Tuesday, October 9, 2012

The Magic Words of Money Management Part 5: “Alignment”

The Magic Words of Money Management Part 5:  “Alignment”

When a money manager starts to talk about “alignment”, he’s trying to move his chair to your side of the table.  The operative line would sound something like this: “We are fully aligned with our investment partners.”  As I discuss alignment, I am going to differentiate between the picture the manager wants you to see and the picture he is actually drawing.

The manager wants you to envision that you’re sitting in the same boat with him.  If conditions are favorable, you both have the wind at your back, and if there are financial storms, you’ll suffer together.  As an investor, you are going to feel better if your fortune and that of the manager rise and fall together.  So being “fully aligned” is designed to suggest that your financial interest and that of the manager are one and the same.

Napkin #6

The reality is different.  It turns out you are not in the same boat with the manager.  If the investment does well, the manager is on a luxury liner, and you’re on a nice boat.  If the investment does poorly, the manager (especially the most senior folks inside the advisor) is still on a luxury liner, albeit a smaller one, and you are in a leaky lifeboat.

The degree of alignment between managers and their clients vary by product, but it is never perfect.  In the mutual fund business, the portfolio managers seldom have a substantial amount of their net worth in the funds they manage.  You can get some idea of how much the manager has invested in the fund by reading the Statement of Additional Information, which is like an appendix to a mutual fund prospectus.  It’s available on the SEC website and on most mutual fund websites.

In private equity and real estate, most managers only have a small portion of their net worth invested in the funds, and some even use a portion of the management fee to “fund” their investment.    You know the fee is too high when there’s a bunch left over to be invested in the fund.  Typically 98% or 99% of the money in a fund comes from investors and 1% or 2% from the manager.  As a manager becomes more experienced and raises subsequent funds, he tends to put less and less of his wealth into the fund.  The manager’s argument is that his prior success is ample evidence of his commitment to his investors.  The reality is that he should be putting more of his wealth into subsequent funds, as managers tend to become less focused on the success of funds as their wealth multiplies (largely from fees) and their personal interests blossom.

Hedge fund managers tend to have more of their net worth invested in their funds, so the alignment is better than for other products.  However, even here the alignment is far from perfect.  As you may recall from a prior post (The “Juice”), hedge fund managers (as well as private equity and real estate managers) take a share of the profits (called “carried interest”).  You should think of carried interest like a stock option.  If a fund does well, the manager gets a sizable chunk of the profits that the investors would have otherwise earned.  If the fund does poorly, the investors take the full loss, and the carried interest simply has no value.
Think of it this way.  If the coin comes up heads, the investor wins, but shares the winnings with the manager.  If the coin comes up tails, the investor loses.

In some cases, carried interest can create massive misalignment.  For example, some funds use deal-by-deal carry.  This means that a manager can get a share of profits on any deal that is successful.  You can imagine a fund in which one investment is highly successful, but the rest of the investments do poorly, and the overall fund is a bust.  In these structures, the manager earns some carry, even though the investors suffer losses.

Even if the carried interest is well structured, it may be going to the wrong people.  Ideally, carry or profit sharing should go to the people who are going to make, monitor, and sell the investments.  However, in a lot of cases the carry is going to parent companies, retired partners (like Governor Romney), or senior executives who have little or nothing to do with actual investing.

When a money manager comes to this point in the investment presentation, you can give your ears a rest.   If the manager and his investment thesis are of interest, you may get a chance to see how well he is aligned with you during due diligence.  It will depend on how transparent (tomorrow’s topic) the manager is willing to be.  All you need to remember is that when the manager says alignment, he’s really telling you his boat is going to be a whole lot better than yours.

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