Fee structures are also often topics for consideration or hot debate. Fees or total expense ratios are expected to be kept as low as possible but, more importantly, fee structures need to demonstrate alignment. They should reflect the added value delivered by the manager and be properly allocated to the key person(s) to ensure tenure of that alignment. So far nothing contentious, or is there?
When it comes to track record and Key Persons, some key questions are often overlooked. “Who has actually earned the track record and who owns it?” Investment houses can replace weak teams or lose good teams over time but are “stuck” with the track record. Sometimes, too much credit is given to a key person who is just a “firm message carrier”. In other cases, brilliant individual investors with flawless track records can’t transport their track record out of their old firm when they start on their own.
The answer is therefore not black and white and careful due diligence is required. Important considerations include: Who is trusted with and accountable for the capital allocation? Who determines the investment strategy? Who truly manages the risk/return profile and prevents excessive risk taking? And who drives the value-add?
Only when these questions have been properly addressed, should the second topic come into play: Who needs to be financially aligned with the required outcome and how?
Person, team or house?
In small investment boutiques, the big bets are mostly called by one or two individuals at the top of the tree, who are either brilliant risk takers or avoiders, strong asset managers and/or plain lucky (until, sometimes, their luck runs out). Take these individuals out of the room and the story changes.
In those situations, it has to be clear who the Key Person(s) is /are and definitely worth making sure they – and the partners they typically assign the asset management to – have a solid track record and their (financial) interests are fully aligned. Alignment should be secured over the entire term of the investment period, both to the upside and to the downside, both financially and of the track record. Be careful of untimely individual wealth creation events. Be careful of “upside only” alignment (examples galore in the GFC of “partners” dumping the investor, for lack of perceived remaining upside, and starting under new names, with track record untarnished).
In larger investment houses the story is often different. Investment strategies for each asset class and risk allocation are determined top-down by a senior investment strategy team, supported by research professionals, and are tested bottom-up with input from the senior market-facing sector specialists and local experts.
Implementation and execution of strategies is similarly done by a combination of experts. Local and sector teams source and together with the fund team, underwrite and manage asset-specific and local risk-weighted returns, all typically signed off and monitored by a multi-disciplined investment committee.
So, who is the Key Person here? Strategist, investment committee, deal sourcer, fund manager or sector specialist asset manager? Should the value-add compensation be solely focused on the one or two smart people representing the firm in a presentation? More and more limited partners allocate funds to the larger firms for exactly those benefits of the total infrastructure, long term accountability and alignment. Compensation structures for the teams should reflect this.
In summary, limited partners should try to get a good look behind the scenes to better understand corporate governance and strategic processes, to assess the firm’s and people’s long-term real track record and long-term alignment.
Inserting single Key Person clauses and focused compensation can often have the opposite effect to the one intended. These initiatives can actually motivate managers to retain weak or difficult members in the team for longer, for fear of reprisals from the limited partner, in whatever form. Ultimately, they risk discouraging wide-ranging perspectives and therefore diverse thinking within teams.
In closing, it is widely accepted these days that well-managed diverse teams outperform homogeneous rivals. This is about the benefit of diversity of thought into various processes. Isn’t the Key Person therefore not in principle already an outdated concept?