curbing the costs of pension fund investment management - curbing the cost of public... · possible...

Presenters:

Curbing the Costs of Pension Fund Investment Management

• Moderator, Steve Delaney, Orange County Employees Retirement System, CA

• Girard Miller, Orange County Employees Retirement System, CA

• Brett Johnson, Pantheon Ventures• Stefan Whitwell, Empirical Solutions

Girard MillerCIO

Orange County CA (OCERS)

And a recent success story about collaborative procurement

Investment Management Fees:A burgeoning drag on returns Despite widespread indexing in traditional categories, larger public plans have migrated to more “alternatives”

Management fees in this world are much higher

The “2 and 20” paradigm

Where OCERS ($90M) fees reside ‐‐with a few in‐state comparisons Unlike smaller plans, some mid‐sized plans have a greatly disproportionate share of costs lodged in “alternatives”

Asset Category

Percentage of OCERS Fund

Percentage of 2012 Fees

Index 29% 2.3%

Active Traditional

41% 24%

Alternatives 30% 73%

Contrasts:

For San Bern County,alternatives are61 % of portfolio and 81% of total fees

For LA W&P, alternativesare only 12 % of fundand 27% of fees

Fees for alternatives are almost always a higher percentage of fund costs than their share of AUM

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Bargaining power Public pension funds invest trillions of dollars

The jumbo mega‐funds command marquee pricing

At the middle and smaller end of our market, public plans are price‐takers with limited pricing power

“Market” tends to be fragmented, heterogeneous and individualistic

Money managers have learned to play the MFN game in their favor

The P4SM concept Public Pension Portfolio Procurement network

Began as a white paper at OCERS Incorporated into OCERS fee policy April 2013

Discussion item for California CALAPRS CIO workshop

Informal network for now; could be formalized if we gain traction and momentum Hence, the Service Mark designation as a public claim of intellectual property

by OCERS for the time being

Possible solutions – simplest first P‐share pricing for fund vehicles (hedge funds, P/E, etc.)

Public pension funds would receive lower fees IF our aggregate investments exceed certain thresholds

Separate share classes Graduated pricing, based on aggregate public funds investments

Fee tiers based on individual account size For example: hedge fund or private equity manager

P‐1A, P‐2A and P‐3A share classes for investments of $25, $50 and $100 million IF total public pension investments > $250M

And P‐1B, P‐2B and P‐3B share classes at lower fees for $25, $50 and $100 million IF total public plan investments > $500M

Possible solutions Investment pooling could be “joint powers pools” in states with

significant decentralization and assets (e.g., CA, PA, FL, MI, IL, TX), or across state lines Not a super‐fund, but rather mini‐pools for each manager’s discrete

strategy May require “fund accounting” for separate interests

Could also be as simple as opening a new commingled account with P‐share pricing set up by a given manager

“Piggybacking” with larger public plans as host

Investment “bundling” through collaborative RFPs OCERS‐CALAPRS example with private equity fund of funds Common RFP, joint selection committee, individual board approvals

Retains independence and “sovereignty” of municipal pension plans but improves bargaining power

Herding cats

“Best practices” fee policies to be adopted by governance boards

Mini‐pool example OCERS selected an emerging markets equity manager

City of London (company name, not the municipality) Unique strategy to invest institutionally in closed‐end funds at a discount

A play on discount valuations in an out‐of‐favor asset class

Manager has established a Delaware trust for a commingled pool

Fees will decrease for public plans to invest in this pool

OCERS fee policy Genesis was internal disagreements among trustees

Alignment of interests vs. low flat fees Ambiguity in strategy Desire to “send a message” to investment industry Authority for CIO to proceed with collaborative procurement

General, principles‐based guidance, not specific rules Encourages but does not require performance‐based fees Emphasis on “paying for alpha, not paying for beta”

Elevates the fee discussion while providing context Explains when fees should be important in decision‐making, and when

they are not Advocates industry‐wide P share classes for public pension funds Encourages pro‐active fee strategies from investment consultants Provides considerable flexibility to staff Requires accountability and reporting

OCERS – GFOA fee resolution Developed by OCERS, adopted formally February 2014

Model resolution published by GFOA in Government Finance Review 1Q2014 (not official GFOA policy fyi)

Advocates P‐shares

Advocates hard hurdles (pay for alpha, not beta)

Encourages other pension plans to adopt similar resolution

Pooling and bundling:Issues and challenges Legal concerns: anti‐trust or unfair business practices

What is definition of “market power”? Where might it be problematic to include the very largest public plans?

Is the process anti‐competitive or pro‐competitive? Do the buyers re‐market the product? How exclusive vs open‐ended is the process and structure?

