PIMCO: A Tale of Many Woes

Long-time rivals of Pacific Investment Management Company (PIMCO) have been tight-lipped all year about the ugly divorce that played out publicly between PIMCO founder Bill Gross and his presumed heir apparent Mohamed El-Erian.  These rivals have been some of the biggest beneficiaries of client money fleeing the firm.  The departure of these two highlights PIMCO’s succession planning failure.  Since their feud became public, the firm has had customer withdrawals totaling hundreds of billions.  Industry experts expect PIMCO undoubtedly will face further redemptions that may further unsettle staff and investors.  What went wrong?

Unresolved tensions between Gross and El-Erian are similar to conflicts encountered by founders and successors throughout the business world, and the escalation of their tensions followed a rather predictable path.  That path was described by sociologist Friedrich Glas as “becoming more entrenched in their positions, forming coalitions, then taking more public action, such as the bickering reported in financial periodicals.” 

These types of outcomes are common among firms that give short shrift to succession planning.  A successful firm attracts top talent, with that new talent expecting the opportunity to succeed its founder.  This talent may come with significant accomplishments of its own and may be or seem impatient to gain control of a company that took the founder significant time to build.  The firm is the founder’s identity, making it difficult for the founder to give up control.  Even as El-Erian left PIMCO, Gross sent out a tweet stating, “I’m ready to go for another 40 years!”  While the tweet may have been sent to instill a sense of confidence to the firm, it may also be perceived as a sign that the founder could not let go of control.

With both Gross and El-Erian gone, PIMCO’s new leadership will undoubtedly lead to a changed corporate culture.  Pension funds, endowments, foundations and consultants will keep a close eye on the new leadership and new culture, and they will look for any prolonged reductions and outflows in firm assets under management.  This turmoil will most assuredly affect portfolio returns.  In addition, when one or more executives leave a firm without the proper preparation, clients frequently withdraw assets.  Investment firms need to ensure that the future leadership is not only capable and has the confidence of clients, but also has been involved in establishing the future direction of the firm and its investment process.

Lesson Learned: Firms should plan ahead because nothing about succession planning is easy.

Michael D. Cathey, CFA

Consulting Principal
NexTier Companies, LLC

DISCLOSURE AND REDEMPTION: Attention to Compliance Details Not Optional

At a recent conference, I ran into a long-time mentor and friend, Marx Cazenave, the founder of Progress Investment Management, LLC (Progress).  He, among others, has coached me on life and the investment management business.  He also reminded me of the power of disclosure and redemption.  We are all a product of our experiences, both good and bad.  This conversation also led to some reflection on NexTier’s core values, one of which is Integrity: “We are committed to operating at the highest ethical standards with uncompromising honesty, transparency and selflessness toward our clients.”  What does this mean?

Consistent with that core value, here is my story and a source of my passion for protocol, process and accountability.  In 1996, I founded Trias Capital Management, LLC (Trias), as a fixed income advisor for institutional investors and ultimately grew it to nearly $2 billion in assets under management.  The firm was one the first of a breed of Emerging Managers.  In 1998, I acquired a money market mutual fund called Millennium Income Trust.  In 2003 as part of a routine exam, the SEC found me in technical violation of three different rules under the Investment Advisers Act and the Investment Company Act.  Importantly, no fraud was involved and no investor lost money, either principal or interest.

The first violation pertained to Millennium Income Trust where I failed to ensure that Trias repaid a receivable owed to the fund in a timely manner.  The receivable was less than $80,000.  The second violation related to the purchase by Trias of callable government agency securities that were ineligible under rule 2a-7 of the Investment Company Act.  The final violation stated that I failed to ensure that Trias kept accurate books and records stemming from carrying an investment in another investment management firm and the incorrect stating of a liability.  In essence, Trias was a small business without an appropriate investment in compliance resources prior to the dedicated chief compliance officer requirement.  We were an Emerging Manager that was not paying close enough attention to processes and procedures.  The resulting penalties by the SEC included a $25,000 civil penalty, a six month suspension from working with an investment advisor and a 12 month suspension from working with an investment company.  All three stipulations have long since been satisfied and I take sole responsibility for the actions of my firm and for the violations that were committed.

This ordeal is why I am adamant and have recommended to my clients, do not cut corners or operate on the cheap.  Compliance requires a level of rigor that cannot be compromised.  I want my clients to learn from my mistake, as I have learned from it.  Investment managers, especially Emerging Managers, must raise their level of operational efficiency to a place that is beyond reproach and adds value to their business.  Anything less will leave your firm vulnerable to regulatory action.  While difficult, this experience has made me a better investment management consultant.

Lesson learned: Attention to compliance is not optional, it is imperative.

James A, Casselberry, Jr.

