We are a long-only, U.S. small-cap value manager with an outstanding long-term performance record especially relative to our benchmark, the Russell 2000 Value index. However, we have been under a fair amount of fee pressure recently both when speaking to prospects and with new clients. I realize we are probably not unique in this regard, but how would you suggest we address this issue?
How do you handle a plan sponsor's fee pressure?
First, you should know that your situation is clearly not unique. There has been fee pressure voiced by asset owners for some time now stemming primarily from disappointing returns and also because many asset managers have repeatedly underperformed their benchmarks. Hence, defined benefit plans have had great difficulty exceeding their actuarial assumed rate, causing their asset/liability ratio to fall dramatically. Likewise, endowment funds have had a very difficult time exceeding or even meeting their spending plan, resulting in universities having to fund portions of their operating expenses from alternative sources of capital.
The fact that you have outperformed your benchmark gives you a strong footing to be somewhat resolute about your current fee schedule. But there are some things you could do to more effectively to draw attention to your outstanding returns. As you know, most private equity funds report “net returns” which simply takes the gross returns and adjusts the return for the fee's impact. So, one thing you could do is to report a net return, total rate of return and show your net alpha over the benchmark, which of course is reported on a gross basis.
You could also demonstrate to your clients that you have produced a very attractive net information ratio which could be derived by taking the alpha adjusted for fees divided by the residual risk you took to generate that alpha. In other words, your alpha net of fees divided by the residual or non-systematic risk your firm took to generate that net alpha.
If you really wanted to be innovative (and this is something I wanted to do about 15 years ago), you can set up a fee schedule that really aligns the interests of your clients with those of your firm. Specifically, your client should be more than willing to pay for the value added or more specifically a risk-adjusted net return that your firm, its team and investment process were able to generate over a jointly agreed upon benchmark over long periods or at least over a full market cycle. Without getting too specific here, you could set up a fee schedule based on your net (fee-adjusted) alpha over various periods and weight the periods such that you are rewarded more handsomely for a net alpha over the benchmark on a rolling three-year period or less for a rolling two-year period and still less for being able to produce a positive net alpha over the last year.
I believe when you show your clients your actual net alpha over the benchmark for rolling periods, that the fee discussion might become a thing of the past.