The Prudent Fiduciary Digest #48

The Prudent Fiduciary Digest

February 8, 2018

I'm pleased to announce that the next Advanced Due Diligence and Manager Selection Workshop will be held April 25-26 in Washington, DC. Check out the brochure; additional information is available on the workshop website. I hope that you can join us for an in-depth look at these important topics.

Many of the readings in this edition of the newsletter pick up on ideas explored at the workshop.

Behavioral learning

One of the themes of the workshop is that many of the principles for analyzing investment organizations are universal. While each asset class may require some specialized knowledge and each kind of asset owner may have unique needs, the most important concepts apply broadly across them.

Therefore, I stress that you continually need to "look both ways," at the asset manager that you are analyzing and at your own organization. Structure, process, culture, beliefs, whatever. The same questions need to be addressed.

I thought of that when reading "An analytics approach to debiasing asset-management decisions," a white paper from McKinsey & Company. There has been a great deal of attention paid to behavioral finance over the last twenty years – and it's easy to locate comprehensive summaries of all of the biases that plague our decision making – yet it's rare to find organizations that have actually tried to use the ideas to make better decisions.

Asset managers are easily stumped by fairly simple questions about their decision making patterns (and asset owners are too). McKinsey discusses some of the ways to address the shortcomings, from high tech analysis to some fairly simple methods to offset our natural tendencies in making decisions.

Any organization should want to avoid as many of the common pitfalls as possible. It's remarkable that so few of these ideas are used in practice.

Contract provisions

"The terms and conditions that asset managers and asset owners use can drive long-term or short-term behavior."

That quote leads off the "top ten list for long-term mandates" found in FCLT Global's paper, "Institutional Investment Mandates: Anchors for Long-term Performance." The list includes fees, benchmark, term, redemptions, capacity, performance report, disclosures, active ownership, evaluation, and integration.

Given the length of that list, you might think that the paper would be long and tedious. Instead, it's a tidy package with just a few sentences on each topic, so it serves as a great starting point to discuss the building blocks of your organization's contractual arrangements with its managers.

Just below, we'll discuss one item on the list. For another – benchmarks – a piece by Cambridge Associates, "Policy Benchmarking: A Guide to Best Practices," provides a nice starting point.

Fees

One of the hot-button issues for investment committees is (or should be) fees. What are you paying? Why? What are your beliefs about fees and how they relate to value received?

One school of thought is that all that matters is the bottom line performance, that if returns are better in one vehicle than others, why should you care what expenses you are paying? But that's making an assumption about the persistence of performance that probably isn't warranted, and it ignores the body of research that shows that fees matter. In general, paying more yields lower returns; the "you get what you pay for" argument doesn't hold up.

Therefore, you should be aware of all of the costs you are paying, wrote Preston McSwain in an article for Enterprising Investor. Finding out what they are can be especially difficult for alternative investments.

Across all asset classes, fees have been coming down, if not by leaps and bounds. Virtually everyone thinks those trends will continue, that asset owners have been getting the short end of the stick. "How did we end up in a world where investors bear the risks and managers reap the rewards?" asked Andrew Beer in a Financial Times op-ed. A posting by Tanuj Khosla for AllAboutAlpha is one example of material being produced about analyzing how much goes (or should go) to the owner of a pool of money versus its manager.

For background information on current fees, check out the survey data and commentary from Callan and bfinance. As I mentioned in the opening of this section, beliefs are important to state (and stick to); a couple of examples of such statements worth reviewing come from Cliffwater and the Alignment of Interests Association.

Private equity

Speaking of fees, let's talk about private equity. The headline of a Bloomberg Markets article gets to the bottom line: "Private Equity’s Biggest Backers Are Tired of the Fees." The stated fees are the highest for any asset class, even before counting other expenses charged by general partners to portfolio companies. Some asset owners have had enough (Chief Investment Officer).

But that's just one area of concern; there are a lot of questions up in the air. For historical perspective, the 2017 Bain annual report on private equity is a good starting point. (The 2018 edition should be coming out soon.)

Many of the trends in that report have continued unabated in the last year. Valuations have increased to record levels ("Acclimating to Thin Air" is the title of Murray Devine's latest valuations report), as has the amount of "dry powder" that's available, even as new competitors arrive and huge new funds continue to be raised. The atmosphere is euphoric and expectations for private equity returns remain high. Can those expectations be met?

Lurking are some old and some new issues. Returns have come down (Pensions & Investments) and the persistence of returns among the best managers, something taken for granted by most allocators, has declined too (top1000funds). Trying to decompose returns to identify skill is difficult; a recent piece of research offers a possible method to do so (FEV Analytics). The "internal rate of return" (IRR) measure most commonly used to measure performance is subject to manipulation; in the last few months there has been attention paid to the use of credit lines to boost IRRs (Howard Marks).

It seems to me that the most important issue remains that assessments of the "risk" of private equity are all over the map. Despite the fact that the stated volatility is low (because of infrequent reporting and the opportunity to smooth valuations), the asset class is made up of leveraged equity investments. An extended period of economic weakness will lead to results that are completely unexpected for many investors. The real test for the asset class will come when (or if) we ever get into that kind of environment.

Questions

Here are some questions you might ask at your next meeting:

~ Have we adopted any practices in response to behavioral finance findings to help our decision making? Have our managers?

~ Are our goals regarding agreements with asset managers clear? Are our relationships with them structured to be conducive to long-term performance and sustainable partnerships?

~ What are our beliefs about fees?

~ Does our private equity strategy make sense given the changes in the environment?