Complexity and coordination “Herding cats” Everybody wants local control of portfolio design Preferences for bundling and platforms vs a superfund Role of consultants

National issues and opportunities Is a “grander vision” feasible, or self‐defeating?

What would be “too big” and arguably anti‐competitive? How can professional/pension associations make a difference?

Best practices Fee policies or guidance on fee management and oversight Alignment of interests Anti‐abuse (e.g., GPs/Advisors loading costs on LPs/fund) Performance fee structures Procurement guidance

Advocacy of P share classes (lowest‐hanging fruit on the policy tree) Advocacy of hard hurdles in many asset classes (pay for alpha, not beta)

Model RFP provisions Nationwide portfolio holdings and fee database

How could GFOA best work cooperatively with other pension associations?

California plan CIOs Completed an unprecedented bundled RFP for private equity First job was to identify common investment mandates and portfolio allocations Where do we have overlapping managers? What disciplines would be most fruitful?

E.g., private equity arose as a common opportunity for plans <$30B Second job was how to conceptualize structure(s)

Initially, very California‐centric, but we “saw the light” on national opportunity and the winner will offer their program nationally

Funds vs platforms JPA vs informal networks or “piggybacking”

Ultimately, we secured legal opinion through PE RFP process

Selection Process for PE FoF Semi‐finals used Best in Class analysis

Compelling performance, portfolio management, track record, investment process

Compelling platform (flexibility of choice) Compelling fees and fee management Best Value

Other screening criteria Winner Take All vs Split the Baby discussion Superior expected return net of fees Consultant input from NEPC and PFM Advisors

Articles of Interest GFOA Government Finance Review, February 2014

“Managing Against Escalating Pension Investment Fees” by Girard Miller

Alt Assets Magazine, 1Q14: “California’s pension plans eye ‘game changer’ for PE”

Articles in Governing and peHub

We expect additional, extensive media coverage and interviews focused on the actual results, given the game‐changing results and dramatic cost savings

Finals Participation by CIOs from California, Wyoming and Missouri

Also used Best in Class criteria 3 finalists; winner take all for endorsement

Winner will pay cost of anti‐trust legal opinion Conducted interviews near the annual CALAPRS conference March 4

Winner: Pantheon

By Unanimous Decisionof P4

SMNetwork Review Panel

Note: The announced selection by the P4 network CIOs was not an official OCERS actionThe OCERS board approval followed the CIO recommendation, unanimously.

Decisive factors in CIOs’ selection Pantheon’s strong performance track record & strategies Access to scarce GPs: seats on 270 advisory committees Flexibility of entire platform

Ability to offer “model portfolios” and even “training wheels” for smaller and first‐time funds

Complete customization flexibility for larger and more sophisticated plans and professionals

Ability to use Pantheon as a “completeness portfolio” Fee discounts for larger accounts, lower fees as P4 assets grow, loyalty discounts for repeat investors. No carry.

Fees on invested capital only. All inclusive, no hidden fees.

Morgan Lewis legal opinion Required by the RFP, underwritten by winning PE FoF bidder Pantheon

Public record, copy available through OCERS Specific to fact set of this bundled procurement General findings:

Well within the “safety zone” of 35 percent of relevant market share

Process was pro‐competitive Pension funds are not re‐sellers “Bundled” bidding is open‐ended, not exclusive Would not result in monopsonistic reduction of aggregate demand

What next? Pantheon will begin marketing their program

Early September deadline for loyalty fee discounts California CIOs met at SACRS conference last week Nationally, options could include:

Informal network National database Formal “purchasing cooperative” Endorsement approach for qualifying P‐share and performance fee structures

More information from OCERS

[email protected]

714.558.6223

For OCERS web site, to see our Fee Policy, the PE FoF RFP and more, go to the Investments section of:

http://www.ocers.org

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Pantheon P4: A private equity innovation for public plansPresenter: Brett JohnsonMay 19, 2014, GFOA Annual Conference

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Joined 2005, 14 years of private equity experience

Brett Johnson, Partner

Brett focuses on evaluating and monitoring North American primary investment opportunities and is a member of the USRegional Investment Committee. Prior to joining Pantheon, he was a Director at The Regents of the University of California,where he was responsible for evaluating and executing private equity investments. Previously, Brett was a vice president atOne Equity Partners and an assistant vice president in an asset based finance unit of Bank One Corp. Brett received a BAin economics from Northwestern University and an MBA from the University of Chicago Graduate School of Business, wherehe graduated with Honors. Brett is based in San Francisco.

