STOP. Do You Know What You’re Signing?
Reported by Elizabeth Pfeuti Illustration by Alex Eben Meyer
If a taxi driver offered to take you in the general direction of where you wanted to go, but would choose the route himself and leave the meter running for years after you had alighted, it’s fairly likely you’d refuse the ride.
If a car salesman sold you a car without allowing you to look under the bonnet, then charged you a fine when it broke down outside his showroom or asked you to pay him to take it back, you might be a little annoyed.
If you took your dentist to court for doing a bad job on your teeth, then found out you’d been paying her legal bills to fight the case, you would probably lose faith in all dentists.
Yet replace the perpetrator in any of these scenarios with a fund manager, custodian, or bank and it’s likely you have already been in such a situation—and it is happening to institutional investors the world over.
Rather than the contracts investors sign not being worth the paper they are written on, they often end up costing them millions more. And perhaps the most shocking part is that it’s not the small print that’s the problem.
Let’s look at the evidence.
Consider Exhibit A from a London-based corporate pension CIO:
“A couple of years ago, we found a large hedge fund to be in breach of its duty of care. We had asked for our money to be moved from one of its funds to another. We thought it would be fine, as the manager had already done it for other clients—but they would not do it for us.
“We pointed them to the contract saying everyone had to be treated the same. They redirected us to the vital component of that legal item, which we had previously not thought about, that said this was to be at ‘the manager’s discretion’. As one of the largest investors in that fund, if we had moved it would have looked like a run on it, so we understood their point. However, we lost money by being there while those who had moved did not.”
The pension sued the fund manager for losses.
“… During which time, the fund regained a bit and the manager dragged out the procedure for so long it would have ended up costing us as much in legal bills as we had lost. As the fund was doing better, we cut our losses and dropped the case.”
We turn to Exhibit B, from a FTSE 100 company pension CIO:
“I once arrived to work at a pension and found the International Swaps and Derivatives Association agreements allowed the counterparty bank to post anything at all as collateral (euro-denominated credit, junk bonds) whereas the pension could only post UK government bonds or cash. I was incredulous.”
The CIO changed the contracts. The financial crisis hit. No harm was done.
Now look at Exhibit C, from a public sector CIO based in the UK:
“The latest contract we were asked to sign was with a custodian, and it was loaded in favour of the provider. Superficially, it seemed to indemnify us, but looking closely we realised that if/when a problem arose, this problem remained ours and not the custodian’s. For example, if a sub-custodian that they chose collapsed or lost our money, we would have to sort it out. I would love to say I was surprised to see this in the contract…”
In 2015, this is the state of play. Alignment of interests? No chance.
Look past the courtship of golf days, Michelin-starred dinners, and money-can’t-buy sporting events. Your assets are a means to an end for financial market participants. They have shareholders, partners, and larger business parents to satisfy—and your naivety makes you fair game.
“It’s strangely interesting to see how the relationship changes,” says one pension investor. “It starts out with the manager being totally reasonable and friendly, and then once you’re in, it all changes.”
Contracts with fund managers, banks, and other providers should offer investors security in a deal. Both sides are able to read and sign up to the contract, which should be expected to treat all fairly.
Fund managers running an illiquid strategy do not want to put their other investors in jeopardy if one party suddenly decides it wants its money back immediately, for example. And if a hedge fund or other financial institution suddenly blows up, is it your custodian’s fault and duty to refund your losses? Of course not, and no asset owner would (or should) ask for special treatment.
But, increasingly, the dice are being loaded in the provider’s favour in the hopes that the investor will either lack the expertise—or the backbone—to do something about it.
“The problem is getting worse as documents are not even being reviewed by investors,” says Judith Donnelly, partner at law firm Squire Patton Boggs, who has also worked as internal counsel for an asset manager. “For example, I have seen clauses saying that even in the case of gross negligence, an investor would not be able to sue the manager. That’s absurd.”
For anyone who has read that a financial institution has neither denied nor accepted an allegation of negligence—even if a multi-million dollar settlement has been paid—it is to do with legal contracts. As soon as they acknowledge the term ‘negligence’, they leave themselves open to investors activating clauses in their contracts to either pull money out or stop paying lucrative fees.
If it is a portfolio manager’s job to make good, consistent returns to attract investors into the fund, it is then up to the general counsel to get as favourable a deal to the manager as possible, say pension lawyers.
As bitter a taste as this might leave in the mouth, the motive is at least understandable.
“I realise that fund managers have to make money,” says one London-based CIO. “There’s ‘tough but fair’, but then there’s ‘totally irrational’. I’ve seen fund managers quoting a 20% management fee plus ‘costs’, which in the contract are unspecified and uncapped. Who would sign that?”
It is not just happening in Europe.
