When it comes to marketing their services, minority and women-owned firms are finding they're caught in a Catch-22: They need name-brand clients to draw in more business, yet it's those same clients that are the toughest on negotiating fees.
Sponsors are increasing their hiring of minority managers, but at the same time are trimming manager rosters and taking a harder stance on fees.
The combination is leading to steeper competition among firms for every piece of business, and often pits emerging managers against each other in a pricing war that can only hurt them, said Edward H. Seidle, president of Anvil Institutional Services Inc., New York, a minority-owned brokerage. Mr. Seidle, a former Securities and Exchange Commission attorney, occasionally advises clients informally on their emerging manager searches.
The annual survey of investment management practices among institutional investors by Greenwich Associates, Greenwich, Conn., found an increase in the use of minority managers and the expectation that even more will be hired. The percent of funds using minority managers increased to 18% in 1993 from 15% in 1992, and the number of funds planning to hire minority managers this year grew to 7% from 6%.
But the funds, faced with the expectation of lower investment returns, are trying to hold the line on fees.
A study by Callan Investments Institute, San Francisco, found 60% of plan sponsors negotiate fees, with 28.6% getting discounts of up to 10% off the stated fee schedule; 38.1% getting 10% to 20% off; and 21.4% getting more than 20% off the schedule. And Christian M. Washington, principal with the consulting firm Washington Hackett Poitevien, New Orleans, said he has seen searches lately where a qualified finalist was knocked from the top of the list because the firm would not negotiate fees.
"The writing is definitely on the wall. There will be more fee pressure. Organizations need to realize that," said James Francis, portfolio manager at Beal Investment Co., New York, an equity manager with $425 million in assets.
As more trustees talk to each other about fee negotiations, more sponsors will try it, he said. Managers need to state their case ahead of time, explaining their fee schedules to consultants and sponsors before it comes down to negotiating fees, he said. Most of the executives interviewed for this article note they already try to price below the market average.
The pressure on fees has caused at least one public plan sponsor to scrap its emerging manager program. The board of the Virginia Retirement System, Richmond, decided last summer to phase out the Development Fund, a farm team of emerging managers that had approximately $360 million allocated among 10 firms. At the time, fund officials said the board felt the concept was expensive to run, required additional oversight from its consultant, RogersCasey, and resulted in a higher fee structure because of the smaller allocations involved.
Smaller managers are caught in a bind as funds trim their rosters, said Mr. Washington, because sponsors tend to have doubts about the ability of an emerging manager to handle large allocations.
Most fee negotiations are driven by the myth of some positive correlation between the amount of assets under management and the manager's ability to handle the allocations, said Mr. Washington. That bias tends to hurt emerging firms when competing for business, he said.
He countered that if Peter Lynch, the former manager of the Fidelity Magellan Fund, were to start his own firm, sponsors would not have a problem allocating $500 million based on his substantial track record.
"There should theoretically be no difference between Peter Lynch or Patricia Lynch or Kwai Chung Lynch or Javier Lynch," said Mr. Washington.
In a way, the sponsor dealing with an emerging manager is in the driver's seat during fee negotiations: The firm needs the sponsor more than the sponsor needs the firm. Small, new firms trying to get established need prestige accounts to gain the attention of still other funds to increase their business.
"When I got that first account, I had no negotiating leverage. I needed that account," said Adela Cepeda, managing director of Abacus Financial Group Inc., Chicago, a 3-year-old fixed-income firm with approximately $300 million in assets.
Ms. Cepeda took that first account below cost, but has been firm on pricing ever since. It was nearly three years before the firm broke even, said Ms. Cepeda. Accounts were small - the average portfolio size for the firm's intermediate-duration strategy is $10 million to $15 million - so it took roughly $200 million in assets to break even, she said.
Sponsors recognize there are economies of scale in larger portfolios, but they don't apply the reverse dynamic to smaller portfolios, said Ms. Cepeda. The costs to the manager are about the same, but with the smaller allocations the sponsors are willing to give emerging managers, the managers need higher fees, she said. Sponsors will award a manager a $10 million account, and ask for the same fee schedule as a manager with $100 million or $200 million, she added.
