Netting risk anywhere is a threat to returns everywhere.
I have taken the liberty to repurpose one of the great quotes of the 20th century, and adulterate it, to elucidate a far more pedestrian financial concept: That of netting risk.
I took for granted that this was a widely known and understood concept. However, recently I have encountered a multitude of investments and trends where it was highly applicable and seemingly underappreciated by other investors. In fact, many institutional investors appeared to be unfamiliar with it, did not entirely understand it or had undervalued the importance of it. Aside from vague definitions of the concept of “netting,” I was unable to find any specific definitions online of “netting risk” in the context of investing in direct or co-investments, multimanager models, funds of funds or alternatives more broadly. According to Investopedia, netting is defined as “consolidating the value of two or more transactions, payments or positions in order to create a single value.” Let us now transition into how all of this fits into co-investing, multimanager models and FoFs.
Most alternative managers, including those in the three aforementioned categories, collect incentive fees that are based on performance. If we have a single hedge fund, Manager A (in the first year of launch to obviate confusing the issue with high-water marks) the manager is up 20% on a $100 million investment, with a 20% incentive fee (assuming no management fee to simplify the discussion), that implies the manager is due a 4% incentive fee from investors, or $4 million. Now assume the same investor invests $1OO million in a second manager, Manager B, who is down 20% the first year. On a gross (pre-fee) basis, the investor is flat, as the $20 million gain nets against the $20 million loss. However, on a net (after fee) basis, the investor has paid Manager A $4 million, which is not netted against the loss from Manager B, as the two managers are unrelated, and the investor is left with $196 million, or a 2% loss, which is the netting risk, having not had the benefit of netting the loss against the gain to pay no fees on flat performance. Any time an investor invests in more than one unrelated fund, with performance fees, the investor bears the netting risk.
In multimanager models, for the purpose of simplification there are two permutations. In the more limited-partner-friendly permutation, Multimanager C, the general partner, bears the netting risk, and if managers A and B were working for C, the GP of C would have to pay A its incentive fees out of the GP's retained earnings, the founder's own pocket or tell A that B's losses offset his gains and A is not getting any incentive fee. In any case, paying and retaining A is the GP's problem and the investor does not pay any incentive fees because on a gross basis he is flat.
In the less limited-partner-friendly model, Multimanager D, the investors bear the netting risk, and are essentially passed through the incentive fee expense on the portfolio managers that are up, without the commensurate benefit of the off-sets from those manager that are down. In this example, if managers A and B were working for D, the investor would have $196 million, having paid A's incentive fee and not benefited from the off-set from B's losses. Although sophisticated institutional investors understand this, a large percentage of the less sophisticated investors do not understand or realize this. I believe netting risk is a concept that seems and sounds simple, but many investors have not spent time thinking about and consequently do not understand it, although they are too embarrassed to admit this.
Although co-investments vs. commingled funds might seem to be a non-sequitur, the analog is entirely parallel. For various reasons — many, though not all, unwarranted — institutional investors have become disenchanted with commingled private equity funds, and have embraced co-investments as the panacea. Ironically, the co-investments are often offered by the same firms that did the commingled funds in which the investors were unhappy with the structures due to a lack of control, poor liquidity, inability to trade single holdings, etc. What these investors often miss is that they are now bearing the netting risk if they do multiple one-off deals or co-investments. That happens, obviously, with different firms, but also if they do them with the same firm, no longer benefiting of the commingling and netting of risk benefits. Shifting gears to real estate for a moment, we recently conducted due-diligence Fund VI of a multibillion-dollar commingled real estate private equity fund with a multiyear track record. We were appalled to learn the incentive fees were at the property level, leaving investors to bear the netting risk at this GP-friendly, LP-unfriendly firm.
In conclusion, unless one invests all of one's assets in one fund, where the general partner bears the netting risk — which is impractical, unlikely and results in other unintended risks, such as concentration, business and fraud risk, to name a few — one will by definition almost always be subject to netting risk investing in fund structures with third parties whose fee structures rely on incentive fees.
I am a believer in the value proposition of alternative investments, as well as their use of incentive fees to align general and limited partners. That said, I also believe institutional investors would be well served by having a better understanding of netting risk, not investing in and spurning funds where the general partners places the netting risk on limited partners and diminishing diversification to deals or managers within a strategy when a similar outcome can be achieved with one manager or commingled fund, with that GP bearing that netting risk rather than the LPs.
Michael Oliver Weinberg is chief investment officer of MOW & AYW LLC, a family office in New York, and an adjunct associate professor at Columbia Business School.
