Following on from last week’s Expert Investor Series #2 (part 1):
This brings me to the third and arguably the most important feature of a great fund manager – and that’s alignment.
3. Alignment between Manager and Investor
Alignment refers to the extent to which the incentives generated by a proposed business model direct a fund manager (acting in its self-interest) to act in the best interests of the investors. And this is precisely why alignment is so precious: because it dynamically generates the right incentives for the manager without the need for endless rules, prohibitions and bureaucracy.
Here’s the thing: if you have smart, driven people investing your money and they are not properly aligned to you – then trouble is heading your way, it’s just a matter of time.
In fact, it’s hard to tell which is the more dangerous: a dumb, lazy manager or a smart, driven manager who is focused on the wrong things.
Choose your poison.
In my experience, great fund managers don’t need to be coerced or cajoled into committing to a highly aligned model – they willingly adopt a highly aligned model because they understand that, in the long term, alignment is in the best interests of their own business. This is because, all other things being equal, alignment promotes better decision making which in turn leads to long term out performance.
This is why you should be highly suspicious of a fund manager who proposes a base fee that is expressed as a percentage of Funds Under Management (FUM) or Assets Under Management (AUM). A business model such as this, by its very construction, motivates the fund manager to grow FUM or AUM – or, as I call it, “empire building”. This is the last thing that the investor wants the manager to be focused on, because it distracts from the main game which is and always must be “to maximise risk adjusted returns”.
You should also be very wary of base fees that are expressed as a percentage of invested capital. These models are sometimes favoured by investors because they link the quantum of fees with the amount of capital deployed and so they don’t give rise to temporary aberrations in the Management Expense Ratio (i.e. ratio of management fees to invested capital). But this temporary virtue is in fact a Faustian bargain because this model also gives rise to powerful incentives for the fund manager to acquire assets too quickly, hold on to assets too long and ultimately rush the disposal process to meet the fund’s closure date. These are very dangerous biases to create for a fund manager and actively work to undermine long term returns.
In a similar vein, you should be very wary of fund managers that propose a base fee that is not explicitly linked to the resources and costs dedicated to performing the investment mandate. When costs and fees are de-linked, it is almost always because the fund manager doesn’t want the investors to realise that the base fee involves a large profit margin. So what’s wrong with a highly profitable base fee? Well the last thing you want as an investor is for your fund manager to be getting “fat and happy” (rich and lazy) for the sheer privilege of managing your money. You want your fund manager to make enough to recruit and retain talented staff and be able to turn the lights on but not so much that they become complacent about performance. And as sure as night follows day, if you over-compensate your manager through the base fee, you undermine the focus and energy that are so essential to long term out performance.
This brings me to the success fee. Most investors are happy to see a fund manager do well when they have generated a great risk adjusted return – and that’s an appropriate way to incentivise and reward a great manager. The key thing is to make sure that this success fee cannot be banked until it has been earned. And that means that success fees should ideally be paid on realisation (vs valuation) and on portfolio (vs asset by asset). There are of course exceptions (e.g. open ended funds or long term closed funds) but these need to be handled with great care if significant misalignment is to be avoided.
But even if you get it right on the base fee (a fixed dollar fee explicitly linked to resourcing and costs) and get it right on the success fee (payable on realisation and on portfolio), you are still very vulnerable to misalignment. This is because the fund manager still has a powerful temptation to migrate the investment mandate to an ever higher risk profile in the hope that a very large success fee may ultimately accrue. If the manager is essentially in a break even position on the base fee, then it’s natural to dial up the risk in a bid to earn higher returns and higher success fees.
To stop this downside misalignment from occurring, many investors rightly ask their managers to coinvest in the fund on a pari passu basis alongside the investors. Depending on the size of the fund manager, the coinvestment can be anywhere from 1% to 25% of the fund’s total commitment. And it has been the fashion in recent times to favour fund managers that have larger balance sheets capable of larger coinvestments – but does that necessarily achieve the desired alignment between the manager and the investor?
I would put it this way: would you rather give your life savings to a listed fund manager with a large balance sheet (funded by other large institutional investors) that coinvests $100 million alongside its investors, or to a specialist private fund manager with a more limited balance sheet (funded by its principals and staff) that coinvests $2.0 million alongside its investors and does so in a “first loss” position. Which model is more likely to generate the desired focus on downside risk protection? If the top 2-3 executives running a fund don’t have a significant proportion of their personal net wealth at risk in the event of under-performance, it will not make a jot of difference to the way key investment decisions are made. So if you are a risk averse investor (and almost all of us are) then you need to be less impressed by the size of the coinvestment and more focused on whether the key fund executives have “skin in the game” and are prepared to go first if poor investment decisions are made.
Great fund managers understand that alignment is at the crux of long term out performance. Get it wrong and it will not only burn you (the investor) – it will ultimately burn the fund manager and its staff.