This essay was originally published by the CFA Institute for their Enterprising Investors website.
In the Often-Alternative World of Alternative Investing
We “properly” don’t consider “performance-based compensation” to be a “cost of [investment] management” and “incentive payments are not included . . . [as] an expense.”
Representatives of large endowment investment offices made these statements, according to Charles Skorina, a leading chief investment officer (CIO) headhunter (he is paid to know who is good and who is not and tracks this closely).
And yes, you read that correctly.
Apparently, these leading investors don’t view incentive fees as costs, even though they are dollars paid to investment managers and can reduce returns by 20% over a set hurdle rate.
Also, keep in mind that this doesn’t mention expenses, which in the limited partnership (LP) investment world, generally aren’t considered costs when calculating net-of-fee performance.
As an example, we commonly see language like the following in LP investment reports and fund offering documents:
“Performance is net of management fees, but does not include incentive fees and are gross of the fund’s expenses, which generally include overhead and administrative expenses, including filing fees, legal expenses, tax preparation expenses, administrator’s fees and the fees associated with an annual audit. In addition, performance figures do not take into account expenses relating to due diligence, research, investment related travel expenses, and fees associated with external manager background checks incurred by the fund.”
Even though I couldn’t help going “whew” after literally cutting and pasting this from a presentation I recently received, nothing is legally wrong here.
This is totally compliant: All is disclosed properly for experienced, “sophisticated,” and “accredited” investors.
The problem, however, is that even after spending over 25 years in this industry at senior levels — in a past life I was a managing director at a few large investment banks — I still find myself learning.
Unfortunately, I’m not alone.
In 2015, the Commonfund Institute, an organization viewed as one of the best sources of endowment investment returns and practices, published a paper titled, “Understanding the Cost of Investment Management.”
After receiving data from approximately 700 top endowments — Ivy League colleges and other leading institutions included — the authors stated that:
“. . . unlike other factors that affect investment returns . . . costs are almost certainly the least well understood.”
They then went on to say:
“. . . the fact that almost 15 percent of [survey] participants did not provide cost data at all suggests that they may not have known what their costs were or were uncertain about them.”
Related to all of the above, the below chart and quote from the Skorina report are illuminating:
“ . . . only 18 percent [of respondents] included incentive and performance fees paid to asset managers, despite the fact that nearly 85 percent . . . reported having asset allocations to alternative investment strategies.”
Considered to Be Investment Costs*
* Percentages represent how many endowments said they consider the above items to be costs of investment management.
Source: Chart data and general format derived from the October 2015 Commonfund Institute report, “Understanding the Cost of Investment Management.”
I’m also wondering how 23% of endowments over $1 billion, and 14% of all the respondents didn’t even view asset management and mutual fund expenses as costs.
Finally, call me an unsophisticated investor, but I just don’t understand the following statement from an Ivy League investment office quoted by Skorina:
“Consistent with prior reporting and conventional accounting . . . performance-based compensation [is not] a cost of [investment] management.”
The last time I checked, all fees, expenses, or compensation paid to a consultant, investment manager, etc., are costs.
I’m not sure who else thinks this way, but when academic reports written by educators from Harvard Business School find that “private equity funds . . . charge average fees of 6% per year,” it seems like all investors — institutions of higher learning included — should spend a little more time educating themselves on how much they actually pay for investment management.
By the way, in my book, this doesn’t all fall back on investors. As I recently wrote, I think the investment industry can do a significantly better job of providing “simple plain language disclosures” of all costs.
Until this changes, however, Caveat “Sophisticated” Investor.
What is my recommendation to all CIOs, trustees, and UHNW family offices that have fiduciary responsibility?
Some private equity and other alternative LP funds are worth it after all costs (please don’t forget taxes for individuals and trusts), but beware.
When true cash-in-your-pocket net returns turn out to be much less than expected or modeled — remember, IRRs can also be misleading — ignorance is no excuse if you don’t understand that expenses and fees are costs that reduced your returns.