[email protected]

Presenting to you today

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Investing in private markets assets for over 30 years

1 Pantheon International Participations PLC 2 As at 1st April 20143 As at 30th September 2013

Signatory of PRI Endorser of ILPA PrivateEquity Principles

European SecondariesHouse of the Year

Winner of IAIR Awards ‘Excellence and Performance

of Asian Fund of Private Equity Funds’ 2013

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As at 1st April 2014 1 As at 30th September 2013

> TEAM: 28

> PE EXPERIENCE: 261 years

> LANGUAGES: 9

> TEAM: 33


> LANGUAGES: 16

> TEAM: 8


> LANGUAGES: 5

1982

Chris MeadsChief Investment Officer and Head of Asian Primaries

Helen SteersHead of European Primaries

Susan Long McAndrewsHead of U.S. Primaries

Dennis McCraryHead of Co-Investment

Elly LivingstoneHead of Global Secondaries

20071987 1992

USA Europe Asia

27 yearsNine US funds

US$15.3bn AUM1

32 yearsSeven European funds

US$8.7bn AUM1

22 yearsSix Asian fundsUS$3.3bn AUM1

Global capabilities

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The Pantheon P4 Platform

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Introduction to Pantheon P4

Pantheon Public Pension Plans Platform

Open to U.S. and Canadian Public Pension Plans

Unprecedented access for smaller-sized plans to Pantheon’s

primary, secondaries and co-investment programs1

1 Allocations to Pantheon’s global secondaries and global co-investment strategies are by agreement with individual Pantheon P4 investors.

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The Pantheon P4 advantage

Portfolio Management

Access

Core Flexibility

Value

Performance

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STRATEGIC

Express strategic view over long term

Target top tier managers

Target broad geographic and stage allocations

Backward vintage diversification

Ability to price assets

Avoid first few years managers’ fees

Minimal or no manager fees

Target specific geography or industry

Control investment pace

Portfolio tailored in line with client’s objectives

Primaries Secondaries Co-investment

OPPORTUNISTIC

Comprehensive and integrated platform

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Research drives our portfolio construction & performance

Dedicated quantitative research team

Provides additional dimension to our market studies and investment research

Over 8,000 GPs in Pantheon’s proprietary database1

Over 2,200 GPs institutional and investable quality GPs screened and 178 commitments made2

Over 270 fund Advisory Board seats

Global screening capability

Exhaustive diligence

Three-tiers of internal review and recommendation

92% GP decline rate2

ACCESS TO QUALITY GPs

DISCIPLINEDINVESTMENT

COMPREHENSIVERESEARCH

Each of these plays a significant role in portfolio construction 1 Source: Pantheon, Pantheon has data on more than 8,000 GPs in its proprietary database as at 31st January 20142 Source: Pantheon; Funds reviewed by Pantheon from 2007-2012

Important ingredients for private equity portfolio management

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Allocations to Global Secondaries and Global Co-Investments are by agreement. The core programs exclude any allocation to venture capital. Pantheon offers a separate complementary dedicated global venture strategy. Allocations to Global Secondaries and Global Co-Investments are by agreement. The ranges are indicative and serve as a target only. Pantheon will always retain flexibility to adapt allocations as required by market developments.

Investor A Investor B Investor C Investor D

Pantheon P4

Core Global

Small / Mid-Market

Buyouts45-55%

Special Situations10-20%

Growth Equity5-15%

Large Buyouts15-25%

Mega Buyouts0-10%

US50-60%

Europe20-30%

Asia/RoW

15-25%

Pre-defined core Global and US strategies

Mega Buyouts0-10%

Large Buyouts20%

Small / Mid-Market Buyouts

25-35%Growth Equity

5-15%

Venture Capital5-15%

Special Situations20-30%

US

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Core US/Europe + Asia primaries

• Asia ex-Japan• 15-20 managers• No venture capital• No first-time managers

Investor A Investor B Investor C Investor D

Pantheon P4

Sector Focus• Energy-focused

strategy• Global

U.S Buyouts• Specified allocations

to large and mid-sizedmanagers

• Mega managers excluded• Three-year commitment

period

European Primaries• Northern Europe only• Minimum five-year track

record• Allocation to venture

capital

These examples are for illustration purposes only to show the ways in which investors may customize their primary commitments to Pantheon P4. They are not strategies recommended by Pantheon.

Pantheon welcomes customized mandates

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Customized P4 strategy defined with Pantheon

Confirm roadmap meets investor’s requirements; move to execution and

monitoring

Detailed parameters and constraints agreed

Validate strategy against Pantheon’s macroeconomic

and thematic investment views

Build investment roadmap for the customized P4

investor

What can an investor do?

