Guest Viewpoint: Sarah Keohane Williamson & Matthew Leatherman
Asset managers and asset owners often see the world from different perspectives but agree on the need to invest for the long term. When both parties agree that long-term investing is more productive, why is it so hard to accomplish?
One reason is that the terms and conditions of the investment mandate – the basis of their shared investment behaviour – can contradict their intentions to focus on the long term.
Nine large, global investors – five asset owners and four managers – met this May in Amsterdam under FCLTGlobal’s auspices to consider the terms that they commonly use for investment mandates. Our not-for-profit organisation, FCLTGlobal, exists to develop and encourage practical, long-term behaviour in business and investment decision-making. It is supported by asset owners, asset managers and corporations that are interested in focusing their capital on the long term.
The group had grown to seven owners and five managers by the time it reconvened in Toronto two months later, representing active and index strategies, fiduciaries of trillions of dollars, and organisations across the world.
Working group participants had important ideas about fees, reporting, evaluation, and many other topics. Accordingly, we have developed a set of model long-term mandate terms that can be customised to particular countries or investment strategies. Here are a few examples.
Fees are often first on the list when discussing investment mandate terms. A discount based on longevity of the relationship may provide a mutual long-term incentive because the owner gets a benefit for being patient and the manager has a more stable commitment.
When owners and managers use a performance fee, they can calculate it over a multi-year period, such as three to five years, and use a hurdle rate that compounds with time accordingly. Deferring such a fee, rather than paying it and clawing it back if performance falls, could lessen the possibility of the manager becoming too risk-averse during later years of the contract.
The benchmark used to judge the success of an investment strategy receives a great deal of scrutiny. We have not found a perfect benchmark to encourage long-term thinking. On the contrary, the selection of a benchmark, while important, is secondary to many other provisions for encouraging long-term behaviour.
The contract term is also a key piece of any owner-manager partnership. Asset owners who use at-will contracts often need to ‘re-underwrite’ relationships in response to short-term events. Furthermore, when there is staff turnover, there may be no champion of an existing relationship, leading to mandate churn. Setting a three- to five-year term with automatic renewals may help build a more long-term relationship. These contracts can still have wide termination discretion, in contrast to the tighter restrictions created by lock-ups, so that the asset owner can exit if necessary.
Capacity discipline also is necessary. Managers may be tempted to raise funds beyond the level at which they can expect to perform for the long term. Contracts can specify a strategy’s capacity, in absolute terms or as a percentage of investable market capitalisation, to help managers maintain that discipline.
Long-term investors will want the performance report to draw attention to the long term, rather than on quarterly returns. Small changes to standard reporting templates may reframe the discussion, such as reporting long-term returns on the left of the page and short-term returns on the right. Focusing the written commentary on long-term results, rather than quarterly events, and being transparent about trading and operational costs, can encourage discussion of issues that influence long-term success.
Other disclosures can also help to build long-term relationships. Changes in firm ownership levels, the portfolio management team, or the relationship team might indicate changes in future performance. An owner and manager can use the contract to commit to disclosing investment and business key performance indicators that correspond to the original hiring rationale.
Active ownership – collaborating with portfolio companies to increase their economic value – is important to many long-term investors. As part of the mandate process, owners can ask managers to detail their current practices for discussing strategy with portfolio companies and voting proxies.
Finally, asset owners can manage their own decision making by using the mandate to set the evaluation process. Documenting and monitoring the reasons for hiring a manager, meeting with managers routinely and measuring the expected transition costs before making a termination decision might all lead to better long-term decisions.
Investment contracts can provide owners and managers with a foundation for successful investing. The provisions discussed here are all in use today, and investors can incorporate them as is appropriate to their particular circumstances.
In addition to the model long-term mandate terms, our work has generated interesting questions for asset owners and managers who would like to explore other ways to promote long-term thinking. For example:
• Could built-in rebalancing mechanisms counteract the performance-chasing cycle of fund flows?
• How can asset owners and managers generate constructive dialogue on portfolio managers’ personal incentives, circumstances, and succession planning?
• Would having a terminated manager continue to report performance for three years counteract the tendency for asset owners to terminate managers after poor performance, only to have it rebound as it reverts to the mean?
We expect that institutional investors who adopt these behaviours will build long-term relationships, earn better returns and, in turn, contribute to capital markets that are more supportive of corporations pursuing long-term, value-creating investments.
Sarah Keohane Williamson is the chief executive officer of FCLTGlobal and Matthew Leatherman is a research director. For further information please contact research@FCLTGlobal.org