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Active fund managers and institutional investors have
complementary goals. A more dynamic, symbiotic relationship between
these entities is possible through an innovative contracting
solution.
At present, the low-yield investment return environment is more
a long-standing condition than recent development. With interest
rates having scraped the floor for more than a decade, and equity
market valuations currently at historically high levels, the
traditional 60:40 portfolio of equities and bonds does not pass
muster for the large-scale investor who needs to meet mandates so
that public servants’ and first responders’ pensions remain
funded. Enter the nimble-minded active fund manager who has the
inside view on market-beating strategies that make the most of the
opportunities alternative asset classes such as hedge funds and
private equity have to offer. With private assets dominating
performance charts and hedge funds offering improved risk
mitigation over other assets, alternatives have become critical
tools for institutional investors.
Despite these benefits, alternatives have suffered their share
of malaise that, at least on the surface, appears to run contrary
to institutional investors’ goals of stewardship on behalf of
their funds’ target recipients. Despite hedge funds and private
assets helping to deliver market-beating returns to public coffers,
the public images of these investment classes have taken a beating.
When it’s not headlines over Reddit-enthusiast meme stocks
sapping a smaller hedge fund firm over some perhaps misplaced
populist cause or headlines over a beloved retailer coming under
private equity control, it’s politicians wagging fingers over
the management fees associated with alternative asset classes
— the very investments that have helped to bolster public
pensions’ solvency.
Concerns about fees are certainly valid. When an investor hires
an asset manager, part of the agreement is the latter will serve as
a fiduciary on that fund for the former. It is thus incumbent on
the asset manager to offer the strategies and portfolios that not
only offer the highest returns but also the most cost efficiency.
At the same time, however, institutional investors tend to be
beholden to governance structures that prevent easy movement among
funds and strategies. Reallocations to any new funds or strategies
are subject to negotiations and approval processes that often take
several months to a year for approval. This means investors might
lose out on opportunities provided by the market — defeating
part of the purpose of hiring talented asset managers in the first
place.
There is also the matter of how far asset managers’
fiduciary duties extend. Common practice among investors is to
allocate to one investment strategy at a given time. Yet an asset
manager’s fiduciary obligation only goes as far as the fund in
which the investor has allocated. Fund managers are not explicitly
prohibited from giving advice to benefit the investor; however,
they are in no way obligated to give information about strategy
rebalancing or investing in other funds.
Here comes the disconnect. Managers who spend their days parsing
out these investments and strategies have plenty to offer investors
on this front. An ideal symbiosis between asset manager and
investor would allow investors to reallocate among strategies and
funds without the encumbrance of lengthy approval processes and
free up the mental bandwidth to meet their mandates of expected
returns. For their part, asset managers would be rewarded on the
overall value they bring to the institutional investment
relationship, rather than on the performance of a given fund. Both
parties would be empowered to bring the best returns possible for
the first responder or teacher recipients of a pension fund or
offering grants and scholarships to prevent promising students from
having to take out loans to attend their dream schools.
Enter the Strategic Relationship Agreement (SRA), a platform
that allows institutional investors the flexibility to allocate
across asset classes depending on market conditions to drive the
strongest, risk-adjusted returns within a structure that allows for
cost-effectiveness. The associated management and performance fees
are calculated in aggregate across investments, leaving fund
managers incentivised to take a proactive role in helping their
investors reach their target mandates. Overall, it is a win-win:
Investors can avail themselves of the latest in best-of-breed
investment strategies, while fund managers can enjoy the
opportunity to see the fruits of their work in alternatives do good
for society’s civil servants and their retirements. Even the
most cynical of newspaper reporters and populist critics can get
behind that sentiment.
Strategic Relationship Agreements: Their History and How They
Work
After the late-2000s financial crisis, institutional portfolio
management has never been the same. Alternative asset classes now
play a key role in helping institutional investors such as pensions
and endowments obtain better risk-adjusted returns while delivering
on the mandates to meet — if not exceed — their
obligations.
By the end of March 2021, US public pensions had $5.14 trillion
in assets under management.