Customize at manager level

Change course midstream on primaries

Terminate primary commitment periods

Access customization at strategy, portfolio and client levels

Individualize a portfolio – no single investor portfolio has to look the same as another

Overview of building Customized Solutions

What can an investor do?

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Track-record of superior performance

Average outperformance: 6.0%Average Net IRR: 14.5%

Set forth below is Pantheon’s pro forma global primary performance, based upon the primary private equity investments of Pantheon’s different regional fund vehicles and separate account clients. Please note that this is hypothetical performance and no Pantheon fund or client has achieved the results in this hypothetical composite.

Data as at 30th September 2013The measures for a pro forma Pantheon Fund performance include the primary investment results of different regional fund vehicles and separate account clients, as described below. So as to represent theperiod of time over which a Pantheon primary fund of funds may commit its capital, Pantheon has created nominal pools of capital, representing three-year time periods, each pool comprising the primaryinvestments made during such period measured by date of first draw down and weighted in line with the Pantheon Global Select 2014 strategic allocations. In compiling the underlying investment results,within regional and fund stage allocations, where possible, all underlying investments are weighted equally by vintage year and represent all primary fund commitments made by PEURO 91 pro forma,PEURO 94 pro forma, PEURO I–VII, PUSA I–IX, PUSA SFP IX, PASIA I–VI, PEAF VI, PEMF (Ex-Asia) and Emerging Market Investments made by Pantheon on behalf of separate account clients from1992–2012. The pro forma results presented herein do not represent actual historical results achieved by any client, but instead reflects illustrative results. Pro forma results, such as those depicted above,have inherent limitations which are described more fully in “Limitations of Investment Performance Data and Pro Forma Data” in Section XV “Risk Factors” in the PPM and as such should not be relied on asan indication of what actual performance would have been for the time period shown or may be in the future.Net IRR. Net IRR is the annualized internal rate of return (“IRR”) as calculated for each of the pro forma pools described above based upon pro forma net monthly cash flows and pro forma residual NAVincluded in the last month. The measure presented is net of a pro forma management fee to Pantheon, assumed to be the highest default rate with respect to Pooled Investors set forth in the Key Terms forthe Program (i.e. an annual management fee of 55bps on aggregate capital commitments). Commencing on the eighth anniversary of the end of the first accounting period and in respect of each yearfollowing, the Management Fee is reduced to 90% of the amount paid in the previous year. Nominal net performance has been calculated without taking into account fund organizational and administrativeexpenses, which include expenses incurred in connection with the formation of and sale of interests in the fund, fees and expenses related to investment activity and all fees and expenses related to theoperation and administration of the fund, nor of cash inefficiencies that may exist within the actual funds. The deduction of such fees would decrease returns. Prospective investors should note that the actualfee structures for the regional funds and separate account clients differed from that included in the pro forma presentation above and varied throughout the periods presented.MSCI World PME. The notional IRRs for the MSCI World Index were calculated using the Public Market Equivalent (PME) methodology, whereby the Pantheon net cash flows are hypothetically invested inthe index, assuming zero cost. The MSCI World Index assumes reinvestment of all dividends after tax and is supplied by Bloomberg/MSCI. In considering this performance prospective investors should bearin mind that past or expected performance is not necessarily indicative of future results and there can be no assurance that Global Select will achieve similar returns or that expected returns will actually beachieved. Past performance is not indicative of future results. Future returns are not guaranteed, and a loss of principal may occur.

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

Pro forma1992 - 1994







TOTAL1992-2012

Net IRR MSCI World PME

Too early

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This document and the information contained herein is the confidential and proprietary information of Pantheon; it may not be reproduced, provided or disclosedto others, or used for any other purpose, without the prior written permission of Pantheon; and must be returned promptly upon request. This document isdistributed by Pantheon which is comprised of operating entities principally based in San Francisco, New York, London and Hong Kong. Pantheon Ventures Inc.and Pantheon Ventures (US) LP are registered as investment advisors with the U.S. Securities and Exchange Commission. Pantheon Ventures (UK) LLP isauthorised and regulated by the Financial Conduct Authority (FCA) in the United Kingdom. Pantheon Ventures (HK) LLP is regulated by the Securities andFutures Commission in Hong Kong.

In Australia, this document and the information contained herein is intended only for wholesale investors under section 761G of the Corporations Act 2001 (Cth)("Wholesale Investor"). By receiving this document you represent and warrant that you are a Wholesale Investor. Pantheon Ventures (UK) LLP is exempt fromthe requirement to hold an Australian financial services licence under the Corporations Act 2001 (Cth) in relation to the provision of any financial product adviceregarding the financial products which are referred to in this document and is regulated by the FCA under UK laws, which differ from Australian laws.