“Partnership agreements are becoming increasingly general partner-friendly,” says Robert Lee, director of hedge funds at Employees Retirement System of Texas (ERS). “It happened before the financial crisis as the power ebbed from investors to managers, it improved during the crisis as investors held the power, and now it is slipping back again.”
“Investors usually have external lawyers, who charge by the hour, so negotiating the removal or amendment of these clauses can be an expensive business,” says Donnelly. “Fund managers know this, so will drag out this part of the process for as long as possible and hope the investor gives up. But that’s a false economy for the investor if it all blows up.”
It would be an appropriate time to acknowledge the point that lawyers have a vested interest to make a big deal out of the problems with investors’ contracts. After all, the more problems there are, the more billable hours they create.
This point misses the bigger picture though, says our friendly third-party counsel.
“If the investor gets the lawyers in early, when they still have a shortlist of asset managers—when they are still in golf-trip mode if you’d like—the managers are more likely to be cooperative than when they have already won the business,” says Donnelly. “The manager could be offering the best fund in the world, but the contract conditions could make it the worst—and most expensive—for the investor. It would end up cheaper for the pension fund in the long run to bring us in early.”
It’s also not just lawyers who are taking issue with legal agreements. Last year, the US Securities and Exchange Commission (SEC) set its sights on contracts, with a particular slant towards private equity.
In a speech to the industry in May 2014, Andrew Bowden, then-director in the SEC’s Office of Compliance Inspections and Examinations, said, “We see that most limited partnership agreements do not provide limited partners with sufficient information rights to be able to adequately monitor not only their investments, but also the operations of their manager.”
“Of course, many managers voluntarily provide important information and disclosures to their investors,” Bowden continued, “but we find that broad, imprecise language in limited partnership agreements often leads to opaqueness when transparency is most needed.”
Ambiguity, it seems, is the fund manager’s friend.
In this speech, Bowden also highlighted areas—mainly related to hidden fees—that the SEC would like private equity practitioners to address. One of these was accelerated fees, a term that describes a practice from which, if applied to their own cash, investors would reasonably run a mile.
Going back to the taxi driver analogy, these fees are explained thus: a passenger (or investor) continues to pay (often uncapped) commission to the bellhop who hailed the cab for years after they were delivered to their destination. And payments to the bellhop can even continue for several years after the taxi driver has sold the vehicle.
It is so commonplace that several of you reading this article will be in line to pay it—or may already be doing so.
“The problem is getting worse as
documents are not even being reviewed
For example, I have seen
clauses saying that even in the case of
an investor would not be
able to sue the manager. That’s absurd.”
But should all the blame lie at the door of the fund managers?
“Why would managers change if there is someone still willing to pay?” asks Texas ERS’ Lee. “Many allocators do not even read agreements, so they stand no chance in understanding how unfriendly they are. This ensures there is an environment for this type of activity.”
“Clients have bargaining power, but many of them feel like they don’t want to use it,” says a UK pension lawyer. He has been told by colleagues that their clients consider them to be a pain in the neck and obstructive.
“It’s expensive to employ a lawyer to look over every contract,” says the CIO of a large UK public sector pension, “but there is a need to spend this money. I’ve heard ‘these are the standard terms’ so many times and ‘it’s a regulatory requirement’ when neither is true. You wonder how many people have fallen for it if they think it will work on me.”
The CIO of a FTSE 100 corporate pension thinks the asset owners who remain unaware of or refuse to tackle the problem are making things worse for the rest.
“We asked our consultant to benchmark where we were on the scale of fees we were paying compared to our peers (not according to what we agreed, but what we actually paid after all the extras were put in) and we were in the bottom third,” he says. “Pension funds don’t negotiate hard enough on this.”
Another problem lies with some in the market not wanting to get a reputation for being difficult.
“If you keep walking away from deals, you’ll lose your job as an investor. Allocating assets and making a return is what you are paid to do,” says one US asset allocator. “Also, there are some who think that by the time something major happens, they’ll likely not be there to pick up the pieces anyway...”
So much for fiduciary duty.
The jury’s attention is turned to Exhibit D, submitted by an experienced CIO who is ramping up his pension’s direct investment portfolio.
“We were looking at a structured deal which came to the market. The asset was favourable for liability matching, but the originator had put a clause in the contract that made the economics of the deal unfavourable—or not even worth it for the investor to get involved. We asked for the clause to be taken out. The other two investors who were interested did not even question it and signed up.”
The investors who signed up were—in this CIO’s view—taken for a ride.
“It pays to take notice of what lies in the contract,” he says. “It might seem like a good deal, but it is often cheap for a reason—and it will make life difficult or expensive for you in the end.”