As of year-end 2020, US public pension alternative asset
allocations were at 19.4 percent, according to statistics from the
National Association of State Retirement Administrators. Statistics
from the National Association of College and University Business
Officers (NACUBO) and the Teachers Insurance and Annuity
Association of America (TIAA) released in February 2021 show the
amount of assets under management across 705 US endowments at
$637.7 billion; with 20 percent in alternative assets.
During the early 2000s, many institutional investors had turned
to funds-of-funds, which effectively were a one-stop shop for
investors. They offered ready-packaged diversification without
having to go through the process of vetting individual fund
managers. Many investors found that funds-of-funds came at a
literal and figurative cost. Both the layers of fees and the lack
of transparency turned out to not be the best fit for their needs
in terms of fee control and reporting to key external
stakeholders.
Amid the trend toward hiring individual asset managers’
strategies and funds, investors were still craving agility to move
among strategies to steer a course during market volatility. Among
them was the San Bernardino County Employees Retirement Association
(SBCERA) pension fund. During the Global Financial Crisis, the plan
was generally able to take advantage of the crisis by deploying
capital into deeply discounted credit opportunities, though
sometimes was frustrated by an inability to take advantage of
opportunities if they did not already have an appropriate structure
in place.
Born out of this need was the Master Custody Account (MCA), the
prior nomenclature of the SRA. The MCA outlined over 40-50 pages of
a legal platform by which institutional investors such as pension
funds had the ability to allocate throughout an asset manager’s
strategies and funds as needed, rather than on a fund-by-fund
basis. The MCA outlined specifics on fiduciary duty: agreements
between fund managers and investors; adherence to any policies set
in place by the investor’s board or state and local laws; and
established the investor’s total annual capital allocation and
a cap on expenses. In essence, the structure allowed an investor to
tap into the entirety of an asset management firm’s brain trust
while resting assured that the firm was working in its best
interests.
The SRA model gives investors the leeway to reject any fund or
strategy that their asset managers present, meaning that the
investor isn’t just buying what the fund manager is selling.
They evaluate the recommendation relative to their current
holdings, impact on total portfolio and available opportunities.
This puts the fiduciary duty on the manager to present ideas and
investments that best fit an investor’s targets and risk
profile. Once an SRA is in place, fees related to a specific
investment should be immaterial as the SRA supersedes individual
fund or deal fees. Rather than measuring the performance of a given
fund, however, the asset manager’s performance is measured
across the entire relationship of funds and strategies to which the
investor has allocated. In addition, signing on to a wider range of
funds means drastically less paperwork, approvals, and public
hearings when a pension decides to allocate to a different
strategy, meaning the investment stakeholders are positioned to
take advantage of market opportunities as they happen.
The SRA model’s outsized success has gotten other
institutional investors to take notice. Since its inception almost
a decade ago, other major investors are on-boarding the platform to
help them make the most of what fund managers have to offer. One
thought-leading program that has embraced the SRA is the Arizona
Public Safety Personnel Retirement System (PSPRS). After
significant review and analysis, the program recently moved forward
in establishing an SRA with one of their best performing and
trusted managers, Crestline Investors. More than half of its $12.7
billion portfolio is allocated to alternative asset classes to
deliver uncorrelated returns, and the ability to pivot in the
alternative asset space when needed is indispensable to the
investor. Says PSPRS Chief Investment Officer Mark Steed,
”The structure allows us to move quickly on direct deals
and co-investments with partners we’ve thoroughly vetted and
who have performed above expectations across a number of funds over
many years.”
Significant benefits extend to the asset manager side as well. A
New York-based firm that has MCAs in place with multiple
institutional investors landed four $500 million, five-year
platforms with European investors after they heard about post-MCA
adoption successes.
In a financial market dislocation, market flexibility is
everything. During a prolonged positive market, managers might
become complacent and feel comfortable staying the course. When
that bull run goes sideways, the agility that an SRA affords can
mean the difference between investors delivering market-beating
returns or having to answer to eager newspaper reporters about
losses in the pension fund under their oversight.
