Asset owners often have very long-term investment goals such as funding liabilities, building an endowment for perpetuity or providing for subsequent generations. For some, especially pension and retirement funds, these goals reflect the long-term needs of individual plan members who rely on these institutions to safeguard and build the savings which they will rely on down the road.
Asset owners often have very long-term investment goals such as funding liabilities, building an endowment for perpetuity or providing for subsequent generations. For some, especially pension and retirement funds, these goals reflect the long-term needs of individual plan members who rely on these institutions to safeguard and build the savings which they will rely on down the road. Ensuring assets are managed in line with these long-term horizons is critical to achieving these goals.
This presents a challenge since assets are often managed by asset managers who may have different time horizons, incentives, and goals.
Among the most important elements in ensuring that institutional investor partnerships fulfill long-term objectives are the investment management contracts, or “mandates”, between asset owners and asset managers. The terms and conditions included constitute a mutual mechanism to align the managers’ behaviors with the owners’ objectives. These contracts play a crucial role in ensuring the success of these relationships over time.
The terms and conditions used in mandates can be key to driving this long-term behavior. Based on a series of recent working groups comprised of leading asset owners and asset managers from around the world, we’ve compiled this list of terms and elements to consider when assessing how best to steer investment mandate negotiations in a long-term course:
Asset managers who use an AUM (assets under management) fee, today’s standard practice, often offer asset owners discounts based on the size of the account. A discount based on longevity of the relationship may provide a longer-term incentive for them. An owner receives a benefit for patience and continuing commitment, while the manager benefits from the comfort of a more reliable capital commitment, both of which may help them capture long-term premia. Owners and managers that prefer to use a performance fee can incorporate long-term incentives by calculating performance over a multi-year period, such as three to five years, and using a hurdle rate that compounds with time accordingly. Asset owners can also defer the performance fee to ensure that only long-term performance is rewarded. Deferring such a fee lessens the possibility that the manager will become overly risk-averse during the later years of the contract.
The benchmark used to judge the success of an investment strategy understandably receives a great deal of scrutiny. We have yet to find a perfect benchmark to encourage long-term thinking. In fact, the selection of a benchmark, while important, appears secondary to many other provisions in terms of providing an incentive for long-term behavior. In other words, how the benchmark is used and its reference time frame are more important than selecting a specific benchmark.
Asset owners can usually terminate their relationships at will and without cause. While asset owners may appreciate maximum flexibility, at-will contract terms present several challenges. Owners may make shorter-term commitments to their managers than they expect their managers to make with their capital. Setting a 3-5-year term with automatic renewals may build the relationship with a long-term timeframe in mind, shifting the onus from reacting to short-term performance to evaluating progress towards long-term goals. These contracts may still offer wide discretion for termination, in contrast to strict lock-ups, so that asset owners can make the decision to terminate if circumstances warrant.
A manager’s opportunity to redeem in-kind can also affect their ability to pursue long-term opportunities. It is challenging for a manager to undertake a long-term investment strategy, such as investing in a turn-around situation, if redemptions may require shorter-term liquidity than the underlying investments provide. The owners’ ability to invest with a long-term outlook is similarly undercut if other investors in the strategy or fund can redeem prematurely. Clarifying in-kind redemption provisions and understanding their impact, if any, on the manager’s strategy can improve alignment of long-term goals.
Discipline is a critical component of long-term investment-management relationships, including the discipline to keep assets under management within the boundaries of an investment strategy’s capacity. It is tempting for managers to grow assets in high-performing strategies beyond the level at which they can expect to achieve long-term outperformance. Contracts can specify a strategy’s capacity, in absolute terms or as a percentage of investable market capitalization, to help managers maintain that discipline over time.
Long-term investors use the mandate discussions to anticipate the ways that the asset owner will monitor the manager’s progress. Rather than focusing on quarterly performance, long-term owners and managers will want performance reports to draw attention to the long term. Minor changes to standard reporting templates can help reframe the discussion, such as reporting long-term returns on the left of the page and short-term returns on the right. Focusing written commentary on long-term results, rather than on events of the quarter, and being transparent about trading and operational costs can also encourage discussion of issues that drive long-term success.
Disclosures beyond performance also can play an important role in building a long-term relationship. Asset owners identify the most important components of the manager’s investment and business operations in the due diligence process. Monitoring these factors for changes and defining relevant KPIs can deepen the long-term relationship and avoid unwanted surprises. Changes in firm ownership or the composition of the portfolio management, research, trading and business management teams may be leading indicators of future investment performance. The mandate can provide a framework for owners and managers to commit to the operational and business KPIs to disclose.
Active ownership or engagement with investee companies is important to many long-term investors. As part of the mandate process, owners can ask managers to detail their current practices for engaging with portfolio companies and for casting proxy votes. In doing so, they can ensure these policies are long-term in nature and match their own long-term goals.
Finally, delineating the evaluation process at the outset of the relationship can help asset owners better manage their own decision-making processes over the long term. For example, documenting and monitoring the reasons for hiring a manager beyond portfolio performance; meeting with managers routinely, rather than just in reaction to underperformance; and measuring expected transition costs before making a termination decision can all lead to better long-term decisions.
Our expectation is that long-term asset owners and asset managers will use these ideas to put significant assets to work in longer-term mandates that support their stated desire to focus on the long term, and that their long-term behavior can translate across the investment value chain. Further details and discussion on tailoring mandates for the long-term can be found in FCLTGlobal’s latest report, Institutional Investment Mandates: Anchors for Long-term Performance.
More information about our research agenda can be found here. To contact our Research team with questions on this subject or other publications please email [email protected].
In the News
5 December 2017 - The FCLT paper, Institutional Investment Mandates: Anchors for Long Term Performance, includes a top-10 list of recommendations for long-term mandates that covers fees, benchmarks, the term of the contract and performance reporting. It gives investors ideas for changing behaviours to better inform long-term thinking; for example, changing the frame of reference of performance reporting, and flipping the standard practice of listing short-term results ahead of longer-term outcomes.
Incentive Alignment | Press Release
5 December 2017 - Boston, MA, December 5, 2017– FCLTGlobal, a not-for-profit organization that advocates for a longer-term focus in business and investment decision-making, has released its newest publication which presents a long-term model for drafting investment management contracts between asset owners and managers. The white paper, Institutional Investment Mandates: Anchors for Long-term Performance, discusses the status quo of such mandates and how the terms and conditions included can affect, either positively or negatively, long-term behaviors and investment partnerships. The research includes a “Top Ten” list of key components of long-term oriented mandates,...
Video
28 February 2018 - CPPIB's Mark Machin discusses the importance of long-term investment mandates. From the 2018 Focusing Capital on the Long Term Summit in New York.