"We're (managing) an account where all (of the client's) other managers in fixed income manage hundreds of millions of dollars. The fee negotiations were a horrible event," said Ms. Cepeda. "I kept saying how much money they (other managers) had under management and they said 'well, that doesn't matter; that is just the rate we pay.' They were very large; they were one of the largest public pension funds around."
Taking loss-leader clients while starting out is OK, just don't make a habit of it, warned Mr. Washington. If the firm's finances can handle it, the manager can choose to work for a small fee for a brief time and then try to get a larger allocation with better fees. When Mr. Washington's own firm was starting, he said some clients paid less than they would to the average consulting firm, but the firm since has been able to charge normal fees.
It is a business decision to take name-brand clients at a loss to generate more business, but it can siphon off revenue and capability in the long run, he said.
But taking in loss leaders sets a bad precedent that can drag down the entire fee schedule, said Michael L. Green, president of EverGreen Capital Management, Omaha, Neb. EverGreen has $102 million in assets. He noted many funds are increasingly requesting "favored nation" clauses in their contracts that specify they will pay fees only as high as the client paying the lowest fees.
The result is a Catch-22, said Mr. Green. A low-ball fee sets a precedent that draws down revenue at a time when the firm is growing and needs to add staff and systems.
"If the new business is costing you, it's really tough," said Mr. Green. "I know of small emerging firms that, as a policy, if the fees are too small, they just bite the bullet and walk away. In the long term, they have to protect the integrity of their fee schedule."
Sometimes, a firm has to be ready to walk away from business that doesn't make sense, the managers say. Mr. Francis said Beal Investment once walked away from negotiations. Fortunately, he added, the sponsor reconsidered the proposal and they were able to reach an agreement.
Managers argue low-ball fee arrangements are a case of the sponsor cutting off its nose to spite its face. They claim an unrealistic fee schedule makes it impossible for a manager to reinvest in staff and support for its accounts, and the quality of service eventually will suffer.
"It's certainly in the client's best interest to pay a reasonable amount to the money manager that will allow them to pay staff and computer systems to service the accounts. That should pay back to the client in spades," said Catherine Friend White, owner and portfolio manager of Financial Architects, Lexington, Mass. The 4-year-old equity and fixed-income shop has $18 million in assets from individual and institutional clients.
"If a particular firm doesn't make the money to pay talent to run that firm, you're getting what you pay for," said Mr. Green.
Low-balling will be bad for the industry in the long term, said Beal's Mr. Francis. The market is saturated, so some players will use pricing as an edge, but when firms get squeezed to the point where they can't reinvest, it will be sponsors' accounts that will suffer, he said. The market will shake down and the trend will reverse itself eventually, he added.
There is hope, said Mr. Washington. There is an increasing perception among sponsors that emerging managers should not necessarily be paid less for their services. He noted his firm oversees a manager-of-managers fund for the University of Texas where overall fees are not far for the norm and one for the New York State and Local Retirement Systems where the fees are commensurate with the market's average.
"In defense of plan sponsors, some of the sponsors that I work with recognize that we're small and we have to maintain the fee levels," said Mr. Green. "They recognize the small firms need the business, but they also need the revenue. Most plan sponsors I talk to want to see you grow. The ones that are sensitive to that issue don't try to squeeze you on the fees."
Managers have to play up their entrepreneurial aspect of their organization and their track record, said Mr. Washington. Funds have an increased focus on alpha, a risk-adjusted, after-fee positive rate of return on their investment, he said, and that can help a star manager.
"Our theory is that emerging firms are made up of the stars of the (established) firms, so it stands to reason that these smaller firms will outperform their largest counterparts," he said. "You should be able to say: 'Look at my track record. I have a record of giving you alpha.'*"
Additionally, the small-firm executive can point out that the firm can offer better and more rapid response to clients than a large, more bureaucratic firm, said Mr. Seidle. He recommends the firms play up the client service aspect and stress that when sponsors want answers they talk to the person who owns the firm and manages the money, and not to a dedicated marketing person disengaged from managing actual assets.
"That's your strength as a small firm," said Mr. Seidle. "Small firms have to play up the fact that 'we're small, but we're a small group of very smart people.'"