Active fund managers and institutional investors have complementary goals. A more dynamic, symbiotic relationship between these entities is possible through an innovative contracting solution.
At present, the low-yield investment return environment is more a long-standing condition than recent development. With interest rates having scraped the floor for more than a decade, and equity market valuations currently at historically high levels, the traditional 60/40 portfolio of equities and bonds does not pass muster for the large-scale investor who needs to meet mandates so that public servants’ and first responders’ pensions remain funded.
Enter the nimble-minded active fund manager who has the inside view on market-beating strategies that make the most of the opportunities alternative asset classes such as hedge funds and private equity have to offer. With private assets dominating performance charts and hedge funds offering improved risk mitigation over other assets, alternatives have become critical tools for institutional investors.
Despite these benefits, alternatives have suffered their share of malaise that, at least on the surface, appears to run contrary to institutional investors’ goals of stewardship on behalf of their funds’ target recipients. Despite hedge funds and private assets helping to deliver market-beating returns to public coffers, the public images of these investment classes have taken a beating.
When it’s not headlines over Reddit-enthusiast meme stocks sapping a smaller hedge fund firm over some perhaps misplaced populist cause or headlines over a beloved retailer coming under private equity control, it’s politicians wagging fingers over the management fees associated with alternative asset classes — the very investments that have helped to bolster public pensions’ solvency.
Concerns about fees are certainly valid. When an investor hires an asset manager, part of the agreement is the latter will serve as a fiduciary on that fund for the former. It is thus incumbent on the asset manager to offer the strategies and portfolios that not only offer the highest returns but also the most cost efficiency. At the same time, however, institutional investors tend to be beholden to governance structures that prevent easy movement among funds and strategies. Reallocations to any new funds or strategies are subject to negotiations and approval processes that often take several months to a year for approval. This means investors might lose out on opportunities provided by the market — defeating part of the purpose of hiring talented asset managers in the first place.
There is also the matter of how far asset managers’ fiduciary duties extend. Common practice among investors is to allocate to one investment strategy at a given time. Yet an asset manager’s fiduciary obligation only goes as far as the fund in which the investor has allocated. Fund managers are not explicitly prohibited from giving advice to benefit the investor; however, they are in no way obligated to give information about strategy rebalancing or investing in other funds.
Here comes the disconnect. Managers who spend their days parsing out these investments and strategies have plenty to offer investors on this front. An ideal symbiosis between asset manager and investor would allow investors to reallocate among strategies and funds without the encumbrance of lengthy approval processes and free up the mental bandwidth to meet their mandates of expected returns.
For their part, asset managers would be rewarded on the overall value they bring to the institutional investment relationship, rather than on the performance of a given fund. Both parties would be empowered to bring the best returns possible for the first responder or teacher recipients of a pension fund or offering grants and scholarships to prevent promising students from having to take out loans to attend their dream schools.
Enter the Strategic Relationship Agreement (SRA), a platform that allows institutional investors the flexibility to allocate across asset classes depending on market conditions to drive the strongest, risk-adjusted returns within a structure that allows for cost-effectiveness. The associated management and performance fees are calculated in aggregate across investments, leaving fund managers incentivised to take a proactive role in helping their investors reach their target mandates. Overall, it is a win-win: Investors can avail themselves of the latest in best-of-breed investment strategies, while fund managers can enjoy the opportunity to see the fruits of their work in alternatives do good for society’s civil servants and their retirements. Even the most cynical of newspaper reporters and populist critics can get behind that sentiment.
Strategic Relationship Agreements: Their history and how they work
After the late-2000s financial crisis, institutional portfolio management has never been the same. Alternative asset classes now play a key role in helping institutional investors such as pensions and endowments obtain better risk-adjusted returns while delivering on the mandates to meet — if not exceed — their obligations.
By the end of March 2021, U.S. public pensions had $5.14 trillion in assets under management.