The Structure of SRAs and Considerations for Investors
When developing a Strategic Relationship Agreement, the investor
and asset manager work out the general terms to guide the
relationship such as the types and classes of investment the
manager is allowed to recommend. The SRA encompasses the
investor’s overall stipulations (though certain private
investments may require an additional side letter to address any
fund-specific issues). This process typically requires legal and
investor oversight. In the end, however, it works out to be much
more cost-effective than what would be needed to invest in multiple
individual funds and strategies with the manager. From there the
investor, usually its CIO, approves which investments are going
into the SRA following due diligence by their team on the specific
recommendations presented to them by the investment manager. The
initial SRA approval typically outlines the maximum amount to be
allocated to the asset manager over a given timeframe, with the
investor retaining control over the allocation process.
Overall, the SRA lends a level of transparency and fee
efficiency befitting the scrutiny accorded to massive public
coffers. The investor and manager negotiate fees and other
stipulations on an SRA-wide basis. Moreover, as the investor has
wider access to an asset manager’s strategies, the management
and performance fee rates tend to be lower, as the larger and
broader investment relationship is taken into consideration.
Compliance concerns are acknowledged at the outset as well. Having
to do this process for each individual fund would prove an arduous
exercise in approvals and contracting delays that could invalidate
a time-sensitive investment opportunity.
SRA Success Stories
Tim Barrett joined Texas Tech University System (TTUS) in 2013
as Assistant Vice Chancellor and CIO. Before taking the helm of the
TTUS program, he had observed the benefits of the MCA / SRA
contracting model that derived from SBCERA. He credits part of the
sea change that has come to the now $1.6 billion endowment to the
SRA model. According to NACUBO data released in February 2021,
Texas Tech’s endowment now ranks 88th out of 717 colleges and
universities based on size.
“It was a rebuild from the ground up. When I came in, we
were in the 100th percentile in the NACUBO universe on a three-year
basis…We have made a lot of progress,” Barrett told trade
publication The Trusted Insight during a 2018 interview.
“Investment program changes of this magnitude truly require
that all stakeholders are engaged and supportive. The use of a
portable Alpha structure and the MCA program are by far the biggest
structural changes.” Texas Tech now has more than a dozen MCA
/ SRA structures in place, accounting for more than 10 percent of
its portfolio. Barrett stated that the SRA structure is extremely
flexible in that it can utilize funds or co-investments.
Furthermore, the authority to transact is driven by the guidelines
within the structure, meaning a thinly staffed office can set
stringent guidelines and have the manager implement without staff
involvement, or the staff can be fully involved with full authority
to accept or decline any fund or co-investment. In short, the MCA /
SRA is viable for virtually any institutional investor.
Maples Group, a leading provider of fund services to investors
and asset managers, brings first-hand expertise on this front.
James Perry, the Head of Institutional Investor Solutions at the
firm (and incidentally, the author of this article) was one of the
co-creators of the platform, along with Thomas Hickey III, Partner
and Chair of Fund Formation at law firm Foley & Lardner.
Perry now spearheads an internal team at Maples regarding the
SRA, helping both sides of the table understand how the structure
unlocks value and designs the tech and operational support to
provide for seamless reporting and accounting. Both Hickey and
Perry have written and presented on the topic many times. After the
publication of an article in the Journal of Securities
Operations & Custody by Hickey and his team at Foley &
Lardner, Hickey was invited to speak on the topic at Harvard Law
School by Professor Holger Spamann and Associate Manish Mital. From
reading the article, they believed the structure of the agreement
could be game-changing for institutional investors and their
contracting with managers. Since 2014, a class on hedge and private
equity fund contracting at Harvard has included the topic, with
Hickey as a regular lecturer.
Being able to tap into the latest market-beating strategies when
needed — and having the leeway to do so — helps
investors make the most of their allocations. On many levels, the
SRA is a perfect tool. When there is a market movement, the SRA
allows investors to be the first to respond — meaning lasting
benefits for all who participate in those well-managed
institutional investment funds.
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guide to the subject matter. Specialist advice should be sought
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