Fund managers should be able to say no to new cash

August 11, 2010

It stands to reason that the more money flowing to a particular investment strategy, the more likely returns will diminish. By logical extension, fund managers should therefore occasionally say no to new cash to keep from hurting performance. But in the money business, that’s easier said than done, especially when considering the growing number of alternative asset managers that are publicly traded.

For a fund manager with shareholders to please, this makes for a potential conflict of interest with investors in its funds. The more assets a firm gathers, the greater its earnings. That’s particularly true in more specialized arenas of the investment world, such as private equity, distressed debt, event-driven and convertible arbitrage, where the fees typically amount to 2 percent a year plus a 20 percent slice of any profit.

Take an imaginary fund that buys debt issued by troubled companies, a mercifully finite universe of investment opportunities. Say the manager limits the size of the fund to $5 billion on the expectation of a 12 percent annual return. Management fees would reap $100 million. Hitting the performance target generates another $120 million, though many investors insist on minimum hurdle rates. Still, add it up and that’s some $220 million of fees, with a 9.6 percent net return for investors. Not too shabby.

Now, consider a $10 billion fund targeting the same securities, but with annual return assumptions of 8 percent to reflect its larger size. Management fees would double. And a 20 percent slice of the profit would bring in $160 million. That’s $360 million for the fund manager — or nearly two-thirds more than the smaller fund. But for investors, the total return would be a third lower.

This hypothetical calculation illustrates the conflicts fund managers face. True, performance ultimately determines the future flow of funds. But the incentives to scoop up new money, even if it dilutes returns, are strong. Some fund managers are managing admirably to resist the temptation.

Take Oaktree Capital, the Los Angeles-based fund manager led by Howard Marks. The firm will soon close its latest distressed debt fund at $4.5 billion despite far higher investor demand. Its last fund invested $11 billion for investors. As a privately controlled entity — though its shares are listed on a private market overseen by Goldman Sachs — that’s an acceptable tradeoff. But when public shareholders are in the mix, who will say no?

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