Access to investment smarts and better fee alignment are just some of the benefits institutional investors can gain through their mandates with funds managers, says Craig Baker, global head of manager research with Towers Watson.
Funds managers can do more for their pension fund clients than run investment strategies. “The more that [pension funds] can have a relationship with managers – that’s wider than a product provider – the better,” Baker says. “This can lead to asset allocation advice and co-investments.”
Backed by its large institutional client base, Towers Watson can demand privileged transparency into managers’ operations. “We want to see – and get to see – the portfolio on and ongoing basis,” Baker says.
For example, the consultant accesses the deal histories of private equity managers and the drivers of return in each transaction, be they leverage, operational improvement or the particular skill of a private equity firm member.
“Clients can get that access, but the key issue is that it’s only the large clients with internal teams that can make use of that information,” Baker says.
And as funds gain scale, they should carve off some of their external funds management spend to invest their own operations. Towers Watson has advocated this strategy in recent years, partially in response to the doubling of the volume of fees paid to managers from 2002-07, an increase largely attributable to increased alternative assets exposures. In addition, “we think too much is being paid away to brokers, so we’re advocates of longer-term mandates,” Baker says.
The type of resourcing that funds seek will vary according to their needs, but in general, most should concentrate on building strong teams of investment experts that can work on portfolio construction and improve alignment on fee deals.
“For very large funds there is no debate that they should be building internal resources, pushing managers on fees, smart beta and [in alternatives] going direct rather than through fund-of-funds.”
Baker says the consultant has claimed some success in its efforts to ensure better fee alignment between clients and managers. In alternatives, the starting point in many negotiations is to reject the notion that the notorious two-and-20 fee structure should apply universally.
“The problem has been the fee structure on what everybody else has charged in that space. It doesn’t make sense in alternatives because two hedge funds or private equity funds are so different.”
In its negotiations, Towers Watson has made more headway with hedge fund managers, whose open-ended vehicles make it easier to change fee rules, whereas private equity fee structures are cemented when funds are closed for years at a time.
This has resulted in lower base fees – or base fees that are cut down over time – and better aligned performance hurdles, such as calculating performance fees over longer time periods. These structures have applied to traditional equity and bond manages as well as alternatives funds.
“We’ve been doing quite a lot of work on showing what proportion of prospective alpha that [managers] produce is being paid in fees,” Baker says.
“Sometimes it doesn’t make sense for managers to be taking a higher proportion of alpha than clients, who supply them with the capital.”