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Why does business structure matter?
Clients will often comment that it is obvious that our fund research should focus on the Investment Team, the Investment Approach and Past Investment Actions. However, they will, at times question the fourth pillar of our approach: the Business and Shareholding. Surely a very good investment team with a solid process and a good through-the-cycle track record would be an excellent fund to invest in regardless of the business structure?
But we feel strongly that we cannot ignore the business side. For example, one of the thought experiments we have is to ask ourselves: “will this fund likely be managed by the same people, using the same approach in 10 years time?” Increasingly we find that when the answer is “no”, there are likely business and shareholder reasons behind it. And this makes sense to us: fund managers do not like change and change is often brought about by the business.
Below we explore a few themes that we believe to be important when evaluating this pillar:
1. Shareholder and Management Intent
There is no perfect theoretical shareholding structure for an investment business. For example, it seems to be a commonly held belief that being listed is bad, being privately owned is good. And that employee ownership is good and outside ownership is bad. But, we can think of good listed asset managers and poor employee owned ones. What matters, in our experience, is the intent of the shareholder (and management who execute on their behalf).
What we look for is a shareholder and management who deeply understand active asset management and who aim to enable it, not disable it. An empowering leadership would promote investment autonomy and remove distractions, like client interactions and new product launches. They would avoid the trappings of short term earnings, seeing long term performance as the engine of business growth. They would ensure incentives are aligned with the long-term and that investors eat their own cooking, by reinvesting their excess earnings into their funds.
Therefore, what matters is not structure, but whether the owners and management build an environment for active management to thrive. And this requires significant intent on their part: to place the short term business decisions behind those of long term investment performance. Consequences of doing the opposite can be severe: in our experience, one of four things happen (none of which are positive) when businesses apply short term pressure to investment teams:
- The best individuals resign and the team breaks up
- The team walks out and joins another business
- The manager or team try to change their philosophy or process to lift performance
- The pressure on the team result in a lack of focus and opportunities are missed
Asset management is probably the only very high margin manufacturing business in the world. Besides being well paid for investment performance, investment people also want to share in the success of the business that they help build and the allocation of shares to investment teams is a key consideration for many businesses. The challenge is to ensure that the fund manager is encouraged, via incentives, to deliver on long term performance, not short term profits.
We aim to understand how each individual is remunerated, whether the level and structure of that remuneration makes sense and most importantly, whether the incentive motivates the individual to deliver good investment outcomes for the investor. A key question we try to answer is whether the incentives support sound, long term investment decision making.
3. Investing alongside the investors
There are many ways to incentivise investment managers – performance based fees, annual bonuses, share schemes etc. But perhaps the most relevant to alignment of interests is how meaningful their own investment is in the fund they manage. Surely if the fund manager’s wealth is impacted by how his fund performs, he is more likely to have a stewardship mindset, believe in it more and do a better job? In our experience, the extent of the co-investment is often exaggerated and businesses tend not to divulge the extent of the co-investment (which should be a big red flag). In addition, individuals are often not required to invest in their own fund – they may select any of the companies’ funds. Needless to say, we look for those investors who eat their own cooking.
4. Product Mix
We often look for signs of asset gathering inside an investment business. Do they launch new products when a unit trust sector is in vogue? Do they increase the workload on star managers, to maximise the commercial success from that individual? In our opinion, investment teams that are able to focus on a single investment philosophy, a core investment process and manage a narrow range of funds tend to do a better job through the cycle. It generally doesn’t work where a business identifies a star manager or a star team, and then adds additional funds or launches new funds under that manager. Besides the reduction in focus, the manager becomes a portfolio administrator, rather than an investor and both chip away at his/her edge.
Business imperatives deeply impact how funds are managed and we think this pillar represents a critical part of our process. Business decisions can disempower investors – with poor incentive schemes, stretching them with product launches and by making changes to their environment. A healthy investment business understands that embracing active management may be at odds with short term profit generation and that fighting this short term profit urge requires sigificant intent. Good investment businesses often need to say no, more often than they say yes and, in the end, long term returns to their clients is what will drive their own profitability.