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| Best Practices: Bankers Agenda |
Performance Enhancers
Gayle B. Ronan
12/01/2005
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Noland recently shared his frustration over how
difficult it is to run a comparison of fee structures against performance net of
fees. He was conversing with fellow attendees at a conference sponsored by
Private Client Resources (PCR), an information services company in Wilton,
Conn., that helps clients compile all of their financial data in one place and
benchmark it against that of other ultra-affluent investors. “Some 75 heads
suddenly began nodding in agreement as I spoke,” he says.
TOP VIEW
Few advisors advertise that they will negotiate performance-based fees, but many
will do so. These compensation agreements have some important advantages over
simple flat fees and those based on a percentage of assets under management;
primarily, when properly structured, they can align the advisor’s and client’s
interests more optimally than other schemes. However, they are arduous to
negotiate, and private investors must ensure they choose the right benchmarks on
which to base their advisor’s compensation. |
One of those who
is in agreement is Chris Snyder, who became a cofounder of PCR because he
thought there should be a mechanism for pulling together investment information
and determining the value received for the fees paid. The firm is trying to
develop a database over the next year or so that will allow clients to compare
managers’ and advisors’ fees, with a goal of eventually linking fee arrangements
to performance.
Such improved clarity could also provide impetus for change
in the way fees are calculated. When investors can analyze their fees in the
context of performance, they may have more incentive for demanding
performance-based fees. Until it becomes crucial to attracting and retaining top
clients, a change in status quo, for the advisory community, makes poor business
sense.
However, that time may be nearing. “It seems clear that investors are
beginning to get frustrated—both private and institutional—with the level of
fees and the alignment of client/manager interests,” says David Blood, the
former CEO of Goldman Sachs Asset Management who in 2004 cofounded Generation
Investment Management, with offices in Washington, D.C., and London. Blood has
been in the unusual position of creating an investment firm from scratch at a
time of increased regulatory scrutiny and growing concern over conflicts of
interest and transparency within the industry. As such, he and his partners
considered their timing an opportunity to rethink traditional fee structures,
and have made performance-based fees their standard practice.
 However, from
the perspective of most investment firms, a performance-based fee structure
requires calculations that are so complex they would make the eyes of the
average client glaze over. Fees based on assets under management, on the other
hand, are both easy to calculate and to explain to investors: a predetermined
percentage, often scaled to offer discounts on larger balances, multiplied by
the client’s account balance as of a specific date. Such a fee structure is
often sold to clients with the assurances that “if you do well, we do well.” If
the company’s strategies work, the account balances of the clients will rise,
leading to increased fee income for the advisor. It appears to be a win-win
arrangement. However, while the AUM fee structure rewards an advisor for
increasing client assets, it does so regardless of whether or not those assets
increased because of outstanding performance on the part of the advisor. The
assets under management may grow simply because of client deposits, reinvestment
of investment income or even a rising market. It makes little difference whether
the advisor is tracking, exceeding or trailing that market.
| “...It isn’t exactly rocket science. It’s basic math. The incremental complexity is well worth it.” |
For advisors who
excel at gathering assets—that is, landing new business—it is a very winning
arrangement. It has been argued that the AUM fee structure can inadvertently
lead an advisor to focus more on marketing than on delivering the superior asset
management services clients contracted for in the first place.
This
potential for conflicts between client interests and those of the advisor
contributed to the SEC’s gradual loosening of previous restrictions regarding
the use of performance fees by registered advisors. In 1998, the agency even
removed contract terms and disclosure restrictions with the goal of enabling any
advisor of any size to introduce performance fee structures, as long as the
client has at least $750,000 under management with the advisor or a net worth of
at least $1.5 million—enough to ensure sufficient sophistication to enter into a
negotiated fee agreement.
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