As of year-end 2020, U.S. public pension alternative asset allocations were at 19.4%, according to statistics from the National Association of State Retirement Administrators. Statistics from the National Association of College and University Business Officers (NACUBO) and the Teachers Insurance and Annuity Association of America (TIAA) released in February 2021 show the amount of assets under management across 705 US endowments at $637.7 billion; with 20% in alternative assets.
During the early 2000s, many institutional investors had turned to funds-of-funds, which effectively were a one-stop shop for investors. They offered ready-packaged diversification without having to go through the process of vetting individual fund managers. Many investors found that funds-of-funds came at a literal and figurative cost. Both the layers of fees and the lack of transparency turned out to not be the best fit for their needs in terms of fee control and reporting to key external stakeholders.
Amid the trend toward hiring individual asset managers’ strategies and funds, investors were still craving agility to move among strategies to steer a course during market volatility. Among them was the San Bernardino County Employees Retirement Association (SBCERA) pension fund. During the Global Financial Crisis, the plan was generally able to take advantage of the crisis by deploying capital into deeply discounted credit opportunities, though sometimes was frustrated by an inability to take advantage of opportunities if they did not already have an appropriate structure in place.
Born out of this need was the Master Custody Account (MCA), the prior nomenclature of the SRA. The MCA outlined over 40-50 pages of a legal platform by which institutional investors such as pension funds had the ability to allocate throughout an asset manager’s strategies and funds as needed, rather than on a fund-by-fund basis. The MCA outlined specifics on fiduciary duty: agreements between fund managers and investors; adherence to any policies set in place by the investor’s board or state and local laws; and established the investor’s total annual capital allocation and a cap on expenses. In essence, the structure allowed an investor to tap into the entirety of an asset management firm’s brain trust while resting assured that the firm was working in its best interests.
The SRA model gives investors the leeway to reject any fund or strategy that their asset managers present, meaning that the investor isn’t just buying what the fund manager is selling. They evaluate the recommendation relative to their current holdings, impact on total portfolio and available opportunities. This puts the fiduciary duty on the manager to present ideas and investments that best fit an investor’s targets and risk profile.
Once an SRA is in place, fees related to a specific investment should be immaterial as the SRA supersedes individual fund or deal fees. Rather than measuring the performance of a given fund, however, the asset manager’s performance is measured across the entire relationship of funds and strategies to which the investor has allocated. In addition, signing on to a wider range of funds means drastically less paperwork, approvals, and public hearings when a pension decides to allocate to a different strategy, meaning the investment stakeholders are positioned to take advantage of market opportunities as they happen.
The SRA model’s outsized success has gotten other institutional investors to take notice. Since its inception almost a decade ago, other major investors are on-boarding the platform to help them make the most of what fund managers have to offer.
One thought-leading program that has embraced the SRA is the Arizona Public Safety Personnel Retirement System (PSPRS). After significant review and analysis, the program recently moved forward in establishing an SRA with one of their best performing and trusted managers, Crestline Investors. More than half of its $12.7 billion portfolio is allocated to alternative asset classes to deliver uncorrelated returns, and the ability to pivot in the alternative asset space when needed is indispensable to the investor.
Says PSPRS Chief Investment Officer Mark Steed, “The structure allows us to move quickly on direct deals and co-investments with partners we’ve thoroughly vetted and who have performed above expectations across a number of funds over many years.”
Significant benefits extend to the asset manager side as well. A New York-based firm that has MCAs in place with multiple institutional investors landed four $500 million, five-year platforms with European investors after they heard about post-MCA adoption successes.
In a financial market dislocation, market flexibility is everything. During a prolonged positive market, managers might become complacent and feel comfortable staying the course. When that bull run goes sideways, the agility that an SRA affords can mean the difference between investors delivering market-beating returns or having to answer to eager newspaper reporters about losses in the pension fund under their oversight.
