Friday, 23 November 2007

Who is fighting your corner?

For marketing purposes I thought I'd try and give this post a better title than my original idea - 'Principals and agents in investment management' - but the original one is what I'm really going to cover. This is something I've been thinking about quite a bit lately and I was prompted to write about it after a financial journo mate of mine recently sent me a really interesting report. It is from Watson Wyatt's investment consulting practice and is entitled "Sales, stewardship and agency issues - Improving the alignment of principals and agents".

The report begins by explaining agency problems - broadly the point that the service providers (agents) that we (principals) appoint don't always act in our best interests. It goes on to question why pension funds have apparently put so little pressure on fund managers to shift away from fees which are a % of assets under management to those based on performance. It points out that the former financially incentivise the fund manager to win more business, rather than actually generate a return (although returns obviously also grow the assets) and mean that they can pick up money for simply rising with the market.

It argues that one reason for this might be found in the relative bargaining power of principal and agent (and bear this in mind for later on):

"The game theory branch of economics can shed some light on the situation. Game theory is essentially the study of bargaining processes – when there is a cake to divide, do people get their fair share, or do some walk away with more than they should? Simplistically it comes down to relative power, or ‘threat power’, with the implication being that the investment agent holds more power than the principal (having gone through a process to find the very best manager, why threaten a fledgling relationship with hard fee negotiations, especially when the prospective
outperformance makes the process look like penny-pinching)."

What is more, Watsons point out, pension funds don't employ only one group of agents. In addition to fund managers they hire consultants, custodians, legal advisers, performance measurers and so on. And some of these agents have their own agents - fund managers employ brokers for example. Finally they argue that we can even see trustees as agents - of the beneficiaries primarily.

With this is mind the report argues that trustees need to focus their attention on the agents that are least 'client-centred'. They provide the results of a survey of fund managers who were asked to rank agents in order of client-centredness. The results, in descending order, were - investment consultants, fund managers, fund of funds, hedge funds, investment banks. Two points - first, you wonder whether fund managers feel compelled to rate consultants most highly because of their 'gatekeeper' role. Second it's worth pointing out that even consultants didn't do that well. Fund managers were asked to score each group on a scale of 1 to 10 with 1 being highest for client-centredness. Consultants managed about 4.

Funnily enough they see a negative correlation between high margins and client-centredness:

"From observation, we would contend that there is a relationship between client-centredness and the profitability of the agent (with high client-centredness associated with lower margins). There is, therefore, a gravitational pull away from high client-centredness towards higher margins."

It's the next bit that is important. Watsons argues that one way that trustees can overcome the principal-agent problem is through mandate design. They argue, rightly in my view, that traditional mandates don't deal with 'ownership issues':

"The ownership of large quoted companies has become increasingly fragmented. Arguably, it is this that has allowed the ‘egregious’ compensation packages of senior executives, the non-accounting for stock options and other examples of questionable corporate behaviour. Essentially the managers of traditional mandates, whether active or passive, have not exercised sufficient control over the corporate agents (and the fiduciaries have not exercised sufficient control over the investment managers)."

But they go on to suggest that private equity might be part of the answer:

"An alternative mandate design is private equity which restores some of the link between ownership and control. Here, company management are incentivised by ownership stakes and the private equity manager (the ‘general partner’ (GP)) exerts
considerable effort to retain as much control as possible. The principals (limited partners (LPs)) should benefit accordingly."

This is one area where I think Watsons actually get it a bit wrong. If you follow the logic they develop in the paper, and take account of what actually happens in the real world, I think you can only come to the conclusion that pension funds are actually more disenfranchised when they invest in private equity.

I base this assertion primarily on the attitudes of people from the PE industry themselves. In discussions with a number of them I have found they are frequently very dismissive of potential and actual limited partners (LPs). These days it would be unthinkable for a mainstream fund manager to be so openly critical of clients, but general partners (GPs) in PE firms can get away with it. There is no doubt on their part about who has the bargaining power. For example, in an admirably straight explanation of PE of an asset class, industry insider Guy Fraser-Sampson makes the following point about an individual LP's position:

"[T]he LP’s only sanction when faced with what may be deemed an unacceptable situation is not to invest, but invest elsewhere. The fund, if it is a quality fund, will be potentially oversubscribed almost immediately. It therefore matters not one jot to the GP whether the LP invests or not; if that particular LP does not proceed, there are others who will… [A]s long as there are new investors waiting to crowd into a fund if existing ones fail to take up their offered entitlement, then GPS will be able to call the shots… [N]ot only is the situation not going to improve, but if anything it is going to get even worse given the large amounts of extra capital which will be seeking a home in the asset class in future."

(From Private Equity As An Asset Class.)

Isn't this exactly the situation that Watsons describe in the first excerpt?

However the PE point aside in conclusion Watsons do suggest that trustees could consider other types of mandate such as long-termist ones, activist ones and so on. They also suggest trustees monitor the potential principal-agent conflicts.

Finally they also suggest collaborative to increase pension funds' leverage with agents. Here I wholeheartedly agree, and indeed in the shareholder engagement world it is already a standard approach on some issues such as climate change. But surely there is much more scope that is yet to be properly explored. Not least relationships private equity firms, and I'll finish with another extract from Guy Fraser-Sampson's book:

"Perhaps surprisingly, there is little attempt made by LPs to get together and negotiate terms collectively, nor to agree ‘industry standard’ terms amongst themselves and say they will only invest on this basis, although common sense would appear to commend both these courses of action."

If the PE industry is openly wondering why we don't work collectively, surely it is time to give it a try?

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