With an abundance of capital amid a scarcity of ‘easy’ deals, a limited partner’s choice of third-party manager often focuses on the manager’s so-called ‘key person’ provision and its track record. The attention devoted to the track record could be directed at a specific-sector, risk-return band, region or a unique combination of expertise.
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 key persons to ensure tenure of that alignment.
But when it comes to track record and key persons, some questions can get overlooked. Who has earned and owns the track record? Investment houses can replace weak teams, or lose good teams, over time, but are stuck with track records. Sometimes, too much credit is given to a key person who is really what I call a ‘firm message carrier.’ Other times, brilliant individuals with flawless records cannot transport them from their old firms when they start on their own.
This is therefore not black and white. Careful due diligence is required. Important questions 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?
“They can actually motivate managers to retain weak, or difficult, members in the team for longer”
Only when these questions have been properly addressed, should this be answered: who needs to be financially aligned with the required outcome and how?
At investment boutiques, big bets are mostly called by individuals at the top: brilliant risk takers, or avoiders, strong asset managers and/or the plain lucky. Take these individuals out and the boutique’s story changes.
In those situations, it has to be clear who the key persons are and definitely worth making sure they – and the partners they assign asset management – have solid records – and their interests are fully aligned. Alignment should be secured over the entire term of the investment period, both to the upside and downside, both financially and of the track record. Be careful of untimely individual wealth creation events. Be careful of ‘upside only’ alignment scenarios. Examples of these were seen following the global financial crisis where certain managers dumped investors for a lack of perceived remaining upside. They started under new names, starting new track records.
At larger managers 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. They are tested bottom-up with input from 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, I ask: 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.
Limited partners should look behind the scenes to better understand 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.
They 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.
If it is widely accepted well-managed, diverse teams outperform homogeneous rivals, isn’t the key person therefore not – in principle, at least – already an outdated concept?