Fee Risk Management

Austin Missoula
Empirical Solutions, LLC

Fee Risk Management
Empirical Solutions Empirical 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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FEE RISK 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
Commissions (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) encourage managers to undertake excessive risks
(b) needlessly permit return erosion
(c) allow undisclosed enrichment
! 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 plans 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 VAR
1
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.

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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: 23.3%. Nearly 300% higher annualized returns by
eliminating just 1% of the trading days. This demonstrates the power
of compounding and why risk management matters to returns.
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 art
b. It means that beneficiaries are not being given an accurate
picture of the overall investments to which they are exposed
c. 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 funds life, without disclosure to the LPs
1
.
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 GP
1
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 managers 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 AUM
1
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.


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Fee performance / compliance logistics:
1. Important to prioritize the work not enough resources to audit all
portfolio managers at once.
2. First year audit will take materially longer than subsequent audits
because it is the first time all agreements are being reviewed and
templates being created for your Plans audit.
3. We suggest a continual audit process, whereby managers are
audited once a year, spread out over each quarter, so the work
load at any given time on your auditor and staff will be reduced.
4. Key that you receive sufficient documentation from the auditor that
shows exactly what was tested, which issues were tested, and
what steps were taken so that your files are complete.


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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. 701
cell: (917) 214-6833
email: stefan@empiricalresults.net

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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