In Europe and the United Kingdom, this document and the information contained herein is provided by Pantheon Ventures (UK) LLP solely to professional clientsor eligible counterparties for the purposes of the rules of the Financial Conduct Authority. In all other jurisdictions, this document is intended for institutionalclients and investors to whom this document can be lawfully distributed without any prior regulatory approval or action.

Nothing in this document constitutes an offer or solicitation to invest in a fund managed or advised by Pantheon or recommendation to purchase any security orservice. Nothing contained in this document is intended to constitute legal, tax, securities or investment advice. The general opinions and information containedin this publication should not be acted or relied upon by any person without obtaining specific and relevant legal, tax, securities or investment advice. In general,alternative investments such as private equity or infrastructure involve a high degree of risk, including potential loss of principal invested. These investments canbe highly illiquid, charge higher fees than other investments, and typically do not grow at an even rate of return and may decline in value. These investments arenot subject to the same regulatory requirements as registered investment products. In addition, past performance is not necessarily indicative of futureresults. This presentation may include “forward-looking statements”. All projections, forecasts or related statements or expressions of opinion are forward-looking statements. Although Pantheon believes that the expectations reflected in such forward-looking statements are reasonable, it can give no assurance thatsuch expectations will prove to be correct, and such forward-looking statements should not be regarded as a guarantee, prediction or definitive statement of factor probability. All information or discussion in these materials regarding funds managed/advised by Pantheon or its affiliates is qualified entirely by the terms andprovisions of the relevant private placement memorandum(s) and limited partnership agreement(s) for such fund(s).

Any reference to the title of “Partner” in these materials refers to such person’s capacity as a partner of Pantheon Ventures (UK) LLP. In addition, any referenceto the title of “Partner” for persons located in the United States refers to such person’s capacity as a limited partner of Pantheon Ventures (US) LP.

Copyright © Pantheon 2014.All rights reserved.

Disclosure

Austin • Missoula

Empirical Solutions, LLCGFOA: Fee Risk Management

Empirical SolutionsEmpirical Solutions PREEMPTIVE RISK MANAGEMENT | Protect. One Client at a Time.

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“Look to thyself,Take care of thyself,For nobody cares for thee.”

Unknown Author

Copyright 2013 Empirical Solutions, LLC. All rights reserved. www.empiricalresults.net


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GFOA BRIEFING AGENDA

1. Fee Risk Management: Who Cares?

2. What is Fee Risk Management?

3. FRM Risk #1: Abject Conflicts

4. FRM Risk #2: Fee Stuffing

5. FRM Risk #3: Blind Trust

6. The 3 Pillars of an Effective FRM Program Insist on Aligned Incentives Continual Education and Negotiation Fee Performance/Compliance Audits



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Fee Risk Management (“FRM”) is at the heart of investment management and financial officers are increasingly scrutinized on how fees are handled.

Due to increasingly large allocations to alternative investments, which feature more complex and opaque fee structures (hedge funds, private equity, venture cap et cetera), FRM matters more than ever.

Making matters worse, there is evidence of foul play.


Fee Risk Management: Who Cares?


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Here is what Drew Bowden, Director of the The Securities and Exchange Commission’s (SEC) Office of Compliance Inspections and Examinations (OCIE) had to say several weeks ago (May 6, 2014):

“When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified…violations of law or material weaknesses in controls over 50 percent of the time.”

Given this finding by the SEC, do you, or the Trustees have an obligation or fiduciary duty to actively monitor how you are being charged fees?


Fee Risk Management: Who Cares?


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Fee Risk Management = taking action so that fee agreements do not: (a) needlessly permit return erosion, (b) encourage managers to undertake excessive risks and (c) permit unjust enrichment (large undisclosed fees)

As you can see, there are 3 dimensions to fee risk:1. Risks created through agreement (conflicts deriving from fee structures)2. Risks initiated by managers (opaque documents, fee stuffing)3. Risks permitted by the plan’s inaction (no performance audit on fees)


Fee Risk Management: What Is It?


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The day-to-day management of risk is complicated by behavioral conflicts of interest endemic to the business.

Conflicts of interest risks are NOT captured by VAR1 or any other fancy calculations. Nearly all conflicts derive from incentive structure.

Fix the fee structure and you can rid most conflicts of interest.

Note: for the purpose of this presentation, we pass no judgment and are not moralists. We are pragmatists, and that requires acknowledging these conflicts when they exist so they can be managed per your fiduciary duty.

1) VAR = value at risk (commonly used method of quantifying risk).

FEE RISK #1: Abject Conflicts Of Interest.