However, many investors continue to sign up for unreasonable contracts as they are counting on the “ifs” not happening. For some who have ridden out the last seven years, this is a fool’s errand
“These clauses are important, as it is when the fund or the manager is under pressure that they will come into play—and we have seen how pressure can suddenly just appear over the last few years,” says one UK pension investor, who previously worked as a consultant. “I have seen some things and thought, ‘If it were my money, there’s no way I would sign it.’ I’m sure there are plenty of fund managers who have thought the same.”
“Legal contracts are there to protect you should something go wrong or if there is a huge shift in the market. They are very important,” says an Australian pension CIO. “As an investor, it’s not about protecting yourself 100% from market moves—you can never do that—but you must realise that a lot of what goes into these contracts can be interpreted differently.”
“We have demanded counter clauses, vetoes, or side letters,” he continues. “Sometimes asset managers say they won’t do side letters as all their clients have to be the same—it’s not as rigid as that, though.”
There is plenty of proof that it is not that rigid.
“At ERS, we negotiate all our contracts,” says Lee. “As a state we require a side letter. We are often successful in negotiating a new share class with better terms than the ones they may be offering. If a manager will not change the contract when we require change, we walk away—even after a lot of work has gone into the selection process.”
One large corporate fund has red and amber “deal breakers” that it has worked out with lawyers to head off tricky questions with managers. Another large UK pension requires fund managers to insert clauses into contracts to fit with its investment policy, such as concentration limits. “If a manager won’t put it in, we will walk away,” its CIO says. “It’s a shame if we have put a lot of work in, but it’s just not worth it—and we owe it to our members to do so.”
Another UK pension has a back-up plan (or two) when confronted with such a situation.
“We always have a plan B and C if we can’t get what we want on the legals,” says its manager. “For each contract we will have at least two shadow managers on standby. We like the asset class; that’s why we’re there. The manager is the second part of the decision, and we have choices.
“There is no such thing as a standard clause and when I have been told that is the case and the manager won’t change it, I have walked away,” he adds. “I see very few strategies that I would describe as unique and that I couldn’t get from someone else with a more reasonable contract.”
While it is noble to take the moral high ground, after weeks—if not months—of work selecting first an asset class, then a strategy, and finally a manager, it can be difficult to actively fall at the final hurdle by walking away from the deal.
“In the public sector, we have deadlines around how long a mandate takes to be awarded,” says a UK public pension CIO. “If we don’t manage it in that timeframe, we have to extend the contract with the provider we are quitting—and they are often less than accommodating.”
“We would consider walking away, but I admit when a lot of time and money has been spent on the process it is hard,” he continues. “Especially when it is only really an issue if—or when—things go wrong. We are dealing with firms that are regulated, so we should be safe, but there are times when I wonder how these clauses get through.”
This is a question an increasing number of investors are asking—how are these clauses getting through when the bills paid to ancillary service providers are going up?
Consultants could be the first port of call. They hold the investor’s hand from the asset-liability management study to manager selection. Shouldn’t they be spotting more of these unreasonable terms?
“There is a problem with the process,” says Donnelly at Squire Patton Boggs. “If consultants have worked hard to get a solution for their client, they don’t want to hear at the end of this process that there are problems. It’s understandable—it’s human nature.”
But human nature doesn’t help when hundred-thousand-dollar invoices for uncapped fees arrive to eat away at a pension’s funding level.
“Consultants are often so focused on fees that they are not made to work to get better terms,” says one relatively small UK pension investor. “Fees appear all the time and are relatively clear. Legals are not as obvious. It’s not immediately clear what the impact could be. For example, clauses on liquidity could impact your entire portfolio—but it’s very difficult to quantify, especially when the market moves erratically and unexpectedly.”
The CIO who walked away from the structured deal mentioned earlier thinks it’s beyond the remit of both the consultant and the lawyers.
“There is a disconnect or a gap, which is where this falls,” he says. “Consultants are paid on this stuff, but I’d be surprised if they even look at it. They show they have negotiated on fees, but who is going through the economics of transactions? Or the processes and operations? Lawyers catch the worst of the clauses, but few work out the economic implications. It’s not as easy as spotting straightforward admin costs or where managers could inflate fees.”
So what is the solution?
“Collaboration is the only way for investors to get what they want from asset managers,” says the public sector CIO. “Local Government Pension Scheme contracts have to comply with a standard. We have agreed on some processes and investment management agreements, which means that some of the smaller schemes that don’t have the might of the largest funds should benefit from our experience.”
In the US they have taken this a step further. Back in Texas, Lee is on the board of the nonprofit Alignment of Interests Association, which brings together hedge funds and their investors to work on contracts that are acceptable and reasonable to both sides of the deal.
“The principles are laid out showing the best practices,” Lee says. “This removes the discussion and gives managers something to build towards. A lot of hedge fund managers have indicated that they support the principles.”
The hypothetical bellhop won’t like it—unless, of course, he’s getting a pension from the likes of Robert Lee or the various European investors who are leading the charge against contractual nefariousness.