Erik Carleton, director of pension investments at Rhode Island-based Textron, estimates asset managers send him a couple of email pitches every hour. They are straws cast to the wind, rarely taking root in the $10 billion investment portfolio for the aerospace and defence group’s retirees. Only the odd one attracts his attention.
The bulk of Textron’s assets under management are invested in line items, where the pension fund adopts a manager’s strategy because it likes it and neither has, nor wants, any influence over how it is run. But an important 5 per cent of the portfolio is invested in bespoke strategies designed with managers to give Textron particular access to the capital markets and latitude to be more creative. Often with neither history nor tangible track record, these strategies require seed funding. Industry giants like BlackRock and State Street rarely approach small asset owners with niche ideas that need developing or invitations to seed new products that will only ever harvest a couple of billion in assets under management, observes Carleton’s boss, Textron CIO Charles Van Vleet. So when one of those straws cast his way combines a good idea with a chance for Textron’s input, Carleton sees an opportunity to shape the structure, cut fees and gain first-mover advantage.
It happened when New Jersey-based Palisade Capital Management’s managing director Jim Marrone approached his long-standing associate Van Vleet with a convertible bond strategy.
“Charles and I knew each other in previous roles and had kept in touch over the years. We have always had a mutual respect for each other’s approach to solving pension fund-related problems,” Marrone recalls.
It made for an informal first pitch of the strategy back in 2013 when Marrone, on a chance visit to Providence to see his son, caught up with Charles for a chat.
The strategy seeks to generate asymmetric returns via liquid, low-beta, low-volatility exposures. It is built around an initial portfolio of 40 to 60 carefully selected US short-duration convertible bonds with three-year maturity or put dates, within a select price range or entry point. It is benchmarked to US high yield but isn’t meant to trade exactly like high yield, as it seeks better upside and downside capture characteristics – when high yield is up, the strategy is up more, and when high yield is down, it is down less. Capital deployment is immediate, and the short duration has advantages in the rising rate environment. It also offers good diversification, using performance drivers that are different from equities, fixed income or real assets.
Van Vleet was quick to see the strategy had a chance of helping Textron meet its 7.5 per cent return hurdle.
The partnership gathered momentum when Carleton joined Textron in 2014 and took the baton for developing the strategy. He had already come across Palisade researching US small- and mid-cap equity strategies, and more niche convertible bonds, and was immediately impressed by the idea.
“It made sense that a shop with expertise in US mid-cap equities and convertible bonds could understand the capital stack,” he says.
Carleton’s enthusiasm for the strategy wasn’t constrained by any limitations within Textron. For example, the pension fund is free to invest with managers with a small AUM (Palisade has $3.8 billion in AUM) and doesn’t have to invest only in tried-and-tested strategies like many institutional investors in the public sector. Nor does Textron work with consultants, another potential constraint when it comes to novel ideas.
“Consulting plays an important role in this industry but tends to have a more complicated path to the intersection of willingness and ability to take risk with new investment dollars,” Carleton says.
Structure
The parties decided on a separate account mandate held at Textron’s custodian that gave trading authority to Palisade. Textron’s initial $30 million seed allocation, since grown to about $100 million, was large enough for a separate account and Textron liked the due diligence around this structure. Carleton explains: “There is an added level of comfort when you are able to seed fund a strategy in a separate account held in trust at the custodian. Plan assets remain explicitly and transparently within our control, even though we turn the keys over to our new partner for trades and execution.”
The separate account model helped with fee negotiation, allowing more latitude for a bespoke fee structure via an Investment Management Agreement (IMA) as opposed to standardised off-the shelf documents. Textron didn’t write anything specific into the contract regarding exit gates or capacity limits.
As Palisade repeatedly analysed the appropriate price ranges and duration to maturity, Textron set about getting comfortable with a product that had no history or tangible track record. The pension fund began to run its own numbers, back-testing selected assets in the short-duration convertible universe. It spent time building a relationship with Palisade and the people who worked there and carried out in-depth due diligence on the manager’s track record in equity and convertible strategies.