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In simple terms, there are 3 behaviors that as a financial officer you need to protect your beneficiaries against:

1. Uncompensated risk taking by managers – this is when managers take excessive risk without providing returns to the plan that justify the taking of those risks.

2. Uncompensated fee taking by managers – this is when managers are either (a) not taking the risk they were paid to take but still happily collecting their fees or (b) sneaking in extra fees, with help from poor disclosure and opaque contract terms.

3. Investment consultants preaching risk management – but whose economic incentives are divergent from those of the Plan.

FEE RISK #1: Abject Conflicts Of Interest.



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Uncompensated risk taking by managers:

1. Arises when you agree to fee structures where the payout is based on nominal returns -- with zero regard to risk taken

Example: most hedge funds charge a performance fee that is calculated solely based on nominal returns.

2. “The Fix?” – Either (a) create a symmetrical fee structure, or, (b) create risk-adjusted hurdles, not nominal return hurdles.

FEE RISK #1: Conflict of Interest -- Uncompensated Risk Taking.



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Consider Manager “A” and Manager “B”. Same year end return but radically different drawdown profile (graphs of cumulative returns). Per the typical hedge fund fee formula, both get paid the same!?!

FEE RISK #1: Uncompensated Risk Taking -- Illustration.


January February March April May June July August September October November December Manager A 1 2 3 4 5 6 7 8 9 10 11 12

Manager B 0 0 0 ‐50 ‐50 ‐50 ‐50 ‐50 ‐50 ‐50 0 12

‐60

‐50

‐40

‐30

‐20

‐10

0

10

20

Cumula

ve Return (%

)

Illustra ve Comparison of Risk Taken: Manager A (blue) and Manager B (red)


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Loss-math shows why uncompensated risk taking is so dangerous:

1. Beginning period loss example: if a Plan loses 30%, it must earn 43% to get back to break-even. It has 43% MORE to earn than it lost (43/30) to get out of the hole and get back to break-even.

2. End of period loss example: a 10% return for 10 years produces an annualized return of 10%, right? By contrast, what if you have 9 years with a 10% return and then in year 10, you lose 30%? This reduces the annualized return over the period to slightly more than 5%. This is a near 50% reduction on an annualized basis! In this example, if your return horizon was ten years, the loss could be catastrophic.

3. Both of these examples get worse once you take fees into account.

FEE RISK #1: Uncompensated Risk Taking – Review of Loss-Math



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8.66% = is the annualized return of the S&P from 7/1/1993 to 6/28/13.

1. During this period there were 5,036 trading days. The average does not tell us anything about the underlying distribution of positive and negative daily returns.

2. Question: what would the annualized return be over the same decade if you eliminated the worst 50 trading days, which represents only 1% of the trading days during that period?

3. Answer: (to be given verbally – best guess gets a prize)

4. Hint: risk management makes a huge difference – think bigger!

FEE RISK #1: Uncompensated Risk Taking – The Impact of Loss-Math



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Uncompensated fee taking by managers:

1. Arises when managers are either (a) not taking risk but still happily collecting their fees or (b) sneaking in extra fees, with help from complex formulas and opaque/poor disclosure.

2. Key Insight: these behaviors direct conflict with the interests of plan beneficiaries – yet are in the interest of the manager!?!?

3. “The Fix?” – (a) Hire specialists to help you negotiate investment documents that address these risks. Even the SEC had to add members to its team given the unique expertise needed in the alternative investment space (b) demand total transparency with meaningful economic consequences in the case of breach.

FEE RISK #1: Conflict of Interest -- Uncompensated Fee Taking.



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Investment consultant specific conflicts of interest:

1. Plans assume that investment consultants explicitly manage risk.

2. Consultants focus on the biggest managers (“too big to fail”) which is convenient to their business model, since they are often forced to lower their pricing to win business, and have little incentive to do anything more than the least required.

3. Consultants define success relative to benchmarks, but relative performance does not pay absolute retirement bills.

FEE RISK #1: Conflict of Interest – With The Investment Consultant



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Benchmarks create an enormous source of conflict of interest and are a classic example of unintended consequences.

Plans need to evaluate investment consultants other than on their table manners and knowledge of wine. Measuring performance relative to a benchmark is meant to create that accountability.

However, benchmarks paradoxically create a disincentive for the consultant to protect capital from loss.

Far fetched? The proof: look at 2008/9 returns. What do we see? Huge plan losses prevented timely and aggressive allocations into distressed asset classes (thereby forcing plans to miss the boat on one of the best risk-adjusted opportunities of this decade).

FEE RISK #1: Conflict of Interest – Benchmark Incentive Risk



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This table illustrates quite clearly that the big wins and worst cases for plans and consultants occur in different quadrants = conflict of interest!