The structure of SRAs and considerations for investors
When developing a SRA, the investor and asset manager work out the general terms to guide the relationship such as the types and classes of investment the manager is allowed to recommend. The SRA encompasses the investor’s overall stipulations (though certain private investments may require an additional side letter to address any fund-specific issues). This process typically requires legal and investor oversight. In the end, however, it works out to be much more cost-effective than what would be needed to invest in multiple individual funds and strategies with the manager. From there the investor, usually its CIO, approves which investments are going into the SRA following due diligence by their team on the specific recommendations presented to them by the investment manager. The initial SRA approval typically outlines the maximum amount to be allocated to the asset manager over a given timeframe, with the investor retaining control over the allocation process.
Overall, the SRA lends a level of transparency and fee efficiency befitting the scrutiny accorded to massive public coffers. The investor and manager negotiate fees and other stipulations on an SRA-wide basis. Moreover, as the investor has wider access to an asset manager’s strategies, the management and performance fee rates tend to be lower, as the larger and broader investment relationship is taken into consideration. Compliance concerns are acknowledged at the outset as well. Having to do this process for each individual fund would prove an arduous exercise in approvals and contracting delays that could invalidate a time-sensitive investment opportunity.
SRA success stories
Tim Barrett joined Texas Tech University System (TTUS) in 2013 as assistant vice chancellor and CIO. Before taking the helm of the TTUS program, he had observed the benefits of the MCA/SRA contracting model that derived from SBCERA. He credits part of the sea change that has come to the now $1.6 billion endowment to the SRA model. According to NACUBO data released in February 2021, Texas Tech’s endowment now ranks 88th out of 717 colleges and universities based on size.
“It was a rebuild from the ground up. When I came in, we were in the 100th percentile in the NACUBO universe on a three-year basis…We have made a lot of progress,” Barrett told trade publication The Trusted Insight during a 2018 interview. “Investment program changes of this magnitude truly require that all stakeholders are engaged and supportive. The use of a Portable Alpha structure and the MCA program are by far the biggest structural changes.”
Texas Tech now has more than a dozen MCA/SRA structures in place, accounting for more than 10 percent of its portfolio. Barrett stated that the SRA structure is extremely flexible in that it can utilize funds or co-investments. Furthermore, the authority to transact is driven by the guidelines within the structure, meaning a thinly staffed office can set stringent guidelines and have the manager implement without staff involvement, or the staff can be fully involved with full authority to accept or decline any fund or co-investment. In short, the MCA/SRA is viable for virtually any institutional investor.
Maples Group, a leading provider of fund services to investors and asset managers, brings first-hand expertise on this front. I was one of the co-creators of the platform, along with Thomas Hickey III, partner and chair of Fund Formation at law firm Foley & Lardner.
I now spearhead an internal team at Maples regarding the SRA, helping both sides of the table understand how the structure unlocks value and designs the tech and operational support to provide for seamless reporting and accounting. Hickey and I have written and presented on the topic many times.
After the publication of an article in the Journal of Securities Operations & Custody by Hickey and his team at Foley & Lardner, Hickey was invited to speak on the topic at Harvard Law School by Professor Holger Spamann and Associate Manish Mital. From reading the article, they believed the structure of the agreement could be game-changing for institutional investors and their contracting with managers. Since 2014, a class on hedge and private equity fund contracting at Harvard has included the topic, with Hickey as a regular lecturer.
Being able to tap into the latest market-beating strategies when needed — and having the leeway to do so — helps investors make the most of their allocations. On many levels, the SRA is a perfect tool. When there is a market movement, the SRA allows investors to be the first to respond — meaning lasting benefits for all who participate in those well-managed institutional investment funds.
The SRA is a tool that:
- Allows for a governance structure that empowers asset managers as fiduciaries across the relationship rather than at the fund/asset level by way of structure and fee netting agreements;
- Provides for more seamless governance between managers and allocators;
- Allows investors to negotiate terms that will govern their investment relationship with managers once, rather than on a fund-by-fund basis;
- Provides investors with affordability and accessibility to the latest in fund manager ingenuity.