Faith becomes trust
That relationship was put to the test. Two days before Palisade’s final pitch to Textron’s investment team and treasurer, Palisade cancelled the meeting. Reviewing the numbers and back-testing, Marrone found an error in how the team was valuing the securities. He had no choice but to call and postpone the meeting.
“I asked for a pass and admitted that we were not ready to present a complete watertight analysis,” he recalls. “I said we needed to work on the strategy for at least another month until we got it right.”
Frustrating at the time, it proved a crucial moment in solidifying Textron’s faith in Palisade’s integrity, deepening the relationship for the long term.
“If we had found that error on our own before we launched, it would have been bad but we could have talked it through,” Carleton says. “If we’d found it after we launched, it would have been much tougher to forgive and that type of misfire can break an otherwise exciting partnership. Faith can sometimes become trust after a challenge, but it’s much cleaner to deal with that before real money is at stake.”
Fees
Although Palisade runs two other similar strategies, because this approach was new, the manager was prepared to discount fees to “a certain level”. Moreover, because Palisade wanted to offer the strategy to other investors seeking the same upside/downside characteristics, it was prepared to drop Textron’s fee when assets under management grew to a certain level. Today, AUM in the strategy stand at five clients with $200 million under management and Palisade has duly cut its fees for Textron.
“About a year into the strategy, I was able to make the call and say, ‘Your fees are coming down,’ ” Marrone says. But fee negotiation is a quid pro quo, and Palisade’s dropping of the fee was balanced by Textron’s awareness that the manager also needed to make some money.
“The Textron team clearly demonstrated that they understood how important client partnerships are to investment boutiques such as ours,” Marrone says. “This resulted in healthy, candid dialogue regarding many topics during the formation of the strategy, including expected returns, asset allocations, risk tolerances and, of course, the fact that we also wanted to make a good return on our own investment in this product.”
There is no sharing of future growth revenues in the model and Textron never pursued if, and how, this model would fit within its corporate plan.
“We are comfortable with what we did agree on,” Carleton says. “We got a material discount to the market for an innovative product.”
Helping build
A key component of the relationship has been Textron acting as a reference for prospective Palisade clients. It’s in Textron’s interests to help market the strategy successfully – and not just for the lower fee due to more AUM. The pension fund got burnt when it seed-funded a new strategy for a small asset manager that accounted for half the firm’s total assets under management. The investment performed “spectacularly badly” from the get-go and it grew progressively difficult to market the fund to potential investors. The manager also stopped paying much attention to the failing product. Yet Textron was reluctant to pull its assets, lest it cripple the manager altogether.
“Not all these things are successful. Like venture-capital investing, some are and some are not,” Van Vleet says.
Drawing more investors to the strategy also involves a trade-off between capacity and performance, something Textron trusts Palisade will get right. The manager is well versed in running capacity-constrained strategies through its experience in overseeing its small-cap equity blueprints for institutional clients.
“The key purpose in managing capacity is to preserve the ability of the strategy to generate the agreed-upon return objectives,” Marrone says. “We take into consideration trading volumes and liquidity when managing our short-duration converts capacity, just like we do in other strategies.”
Brown M&M’s
“Jim Marrone and Palisade Capital passed the Van Halen brown M&M test,” Van Vleet concludes, referencing the legendary detail the rock group used to write into its contracts with tour operators. In a test to check they had read the contract, the band stipulated no brown M&M’s in the bowl of multicoloured sweets backstage. Any brown M&M’s and they knew the operator hadn’t read the contract and a serious line check of the stage setup ensued.
“Jim built a relationship with Textron by demonstrating time and time again that he had done his homework and had studied and knew the Textron team, plan and fund design,” Van Vleet says. Cue the seeds of success: a lengthy process built not on speculative emails but around people and relationships.
And the brown M&M rule.