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“It is difficult to get a man to understand something, when his salary depends upon his not understanding it.”

Upton Sinclair




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Fee Stuffing = sneaking cookies out of the cookie jar undetected

1. Fee stuffing raises serious ethical and practical issues:a. It erodes trust because it depends on opacity and terms of artb. It means that beneficiaries are not being given an accurate

picture of the overall investments to which they are exposedc. The degree of fee stuffing appears significant (SEC) d. It prevents trustees, board members, consultants and staff

from making informed investment decisions (fiduciary duty)

2. “The Fix?” – (a) Hire specialists to help you negotiate investment documents that address these risks. Even the SEC had to add members to its team given the unique expertise needed in the alternative investment space (b) demand total transparency with meaningful economic consequences in the case of breach.

FEE RISK #2: Fee Stuffing.



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Examples of Common Fee Stuffing In Private Equity:

1. Charging undisclosed “administrative” or other fees not contemplated by the limited partnership agreement (which you would only catch if you analyzed the fee details and then re-read the typically lengthy partnership agreement; managers benefit when actions fall outside of contemplated categories because often limited partners have very limited information rights (needed to adequately monitor) and little recourse outside of fraud etc.

2. Managers shifting expenses from themselves to their clients during the middle of a fund’s life, without disclosure to the LPs1.

3. Charging transaction fees in cases not contemplated by the limited partnership agreement, such as recapitalizations.

Note (1): LPs stands for “limited partners” in a limited partnership.

FEE RISK #2: Fee Stuffing -- Examples.



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Examples of Common Fee Stuffing In Private Equity:

4. Using process automation as a vehicle to shift expenses (example: client reporting, which until now was a GP1 expense).

5. Monitoring agreements exceeding the contemplated holding period (sometimes with infinite maturity) and accelerated fee payments triggered by changes of control (such as a sale, which was contemplated from the very beginning, by definition).

6. Hiring related-party service providers, who provide services of questionable value.

7. Shifting the cost of the manager’s team by dressing them up as “operating partners” but then treating them in the legal documents as unrelated parties so that they do not offset management fees.

Note (1): GP stands for “general partner” in a limited partnership; the party that controls the partnership..

FEE RISK #2: Fee Stuffing – More Examples.



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“Trust through verification” = a better model.

Many plans do not conduct a performance audit on fees and just assume that their accountants do this. They do not. And to do so requires specialized product, finance and legal expertise.

Do you recall the brilliant reply that President Reagan offered, when challenged by Gorbachev as to why he (President Reagan) was insisting on on-site inspections when he was also intimating to Gorbachev that he trusted him? Reagan powerfully replied, “Mr. Gorbachev, I believe in trust through verification.”

Especially when we have a fiduciary obligation to beneficiaries, it is crucial to verify that fees were correctly charged, and that disallowed fees were not charged to beneficiaries and through that kind of rigor, establish ‘trust though verification.’

FEE RISK #3: Blind Trust.



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Pillar #1 = Insist on aligned incentives.

1. Insist on fee structures where managers are rewarded for skill. Note that skill is evidenced in two dimensions: risk and reward. How much risk did they take per unit of earned return?

2. Make sure that non-fee clauses are written so they align your interests. If there is no practical consequence to the manager for acting outside the boundaries set in the limited partnership agreement, then your interests are not aligned. Likewise, insist on powerful audit rights, both at the manager level and the deal level.

EFFECTIVE FEE RM: Pillar #1 = Align Incentives.



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Review of basic fee terms:

1. Simple % of AUM (e.g. 50 basis points per year)

2. Hedge fund fees: typically combination of a simple fee (see above) plus a performance fee (see next)

3. Performance fee (“PF”): where manager gets paid a % of the returns; subject to a hurdle rate (see next) and watermark (the fund is only paid on incremental new gains above the previous high, which is referred to as the high watermark).

4. There are different hurdle rates (soft, hard and blended). Hard hurdles only permit paying a PF on the amount in excess of the hurdle. Soft hurdles pay the PF on the entire gain (above the previous high watermark) but only after the hurdle is first met.




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Review of basic fee terms -- continued:

5. Blended hurdles: pay the PF based on total returns, but never if doing so would reduce the net return to be lower than the hurdle.

6. Time based return hurdles: most commonly IRR (internal rate of return), which adds the element of return per time to the hurdle.

7. Fulcrum fees: increase if returns beat those of a specific index and reduce if returns underperform the index (performance adjusted)

8. Symmetrical fees: similar concept to Fulcrum fees but more fluid (Fulcrum fees tend to be more binary). Symmetrical fee example, 2.65% management fee + 20% of the gross performance above -10% and below +10% (assumes expected fund vol = 10%).




