We’re fresh out of BUC (“Backstop User Conference”) 2018, and we’re overflowing with insights, information, and big ideas. In case you went BUC-less in 2018, we’re summarizing the key takeaways from our industry luminary-stacked panels. Today, we’re starting with “Behind the Curtain: How Institutional Asset Owners Really Select Their Managers.” If you’re a manager that wants to take a deep-dive into how allocators pick their horses, you’ll want to take a look at these insights, straight from the mouths of renowned Funds of Funds and investment consultants (Horsley Bridge Partners, Alternative Investment Group, Protégé Partners, and Strategic Investment Group).
Nobody disqualifies a manager on fees alone.
In fact, our panelists recognized that if you squeeze new managers on the front-end, they can’t put the right infrastructure in place to make them successful and more “institutional” in their operations. Horsley Bridge even sometimes advises new managers to charge higher fees in their first couple years so they can build out their back office (of course, they’ll negotiate harder on the carry/performance in exchange). Another panelist chimed in, “I’m really skeptical of the zero management fee – because how’s that going to work in a down year?” All agreed that fees are just one piece of the overall picture.
Typical fees for new managers are…
When pressed for numbers, the panelists shared that they see 1% to 2.25% on management fees, with anything over 2% being unusual. As for carry or performance fees, they see 20% on the Private Equity side, with the Venture Capital side going up to 35%. They’re also seeing a lot of hurdles going from 30 to 35%, although all panelists mentioned that they push back on the “extreme carry” positions, because “few managers can command that.”
Culture is more important than you think.
“The culture side of any business is the primary thing we focus on.” Because asset owners are investing in visionary managers, it’s absolutely critical for them to get to know the people and the players across the firm. Frequently, the operational due diligence (ODD) team will not just want to meet with the manager, but with the individual team members who play a crucial role in each stage – the CFO, the COO, the Portfolio Manager, and the CCO. They will want to “follow the cash,” and that means actually hearing the people who do the work describe how they do what they do. “That builds confidence. That builds integrity, which is the foundation of the relationship between you and the manager. You want to see it at the top, but hear it at the bottom. If there is a great culture, that’s going to happen.” Of course, none of it matters if the performance isn’t there.
Speaking of performance, cross-correlations matter.
All of our panelists owned proprietary models and tools that helped them determine the strategies and “the right bets” they want to make in the coming year. So managers that are really “beta” managers are easily sussed out by these tools, as well as the managers who deviated from the strategies they espoused at the outset. While high-performing managers would not be completely eliminated by unfavorable cross-correlations, they might be weighted down or reduced to fit the asset owner’s overall portfolio strategy.
There are 4 pillars in ODD.
As Dan Federmann, a former CFO, COO, and head of ODD, explained: ODD has 4 main pillars.
- Independence: Is there a fund administrator that provides independently validated reporting? Are there internal systems that provide transparency in decision-making?
- Segregation of duties: Is a single person responsible for everything? For example, are investment decisions and marketing separated from accounting responsibilities?
- Existence: Do the underlying holdings actually exist?
- Valuation: Are the right marks being used to value the instruments?
It’s better to disclose upfront than to be found out later.
According to our panelists, disclosing conflicts of interest and other pertinent information is much better done upfront. If the information comes out later, it can seem disingenuous and erodes trust (for example, as long as the right controls are in place, it may be okay if two principals are married…as long as it’s disclosed upfront.)
It’s the little things that matter.
Our panelists shared some colorful “horror” stories during their session, all about how the “small” details can get a manager vetoed:
- “I found out one of the Portfolio Managers had let his CFA lapse. I’m about to give you $100 million, and you can’t pay the $12 to renew your license?”
- “The CIO and CCO were married and forgot to tell me. Then I found out the firm was 51% owned by her, but actually run by him. That doesn’t look right.”
- “The co-Portfolio Manager said he had a PhD, but didn’t actually. This led to 6 months of dead deal cost and two Investment Committee meetings, eventually resulting in a veto.”
- “Sometimes the subdocs are archaic. We went to a manager and asked, ‘What are you willing to do for us on the management fees?’ They said, ‘We’ll go down to 1.5%.’ Problem was, we were already supposed to be at 1.5%. We had to rip their head of IR a new one because they should have known that we’d hit our fee breaks. We, in turn, got ripped a new one by our client. We had to issue checks for overpayment. It was embarrassing all around.”
They’ll demand separately managed accounts for greater transparency and liquidity.
A couple of our panelists shared that managed accounts are a good way to get additional transparency, but all were fully aware that it doubles the operational burden on an investment manager. This was when the existence of internal systems mattered the most – to help the organization drive greater efficiency and accuracy within a culture of compliance.
Relationships are everything.
On the hedge fund side, our asset owners tracked managers through their investment teams anywhere from 6 months to a year before passing over to their ODD teams. After the ODD team takes over, it can take another 2-3 months to clear them. If they find outstanding items that need to be addressed, it can take another 6 months from that point to remediate the hurdles.
On the VC/PE side, it can take as short as 6 weeks, but if the finish line comes by and a deal isn’t reached in time, then the fund closes and another 5 years can go by before investment is open again, so often times asset owners are building multi-year relationships with managers they’ve never invested in. All this is to say, relationships are everything in this business, so cultivate them with care.
Stay tuned for more BIG IDEAS from BUC!
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