The much discussed push by institutional investors to reduce their asset management costs, which has taken hold in earnest since the financial crisis, is now bringing a new question to the fore: will lower fees lead to lower-quality asset management services and to the insolvency of asset managers, some of whom will be forced to exit the business?
Institutional investors—endowments, pension funds, foundations—are demanding fee transparency in order to cut costs, but investment talent and customer service doesn’t come cheap, observed Charles Skorina, principal of an executive recruitment firm that specializes in placing CIOs. “How can these investors expect the same level of service and performance from their active managers by paying them less? Institutional investors don’t know how much managers are really charging them without transparency,” he said, adding: “Particularly in private equity, where there are many fees and sometimes insiders making money on a deal without disclosing their participation, transparency is the key to knowing where and how much of a cut in fees to ask for.”
“Don’t kill the golden goose,” pleaded a former CIO of a California public pension fund. He argued that lowering management fees may usher a diminution in manager performance based on the reduced capital they would have to reinvest in themselves and, for instance, for continued R&D of new investment strategies and solutions. “If a pension fund pays BlackRock $500 million, and gets returns of $2 billion, for example, that represents a healthy net return for the asset owner and also provides the asset manager with sufficient income to develop better investment solutions to the ultimate benefit of its clients—there’s enough excess there to reinvest in the business,” he argued.
The CIO of one Northeast foundation believes that whether lower fees inevitably result in lower-quality fund management comes down to how different pension funds choose to approach fee alignment.
Tom Tull, CIO of the $29 billion Employees Retirement System of Texas (ERS), said “Fee alignment pertains to the manager charging fees consistent with reality. When a manager is just starting up it makes sense to charge a higher fee to cover costs based on assets managed. But then when the firm is extremely successful, and its asset base is considerably larger, we would argue that there is room for lower fees, something akin to economies of scale,” he said.
Asset owners should be pushing for an alignment of interest [on fees] with fund managers and not just absolute fee levels, according to Vijoy Chattergy, the former chief investment officer of the $17 billion Honolulu-based Employees’ Retirement System of the State of Hawaii (HIERS). “Savvy asset owners will find better measures of how fees drag down performance, such as opportunity and impact costs of trading, in order to hold active managers more accountable,” he said. “In a world where it is understood how to differentiate between unskilled beta exposure, semi-skilled factor exposure, and actual skill-based ‘alpha,’ asset owners will parse managers’ performance to demand that active fees are justified by identifiable skill.”
Not all asset owners subscribe to the idea of applying relentless downward fee pressure on their managers, nor do they claim that the purportedly growing activity is substantial. The sheer volume of asset managers and consultants available to provide services to institutions is one factor why lowing of management fees has not been more significant. “We all have choices in the marketplace—if there’s any likelihood of us getting more value for our money, we’ll go elsewhere,” Tull said. “At this stage in the cycle, I’m seeing managers increasing fees, and deal terms are experiencing inflation—some people are chasing good managers and willing to pay higher fees, we are not.”
Management fees vary by asset class, Tull noted. “Right now, alternatives are seeing deal inflation—this is usually the point where allocators will pass if they can’t find a good manager and fill the spot internally or pass for another day,” he added. “Today in private equity, we are seeing roughly 1.3% to 1.4% management fees and anywhere from 13.5% to 16.5% profit sharing [as opposed to the typical 2% and 20% rule].”
Plan sponsors like Texas ERS can manage money internally at 11 basis points, whereas it would cost at least 40 basis points for an external manager, Tull continued. “Firms reducing management fees are midsize and smaller, not so much the monster firms because they don’t need to,” he noted. Occasionally, on private equity deals that do not have enough capital, managers will approach funds to join in on the investment through co-investments where the fund will not be charged management fees on the money that it adds to the capital stack, Tull said. “Though this method reduces overall fees, the fund must already have a team in place to analyze the co-investment within a week or two, and most public funds cannot do that,” he said.
Don’t kill the golden goose.
Fee compression not new
Concerns over high fees is a topic that goes back in human history to maybe ancient Sumeria or the Silk Road and is not new with our generation, Chattergy mused. “While there is a lot of effort devoted to fee compression ideas for hedge funds and private equity GPs today, investors have always pushed for and received relief, as seen with the change in broker commission quotes to pennies in the 1970s,” he said, adding, “It’s a long game to embrace these changes, but ultimately asset owners have the advantage, if they come to recognize their ability to establish a more fair playing field.”
Scrutiny of investment fees is not new, agreed Dan Cummings, a senior vice president at recruitment firm EFL Associates. “As board members change, that scrutiny can intensify or subside. A few years ago, placement fees were all the news. Now, with the markets performing as they have, there is a renewed emphasis on investment fees and a demand for higher transparency of private asset fees.”
Passive versus Active Management
For active management fees to be justified, an institutional investor needs to be confident in a manager’s ability to produce a return in excess of the relevant benchmark over the long-term, said Vincent Francom, director of public markets at Verus Investments. Performance-based fees can be an attractive option for some investors because it aligns the manager’s compensation with their results and provides evidence that a manager has confidence in their own abilities to generate excess return, he said. “One caveat of performance-based fees is that the manager gets paid based on outperforming the benchmark, whether the manager’s absolute return is positive or negative,” he said. “I understand why plans may choose to go the in-house investment management route, but it may not make sense for all asset classes; for instance, in the case of private equity, it would be difficult and expensive to source the investment talent to run it internally.”
One caveat of performance-based fees is that the manager gets paid based on outperforming the benchmark, whether the manager’s absolute return is positive or negative.
When fees don’t square with promised returns
Two institutions that are on record as being eager to achieve lower fees are the Employees Retirement System of Rhode Island (see related IA story here) and the Pennsylvania Public School Employees’ Retirement System (PSERS).
When Seth Magaziner took office in 2014 as General Treasurer of Rhode Island, overseeing $8.3 billion of the state’s pension fund assets, he mandated that all fund managers allow the institution to publish fees on its website. This gives the plan sponsor more bargaining power to get better deals on expenses, according to Magaziner. Since 2015, CalPERS, CalSTRS and the New York City pension funds adopted similar policies. Rhode Island hasn’t lost a single manager over the policy since launching it in 2015.
In mid-August, PSERS, a $54.8 billion fund, passed a resolution to reduce the fees it pays to external money managers over a three-year period, as a response to an agenda advanced by Pennsylvania State Treasurer Joseph Torsella last year. The fund and its consultants, Aon Hewitt, Aksia and Hamilton Lane, have targeted $2.49 billion reduction in fees over the next 30 years. PSERS, Aon, Aksia and Hamilton Lane did not respond to requests for comment by press time.
EFL’s Cummings performed a CIO search for Torsella, who selected current PSERS CIO James Grossman. “Treasurer Torsella has taken a very close look at manager fees and, given the performance of the markets, is an advocate for more passive asset management,” he said. “Such an approach has done quite well for a number of investors.”