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Examples of aligned and dynamic alternative fee mechanisms:

1. Dynamic fees, where the PF fee varies based on the risk-adjusted returns over some period

2. Symmetrical fees – creates skin in the game (see previous page)

3. Fulcrum fees – creates skin in the game (see previous page)

4. Absolute or blended hurdles – protects against underperformance

5. Risk adjusted hurdles instead of nominal return hurdles

6. Time mechanisms – that permit managers to accrue fees at their desired rate, but only pay when risk-adjusted returns are earned

7. Time mechanisms – that average PF over longer periods of time to more closely align plan and manager incentives




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Pillar #2 = Continual negotiation and education is a best practice.

1. Negotiate upfront. Obviously. But so few institutions do this well and aggressively enough, that it merits mention.

2. Negotiate on an on-going basis. E.g. invest with small manager that then grows much bigger. Go back and ask to negotiate lower management fees now that it has more AUM1 et cetera!

3. Managers are incentivized to come up with new terms of art and new devices to squeeze more economics out of each deal, which given the zero sum nature of these means it directly or indirectly hits the limited partner. Continual education in the alternative space with corporate governance and fee focus is key.

Note (1): AUM stands for “assets under management”.

EFFECTIVE FEE RM: Pillar #2 = Continual Education and Negotiation.



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1. Be assertive and firm. Even easier when you can coordinate or combine your allocation with other institutional investors to offer greater size to the managers in exchange for improved terms.

2. Negotiate on a regular and predefined schedule. The best FRM programs will initiate a formal request to fee improvement, based on the sooner of certain performance characteristics or time.

3. Keep performance in mind. Divest when the funds experience above-average returns. Stay if a routine drawdown but consider asking for a fee concession to stay the course. This is business – not charity.

4. How you request the concession matters. Simple, specific and written requests generate the best results. Open-ended verbal requests are met with “woe is us” refrains with violins playing in the background.

EFFECTIVE FEE RM: Pillar #2 = Tips for Effective Negotiation.



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Pillar #3 = Conduct annual fee performance / compliance reviews.

1. Benefits to conducting fee performance / compliance audits:

a) More palatable than having to increase full-time headcount with the requisite expertise on full time payroll

b) Given the millions of fees being paid out, it is needed to ensure that fee calculations / billing is compliant / accurate

c) Protects trustees and staff by demonstrating that they are taking steps to exercise their fiduciary duty

d) As Benjamin Franklin famously remarked, “A penny saved is a penny earned” – so watching fees (expenses) is critical!

EFFECTIVE FEE RM: Pillar #3 = Fee Performance Audits.



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Fee performance / compliance reviews may include the following:

1. Confirm that disclosed fees are being calculated correctly.

2. Confirm that deal fees (fees that the manager is permitted to charge to specific private equity deals) are being properly charged.

3. Ascertain what additional pseudo fees are being extracted and where through carefully and detailed questionnaires, as well as interviews of the managers.

4. An analysis of what the plan received for the fees paid, taking risk into account to help get a clearer picture of risk/reward.

5. Confidential suggestions on where/what the plan should target for negotiation with existing mandates as well as proposed ones.

EFFECTIVE FEE RM: Pillar #3 = Fee Performance Audits.



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Bottom line, as finance officers, you are the protectors of good hard working Americans. They are depending on you to watch their back and prevent them from getting fleeced. Self-interest is good but so is accountability. Make sure your Plan is equipped to certify that the fees you are paying are correct and not overstated – your beneficiaries need every penny coming their way.


Conclusion


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Stefan Whitwell, CFA, CIPM (Austin, Texas)office: (877) 936-3372 ext. 701cell: (917) 214-6833email: [email protected]

Contact Information



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Stefan Whitwell, CFA, CIPM, Managing Director Two decades of investment and risk management experience; expertise includes both

traditional and alternative assets.

Previous experience includes institutional and hedge fund coverage at Credit Suisse First Boston and Goldman Sachs, and mergers and acquisitions investment banking at James D. Wolfensohn, Incorporated.

Awarded the Chartered Financial Analyst designation (Charter #40140) in 2000 and the Certificate in Investment Performance Measurement (Certificate #000892) in 2012 by the CFA Institute. Served on one of the CFA Exam standards setting committees for the CFA Institute in the summer of 2012.

Graduated from the Wharton School at the University of Pennsylvania with a Bachelor of Science in economics and concentration in finance.

Listed with the National Futures Association as Principal, registered as an Associated Person, Forex Associated Person and Associate Member of the National Futures Association (NFA ID #0277030).

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