Types of Investment Manager Contracts

Prospectuses, private placement memorandums, and/or limited partnership agreements all contain the terms of the investment management services. Allocators must make sure the terms involving liquidity and management fees all make sense, given the portfolio goals.

Liquidity refers to the ease with which an investor can redeem their investment in the form of cash. The most liquid vehicles are closed-end mutual funds and ETFs. These investments can be bought and sold intra-day at current market prices. Next in terms of liquidity are open-ended funds, which can be bought and sold at the end of the trading day.

Limited partnerships, such as hedge funds, venture capital funds, and private equity funds, typically require investors to invest their money for longer periods. Hedge fund terms include:

• Redemption frequency: How often the investor may make withdrawals.
• Notification period: The amount of advanced notice required.
• Lockup period: This is the period after investment in which withdrawals may not be made. Hard lockups mean no redemption is possible, and soft lockups mean a penalty is assessed, although withdrawal is permitted.
• Gates: Limits on withdrawal sizes.

Private equity and venture capital funds offer the least liquidity. Investors must commit specific amounts (capital calls) during the investment phase and receive distributions as investments turn profitable over the fund's term. An investment phase typically lasts 5 years, with the fund's life at 10 years and options for two 1-year extensions. These limitations provide commitment for the investment team but restrict investor flexibility.

SMAs allow investors to control their liquidity as funds are held in their name. Liquidity depends on the underlying assets in the account. Publicly traded stocks are highly liquid, while certain physical real estate holdings in the same account may be less liquid despite being part of the portfolio.

Management Fees

Management fees are charged in order to largely cover the costs of regulation, technology, lease of office space, and payroll. Bonuses tend to comprise a large portion of these expenses and thus can be cut back to improve firm profitability.

Expense ratios for mutual funds have been under pressure since around the year 2000 and, in some cases, have come down on average 40%. This trend has continued even further in recent years.

Investment firms charge fees in several different ways. In general:

• Mutual funds charge fees based on assets under management in a fund. Some classes of mutual funds, including those with reduced fees, require minimum balances.
• In contrast, institutional managers frequently offer declining percentage fees on increasing account sizes for separate or commingled pool accounts. With minimum account sizes or minimum dollar fees being common. Fixed-percentage fees facilitate managers' and investors' planning for future cash flows, whereas dollar fees are subject to the variability of asset values.

Incentives are not always perfectly aligned between managers and clients. Clients bear the full economic risk of losses, whereas managers with clients who experience a decline in asset values will only lose out to the extent their fees will be lower. Ultimately, managers want to perform well to retain current clients and ensure future marketing efforts to attract new clients.

AUM Fees

AUM fees involve charging a percentage of the total amount invested with a manager. These fees align incentives between managers and clients, as a growing asset base benefits both.

Asset Stickiness

Large asset sizes make managers hesitant to take risks and potentially lose them. Investor assets are typically “sticky,” meaning once allocated to a manager, investors tend to stay with that manager even if performance slightly declines (due to status quo bias).

Question

As it relates to hedge fund liquidity restrictions, a gate is best defined as?

1. The amount of advanced notice required.
2. Limits on withdrawal sizes.
3. The period after investment in which withdrawals may not be made.

Solution

The correct answer is B.

Choice A represents a notification period, indicating how much advance notice is needed. Choice B refers to a gate that sets a restriction on withdrawal amounts. Lastly, choice C corresponds to a lockup period, specifying the duration after an investment during which withdrawals are restricted. A hard lockup implies no redemptions are allowed, while a soft lockup permits withdrawals with a penalty.

Reading 13: Investment Manager Selection

Los 13 (g) Compare types of investment manager contracts, including their major provisions and advantages and disadvantages