In the wake of the Securities and Exchange Commission (SEC) investigation of potential conflicts of interest in consulting firms, small independent consultants are finding themselves in vogue – and they are determined to hold on to their position in the long term by proving that they offer superior service.
Since early 2004, the SEC has been actively investigating consulting firms operating in the US to ensure that they are not involved in ‘pay for play’ schemes. These involve money managers buying services such as conference attendance or marketing support, either directly or indirectly through ‘soft dollars’, from consultants to ensure their placement in their databases of recommended companies.
In the SEC’s first sweep of 24 consultants it found that more than half provided services to pensions funds and money managers, presenting a good possibility of conflict of interest. It also identified a number of cases of favouritism by consultants towards money managers that had paid for services. While it did not identify any firms by name, most of them had previously disclosed publicly that they were under investigation, and a number have also circulated letters from the SEC certifying that they are clear of any wrongdoing.
Since this investigation began, independence has become a selling point for consulting firms, as pension funds are hoping to ensure than they receive best advice. “Independence has been a competitive advantage over the past few years,” states Steve Cummings, principal, president and CEO of Ennis Knupp, a firm based in Chicago. “As a client said to me recently, ‘I used to think of your independence as a quaint feature, but now you look downright trendy’.”
For these firms, independence is more than just a label, or a letter from the SEC designating them as in the clear. Rather, it is a distinct way of doing business that allows them to give best advice. “Independence is a real issue,” Cumming explains. “It is not because firms that have conflicts of interest inherent in their business model give bad advice – but it is difficult to be a lay fiduciary if you are not sure where your interests lie. If you operate within a business model with multiple sources of revenue, biases may ever so slightly creep in.”
Independence also allows consultants to make their presentations clear and unambiguous, according to Mike Manning, president of New England Pension Consultants (NEPC). “It can wear on you if you have conflicts of interest. You have to defend every decision.”
While some firms, such as Ennis Knupp or NEPC, have a long tradition of independence behind them, some new entrants to the marketplace are finding that it is also a benefit.
Cliffwater, based in Santa Monica, California, is a case in point. Founded by several former Wilshire executives, including Steve Nesbitt, a long-time Wilshire managing partner, the new firm focuses on alternative investments – hedge funds, private equity, and real assets such as real estate, inflation-protected securities, or natural resources. The firm is also interested in selected general consulting opportunities with an alternatives focus.
Cliffwater’s approach - targeting a the alternatives market, without the legacy of long-term traditional consulting business - has been quite successful. Since its start-up in June 2004, it has won 11 institutional clients, with combined assets of $100bn (e83bn).
“There are opportunities as an independent,” maintains Cliffwater co-founder and managing director Dennis Sugino, also a former Wilshire executive. “The SEC and various attorneys general have made it well known that avoidance of conflicts is very important. This is what our firm was founded on. Consulting is our sole source of revenue.”
The firm targets alternatives as an essential added-value strategy for its clients, choosing a broader approach than just homing in on either hedge funds or private equity. Not only is there often cross-over between the two, but also it is more fulfilling for Cliffwater consultants. “We offer broader opportunities for people excited about alternative investments,” Sugino explains. It also allows the firm to ride out glitches in any one market, such as the possibility of decreased interest in hedge funds. In fact, Sugino sees “continued interested in the hedge fund area. Such a situation focuses more attention on due diligence and stresses the importance of having consultants working for their clients.”
Mike Manning of NEPC “understands the attractiveness” of starting up boutique firms. His firm, however, prefers to take a holistic view of advisory services and risk management for its clients, and he describes having multiple consulting relationships as “like having three architects on your house”.
Although he does not believe that independence is the primary differentiator in the marketplace, Manning says the firm has experienced significant growth recently. “We’re in an enviable position,” he said, “and trying to be mindful of the opportunities that are presenting themselves, only pursuing the right ones.”
A clear sign of the firm’s buoyancy is that it has recently taken on nine new consultants, who joined from seven other firms. “You see very few lateral transfers in the industry,” Manning points out. “Ultimately they have decided that they want to be in a consulting firm that is independent and has done a great job for its clients. The factors that attract clients also attract employees.” Small firms, he believes have an advantage in finding and retaining quality employees. “We can offer intellectual excitement and freedom. Our employees make an impact on our organisation, and on our clients’ investment programmes.”
Ennis Knupp’s Cummings agrees. “If someone has decided that he or she wants to be a consultant, they’ll want to be here. If they view consulting as a stepping stone to being an investment manager, they’ll look elsewhere.” A smaller firm offers a flatter organisational structure, as well as clarity in the business model. “We only do one thing – providing high-quality consulting services to large investors – and that attracts people who like that one thing.”
The buzz is that Ennis Knupp has seen substantial growth in recent years, rising to the top tier of consultants. Cummings declined to define the size of the firm’s business, but said that clients range in size from $6m to $160bn. It is also highly respected by its competitors, and is always mentioned as a firm to watch.
Cummings maintains that Ennis Knupp’s strength is the individualised attention it offers its clients as well as its internal innovation. It was an early adopter of passive versus active strategies, since 1981, and also one of the first to move away from the style boxes mentality. Bucking the trend, it has also been cool on hedge funds since the beginning. But Cummings draws a distinction between thinking independently and being cutting edge. “Institutional investors have enough to worry about without trying new things.”
The smaller independents have a window of opportunity now to take business away from the big firms. However, while the conflict of interest issue will not last forever, the big firms have a tough few years ahead in finding ways to compensate for the loss of ancillary income, and retaining staff who leave when they realise that the revenue is not out there.
“There is a lot of competition out there, and this is not a high-margin business,” admits Julia Bonafede, senior managing director and the head of the Wilshire Consulting business unit. Wilshire Consulting is actively looking at new markets, she says, particularly in the middle segment. For these funds, the firm is offering a CIO outsourcing service, in which Wilshire actually directs the assets. Other large consultants, like Mercers, are looking to leverage their extensive - and expensive - research databases.
While some of their rivals might judge the big firms to be “dinosaurs” unlikely to survive in the new business climate, those giants are not taking things lying down.