and even billions, explaining the nearly universal pursuit of active strategies by institutional investors.
Thoughtful investors approach active management opportunities with great skepticism, starting with the presumption that managers exhibit no skill. Historical performance numbers deserve careful scrutiny, with astute observers mindful of the part good fortune plays in successful track records. Odds of winning the active management game increase when committing funds to managers possessing an “edge” likely to produce superior performance in extremely competitive markets.
Selecting the right people to manage assets poses the single biggest challenge to fiduciaries, since integrity, intelligence, and energy influence portfolio outcomes in the most fundamental manner. The actions of external managers contribute not only to investment performance, but also to the reputation and public perception of the institution itself, forcing fiduciaries to embrace extremely high standards in manager selection.
Appropriate organizational structure plays a part in successful execution of investment programs by ensuring sufficient alignment of interest between the institutional fund and the external advisor. Independent investment advisors with carefully structured economic incentives stand the greatest chance of producing high risk-adjusted returns, as appropriate incentives cause managers to place institutional goals ahead of personal agendas. While thoughtful deal terms and sensible organizational attributes contribute to the likelihood of success, even the most carefully constructed arrangements fail when implemented by the wrong people.
Entrepreneurial firms provide the greatest likelihood of dealing successfully with ever changing market dynamics, ultimately increasing the chances of delivering superior investment returns. Unfortunately, successful firms contain the seeds of their own destruction, as size inhibits performance and age saps energy. Vigilant fiduciaries stand ready to cull the old and tired, while identifying the new and energetic.
Deal structure plays a critical role in shaping the behavior of investment managers and determining the fairness of investment gain and loss allocations. By encouraging asset managers to behave as principals, appropriate deal terms cause investors to seek investment gains and de-emphasize return-reducing streams of fee income.
Typical compensation arrangements cause asset manager income to depend on factors beyond the investment advisor’s control. As bull market gains inflate marketable security portfolios and increase private fund assets, managers benefit through enhanced management fees and profits interests. Bear market losses impose costs unrelated to manager actions. In the case of both marketable and private deal structures, investment advisors’ compensation waxes and wanes with the market’s fortunes, resulting in earnings streams not directly tied to the level of value created.
By operating under asset-based compensation arrangements that fail to consider value-added measures, investment managers lose focus on return generation, emphasizing instead a stay-in-business strategy designed to protect streams of fee income. Partly as a consequence of poor deal structure, standard compensation arrangements allocate investment gains and losses unfairly, frequently enriching the investment manager while generating substandard risk-adjusted returns to providers of funds.
Appropriate deal terms serve to encourage fund managers to behave as principals, causing them to pursue gains while avoiding losses. Structural characteristics that play an important role in aligning investment manager and investor interests include the nature of the investment vehicle, level of fees, form of incentive compensation, and size of manager co-investment. By seeking investment arrangements that motivate managers to pursue high levels of risk-adjusted portfolio gains, investors encourage a focus on generating satisfactory investment results.
Investors hoping to beat the odds by playing the game of active management face daunting obstacles ranging from the efficiency in pricing of most marketable securities to the burden of extraordinary fees in most alternative asset investment vehicles. Only by identifying extremely high quality people operating in an appropriately structured organization do active investors create an opportunity to add value to the investment process. Painstaking identification, careful structuring, and patient implementation of investment management relationships provide essential underpinnings to an active management program.