Senior Managing Director

NexTier Companies, LLC 

INSTITUTIONS SHOULD CONSIDER DIRECT EMERGING MANAGER HEDGE FUND INVESTMENTS

Smaller institutions have conventionally looked to fund of funds (FOF) managers to fulfill their hedge fund allocations. Similarly, emerging managers have looked to FOFs for capital to grow their businesses. But these views ignore advantages of investing directly in hedge funds, and with Emerging Managers (as defined herein) specifically. We define "small institutions" as those in the $100 million to $1 billion range. They are large enough to make value-adding hedge fund allocations but may not have the resources or needs of larger institutional investors.

Also, we define Emerging Managers as those systematically overlooked by larger investors due to the manager's size, lack of track record or other reasons. Direct hedge fund investments do require a different kind of due diligence than do FOFs. However, the act of identifying compatible managers, investigating their investment and operational acumen, selecting a winner and monitoring that winner takes a similar amount of work whether one is considering a FOF or a single direct hedge fund investment.

The argument that FOFs are "cheaper" than going direct because less research is involved is debatable. Furthermore, FOF investments sacrifice control, liquidity, transparency and fit within one's portfolio. The operational risk increases with the number of sub-managers in a FOF and is compounded by the operational risk of the FOF manager itself. Direct investing in Emerging Managers offers further benefits because they often can invest in opportunities and respond to market events that a larger manager cannot, offer favorable terms and provide more customized service. For these reasons, smaller plans should involve Emerging Managers in a direct hedge fund program. 

From experience, I am skeptical that substantial differentiation exists among many larger flagship FOFs. They tend to choose many of the same underlying hedge funds, reaching similar conclusions on which ones are good, and have exposures to the same underlying investments. On the results side, many FOFs effectively shoot for the same high-single-digit returns. A plan with $10 million or more to invest in hedge funds is better off picking the best manager it can find within its parameters and should consider the additional benefits of Emerging Managers. In doing so, institutional investors will likely pay lower fees with greater liquidity, greater transparency, lower operational risk, better access to the manager and more diversification in its overall portfolio. These investors will probably enjoy better long-term performance as well.

Lesson Learned: With even a small allocation, direct investing in hedge funds can pay.

Matthew V. Steffora, CFA
Consulting Principal
NexTier Companies, LLC

INSTITUTIONAL REAL ESTATE INVESTORS: Emerging Managers Help Improve Performance

In the aftermath of the sub-prime mortgage and real estate debacle, institutional investors are rethinking their real estate investment allocations. Instead of allocating along traditional index-oriented lines, these investors are looking for value-added holdings that can positively impact portfolio performance (i.e., excess alpha). We believe real estate emerging managers (Emerging Managers) can be that source of improved portfolio performance. We define Emerging Managers as any fund management, investment management or asset management firm that is typically excluded from traditional search processes for institutional investors and plan sponsors across all asset classes regardless of their ownership structure or size.

Earlier this month, Institutional Investor reported that TerraCap Management Corp. (TerraCap), an Emerging Manager, has seen institutional interest accelerate in its distressed commercial real estate strategy, as it nears the close of its second fund. The Bonita Springs, Florida firm has received allocations from the University of Florida endowment, Holyoke (MA) Retirement System and a number of other institutional investors and family offices. According to a November 2012 article in Real Estate Alert, Terra raised their $25.7 million first fund in 2010. It was reported that this fund has earned over 30% annualized return on investment.

TerraCap is an excellent example of an Emerging Manager that has tapped into markets in which large institutional real estate firms do not generally participate. 

• Smaller sized investments. Commercial properties that are too small ($2 million to $15 million) for branded firms, but larger than investments local investors can handle. 
• Off-Market Deals. Off-market, or private, deals reduce competition from better capitalized buyers. 
• Specialized Markets Requiring Local Knowledge and Focus. Distressed and foreclosed properties require value-added activity utilizing specialized knowledge and time consuming focus. In the case of TerraCap, taking advantage of international and domestic immigration trends in the region. 

Access to Emerging Managers and their potential excess alpha can be unlocked through direct investments in comingled funds or separate accounts managed by these firms recognizing that those investments can be made through either a fund of funds or a manager of manager platform. Direct investment, particularly with local Emerging Managers, has the benefit of engaging with the local economy. 

In conclusion, Emerging Managers have a role to play in the portfolios of sophisticated institutional real estate investors who are able, and willing, to invest outside the typical index-oriented structure. 

Lessons Learned:  Emerging manager shouldn't be ignored.

James A. Casselberry, Jr.
Senior Managing Director
NexTier Companies, LLC

CLOSING THE PENSION FUNDING GAP: Emerging Managers Have A Role

The funding gap for public pensions is enormous. This should not be breaking news to anyone. Underfunded public pension plans have been a major discussion topic over the past few years, receiving a lot of media attention and notably being detailed in a couple reports from the Pew Center on the States: a 2010 report, The Trillion Dollar Gap focused on state retirement systems and a 2013 report, A Widening Gap in Cities focused on municipal retirement systems. As you might expect, similar gaps exist for most other pension plans as well, including corporates, Taft-Hartleys and retiree health care funds.

The approaches to address these shortfalls are limited: 

• increase direct funding, 
• reduce benefits and 
• add "alpha." 

