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“The fundamental point is this: The process of due diligence for transition management is broken.” If there is any doubt, this is Rick Di Mascio—head of London-based Inalytics, ex-plan sponsor, and all-round iconoclast—just getting started. Not all the blame lies with transition managers, however. “Ultimately, plan sponsors have a responsibility for oversight, yet it appears that in the majority of cases the normal rules for due diligence get suspended when it comes to transitions,” says Di Mascio. “At one level this isn’t surprising because the bigger the transition, the more effort it took to get there. It could be a general de-risking, a move towards liability-driven investing, it could be many different things, but whatever the reason they see the finish line and they often just want to get over it.”
Di Mascio has a specific gravitas when it comes to this topic. Although he refuses to discuss the specific incident, his firm recently led the due diligence on a State Street transition gone wrong. The analysis carried out resulted in two senior executives being let go from the firm and the State Street transition management team being brought back under the fold of the well-respected company veteran Nicholas Bonn. Di Mascio was also the chairman of the T-Charter, an industry body set up to establish a code of best practice and standards for the transitions industry.
Di Mascio believes that some transition managers exploit the weariness associated with transitions and trot out some of the most dangerous words in the industry: “‘Trust me, I’ll look after you’—and they say thank goodness!” he says. “It’s a human point, but it’s the start of it all.”
Once this Faustian bargain has been struck, another problem emerges. “In the traditional asset management world, managers would never be allowed to benchmark themselves,” he asserts. Except for Madoff impersonators, “benchmarking is executed by recognized third parties. It’s the same with the performance of the portfolio—it should be independently measured, a standard common across industries as far afield as airlines and energy.” The kicker: “This is not the case for transition management.” In the transition world, according to Di Mascio, vendors “set their own benchmark with a pre-trade estimate then measure their own performance.”
Di Mascio’s words are mirrored by another expert in this niche world: Steve Glass, CEO of Zeno Consulting (formerly Plexus), who—full disclosure—knows Di Mascio well. “I think the issue is less about pre-trade and more about post-trade analysis,” Glass says. “I hear what Rick’s saying, and I certainly don’t disagree. There is this built-in incentive to lowball pre-trade estimates—if they think that’s the key decision-making factor—but I am troubled by the fact that if they are within one standard deviation of their estimate, they consider themselves a success. It’s a wide target—we don’t want to be that forgiving.”
Adding to this problem is the opaque nature of cost. “Transition costing is made up of essentially two parts,” Di Mascio says. “You have explicit costs—a figure printed on the contract, usually somewhere between three and six basis points, plus taxes. That’s the fee. Theoretically, a pension fund transitioning $100 million in assets, for example, would want the same amount of capital the next morning minus five basis points.” However, there is a problem in that prices can move against clients, which results in a shortfall from the previous close. “On average, this used to cost funds 80 basis points eight years ago, and this has now gone down to 20 to 30 basis points,” he says. “However, add that to the five basis points you pay in fees, and you have a 35 basis-point loss.” A fund is relatively indifferent to how it loses money, Di Mascio says. It simply knows that the cost of transitioning the assets was 35 basis points, or $350,000.
The problem arises if a transition manager bundles those costs and quotes a total number—say 40 basis points in total. “What happens if you have $100 million moving to a liability-driven investing mandate from equities?” he says. “How much does this cost? You just don’t know and you have to rely on the transition manager for an accurate estimate. The temptation to game the estimate and to set a benchmark they know they can beat is huge. We can’t say for certain that this goes on, but we see some strange things when we look into our proprietary database of transition manager track records—like there are some managers who nearly always seem to beat their benchmark. Is this skill, luck, or something else?” Additionally, he says, in investment management there is alpha and beta, and “we decided long ago that it was important to differentiate between the two. Not so with transition management. We really don’t know if a good transition is the result of good planning and execution or favorable markets. And we cannot know under the current model.”
Capital owners, if they thought about it for long enough, likely would be unhappy with the current structure. It is, however, ubiquitous. “Which in practice means it is extremely hard to hold transition managers accountable,” according to Di Mascio.
Glass, for one, thinks that looking at past track records of transition managers could mitigate some of these issues. “I would say that what is not done enough is looking at how managers did in all the transitions they previously executed. It may not help in isolated cases—the best auditors in the world can’t uncover collusion, sometimes—but, that said, one of the things that doesn’t get enough attention is for clients to ask their transition managers, ‘Look, your pre-trade estimates should be in line with actual results most of the time, and if you look at a large number of transitions, it ought to be a bell curve.’” A skew either way should be a red flag for potential purchasers of transition management services, he says—but asset owners aren’t demanding this data often enough.
Di Mascio also, unsurprisingly, has some ideas on how to change this. His work with the T-Charter in the United Kingdom—similar to moves by the Pension Benefit Guaranty Corporation in America—has attempted to improve some of the problem areas mentioned above. “We looked at the issues of remuneration and conflicts of interest long and hard, and made some very clear recommendations,” he notes. Di Mascio’s firm has recently been hired by the United Kingdom Government to advise on a $40 billion transition management project—and Di Mascio insists that “we will do everything possible to ensure that the code is applied religiously for this event. So, for example, conflicts of interest will need to be disclosed along with the policy to handle them, sources of remuneration will need to be listed out, [and] the pre-trade will have to disclose the dollar amount of all remuneration received, including [remuneration] from mark up and mark downs.” When the transition has been completed, he says, the firm will measure the outcome, and a view will be taken as to its quality.
Glass raises an interesting point about firms like Inalytics and Zeno Consulting. “It’s self-serving, I realize this, but if transition managers know that a third party is involved, that likely will make them be more diligent in dotting their i’s and crossing their t’s.” Perhaps we can add one more layer to Di Mascio’s original analogy: if the transition is the last step before the finishing line, plan sponsors should consider having an independent third party there to help them over it.
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