Generally, investors are classified into one of two categories. Those who use external management to invest their money are considered allocators. Whereas, those who use internal personnel to invest directly into securities or other assets are labeled investors.
This article will explore that concept a little differently. It will focus only on those that use external managers. It will classify as allocators only those who do not spend the time necessary in their due diligence on the manager to address alignment of interests related to fees and legal terms.
Those who make this a part of due diligence will be acknowledged as investors.
A critical part of due diligence
Is aligning interests important enough to spend a significant amount of time on it in due diligence? The answer is an unequivocal yes!
All too often, the limited partner assumes that the general partner will act in its best interest and fails to conduct a thorough look at the legal documents or the fee structure.
Every limited partner wants to pay less in fees, but some don’t consider the fee structure an important vehicle for directing the behaviour of the general partner. Those same allocators also don’t realise that the general partner wants maximum flexibility in the use of the limited partner’s money, with as little risk as possible.
With attorneys being paid handsomely today, they feel an obligation to get the most for their client. The general partner’s attorneys’ typical strategy is to put everything into a legal document (for example, a lasting power of attorney) that favours their client and let the opposing counsel, representing investors, sift through the excruciating detail to find what needs to be eliminated or discussed.
The value of scrutinising fee arrangements
Let’s look at some examples as they relate to fees and legal terms that can have an impact upon the outcome of the performance of a fund. Note that these examples represent just a handful of the many factors to be considered when performing due diligence; this article is not designed to be comprehensive.
There is growing discussion around fees in the industry, not just around disclosure but calculation as well. This is increasing in importance as fees become a much larger percentage of returns in a lower-return environment. Choosing an appropriate structure is essential.
The 1 per cent/30 per cent model is one of many alternative fee arrangements being seriously studied and is designed to help the limited partner receive a much fairer net return in a low-return environment.
If there are high returns, a 1 per cent/30 per cent calculation provides the manager additional revenue above a traditional 2 per cent/20 per cent model when it becomes more affordable to the limited partner.
There are also flat-fee arrangements with managers, which assure the investor that the management fee won’t increase at market rates of return, while also assuring the manager of a certain dollar amount to cover its business costs if returns are negative.
Further, many investors are negotiating hurdles in this low-return environment. Also, fees should be paid for alpha and not beta. That requires a well-structured benchmark so fees are paid only on the excess return over the benchmark. In such arrangements, investors must also consider what to do if the manager doesn’t meet the return expectations.
Obviously, high-water marks have been around for a long time and were designed to keep the limited partner from paying excessive fees on poor performance over the years. But what about compounding the benchmark as it relates to carry to better match the compounding of the investor’s liabilities? Limited partners who are just allocators probably don’t think about the importance of matching the compounding for both assets and liabilities.
Remember, managers are charging high fees with promises of great returns to the limited partner. Shouldn’t there be an understanding of the needs of the limited partner to meet its liabilities (such as accruing pension liabilities and payouts)?
Make no assumptions about legal terms
Limited partners should take a second look at their negotiation of legal terms with the general partner as well. There are many examples of legal terms to which limited partners that want to be investors must pay attention.
One chief investment officer of a municipal plan was shocked to find out that the settlement payment for a US Securities and Exchange Commission violation by the manager of one of the plan’s funds was charged to the manager’s fund.
The municipal plan’s attorneys had properly negotiated that the expenses for the litigation the manager incurred could not be charged to the fund in the indemnification provision of the agreement, but had failed to consider the judgement or settlement costs.
Another extremely important legal issue is that of fiduciary duty.
The concepts of duty of care and duty of loyalty are both bundled into the fiduciary context. These duties assure good behaviour on the part of the manager. However, clever attorneys representing general partners have been eliminating the statutory fiduciary duty protections for limited partners and replacing them with contractual provisions that favour the manager.
Without those protections, the limited partner has limited recourse of action.
All too often, allocators ignore the importance of fiduciary language, thinking the manager is naturally a fiduciary by law. The fiduciary duty language is only one example of the need to perform legal due diligence.
In summary, a good investor must be knowledgeable of the fee structure and legal terms in the fund documents. A good investor realises that the ultimate decision rests with the business partners and not the attorneys.
By working with experienced attorneys, however, an investor can become aware of the pitfalls for limited partners in the fund documents.
Good investors will press the general partner for fair treatment, not fearing harming the relationship. They understand the importance of their fiduciary responsibility and expect the same from the manager.
Bruce Cundick is the chief investment officer of the Utah Retirement Systems.