So how can smaller investment managers (Emerging Managers) play a role in the solution?

Empirical data shows that Emerging Managers, systematically by asset type, generate superior returns to their larger cousins. Therefore the demand for Emerging Managers should grow as the search for excess alpha accelerates.

Here are a few of the many examples of this outperformance: 

• Smaller Hedge Fund Managers Outperform: A Study of Nearly 3,000 Equity Long/Short Hedge Funds, 
• No Contest: Emerging Managers Lap Investment Elephants and 
• Survival of the Nimble: Why Smaller Investment Mangers Outperformed Larger Managers Despite a Challenging Market Cycle for Fundamentally Based Active Mangers. 

As we have previously discussed, Emerging Managers need to address their capacity issues in order to penetrate and thrive in the institutional investment management space and large asset allocators need to adapt their practices to allocate more efficiently to Emerging Managers.

Clearly, the pension funding gaps will not be resolved by the use of Emerging Managers alone. It is going to take public policy reform to resolve these daunting challenges if we have any hope of solving the funding calculus. Nevertheless, Emerging Managers have a role and it behooves everyone to make some adjustments and use them as part of the solution. Much more to come from our team on this topic.

Lessons Learned: Small managers can be part of the funding gap solutions.

Lawrence C. Manson, Jr.
Chief Executive Officer
NexTier Companies, LLC

EMERGING MANAGERS: The Alpha Story

Despite the ever increasing amount of evidence that smaller managers (Emerging Managers) across all asset classes generate excess alpha, small managers still experience significant barriers to market entry and growth.

The Opportunity

Large allocators of assets in the institutional investment world are increasingly seeking the higher rates of return that Emerging Managers can provide, as Emerging Managers are seeking additional assets to manage.

The Problem

Such allocators of assets and their advisors, consultants and gatekeepers, do not have efficient mechanisms or maybe even the talent and experience to weigh the business risk associated with selecting any given Emerging Manager. Emerging Managers generally do not have the organizational depth to address the traditional needs of large allocators, the so-called “elephants.”

The Observation

By and large, Emerging Managers focus their energies on their products and the respective performance, and in so doing provide excellent returns but ignore vital infrastructure issues. Nevertheless, the large allocators continue to benchmark them against their much larger cousins with respect to business risk. This generally leads these allocators and their advisors, consultants and gatekeepers to default to “larger is better,” due to less perceived business risk without further examination.

Even though Emerging Managers are simply small businesses founded by investment managers, they often do not have the bandwidth to manage their business platform without sacrificing performance. Most Emerging Manager programs were originally designed to level the playing field. However, the new age programs should be focusing on more than market entry opportunities, but rather business development and successful business transitions and exits. Why? The Emerging Manager life cycle being understood and supported will go a long way in deriving “sustainable” excess alpha that Emerging Managers are providing. Much more to come from our team on this topic.

Lessons Learned: Emerging managers shouldn't be ignored.

James A. Casselberry, Jr.
Senior Managing Director
NexTier Companies, LLC

SUCCESSION PLANNING: A Must, Not an Option for Investment Managers

Inc.com had a tongue in cheek, but interesting article yesterday discussing an issue being dealt with by both business owners and…Kim Jong-un. While the comparison is humorous, the topic discussed is exceptionally important: Succession Planning.

Succession planning for most businesses is difficult. Any plan needs to be well thought out and comprehensive, but this can be an emotional and uncomfortable process. Although, what likely makes your clients even more uncomfortable is your not having an adequate plan in place.

We've all been told to plan for the scenario, if a senior executive suffers an unexpected illness or is “hit” by the proverbial bus. Even if there is a clear line of succession, how much of the value in a firm is tied up in that person, including their relationships and knowledge? Furthermore, companies, especially service business like investment managers, should be planning for a healthy transition when it is time for a generation to retire or leave the firm.

In either case, when an executive leaves, without proper preparation, clients leave and a firm loses value, and in the case of investment managers, lose assets under management. Companies, especially service business, like investment managers, need to ensure that the next generation is not only capable, but has been involved in decision-making, particularly the future direction of the organization and the investment process.

A departing executive is one scenario, but the need for succession planning is even more important when contemplating a liquidity event to capture the legacy value of your firm through a potential transaction, including but not limited to merger, acquisition, recapitalization and/or divestiture. Succession planning is a series of steps to be implemented over time. The process may start with a simple rebalancing of the equity interest amongst the partners and other important employees to reflect changes in the strategic direction of your firm. On the other hand, it could be as involved as modifying the formation documents of the firm to include the repurchase arrangements amongst the firm and any equity stakeholder upon the termination of their respective relationship with the firm along with a related financing plan and a specific personnel development plan for the next leadership of the firm approved by the governing body of the firm.

The benefits of creating long-term stability for an organization are undoubtedly worth the work of preparing a succession plan.

Lessons Learned: Succession Planning isn't optional.

Lawrence C. Manson, Jr.
Chief Executive Officer
NexTier Companies, LLC