Key man risk

Research Review is compiled by PortfolioConstruction Forum in association with Money Management, to help practitioners assess the robustness and disclosure of each fund research house compared with one another, and given the transparency they expect of those they rate.

This month, PortfolioConstruction Forum asked the research houses: Key man risk is often cited by dealer group researchers and advisers as a sufficiently significant concern to prohibit them investing in a boutique and/or specialist investment capability. Is this valid?

MORNINGSTAR

Many investors and financial advisers believe key man risk to be a threat when considering investing in a boutique fund. The risk stems from an overreliance on key personnel for ideas generation, security selection, and portfolio construction. These key individuals are not only integral to a fund’s investment process, they’ve also become part of its brand. This ‘star culture’ approach means that the success of many strategies is highly-correlated to a single manager’s expertise. 

While both institutions and boutiques are susceptible to key man risk, dissimilar frameworks between the two mean that they exhibit it in different fashions. More process-driven institutions impose systematic methods and philosophies on managers in environments with wider resource pools and embedded infrastructures. These provide safety nets in the absence of crucial individuals. In contrast, boutiques can tend to have more flexible structures, providing managers with the autonomy to flourish, and are typically founded on the reputation of high-profile professionals. This cultivates a greater dependence on people. 

However, while key man risk may be more widespread among boutiques, the degree of risk can often be higher at institutions. The irony is that boutiques are frequently born because of key man risk materialising within institutions, and managers flying solo.

Firms frequently take steps to manage key man risk. The most common and arguably the most effective approach is to provide equity to core individuals. By doing so, firms create a personal and financial tie with portfolio managers, which fosters loyalty. The boutique model has a greater ability to release equity to individuals over larger institutions, as seen in higher ownership levels. Equity ownership is not a universal panacea, however, as there are a number of examples of large institutions with strong and stable teams and excellent performance track records. Investors and advisers should also look favourably upon those managers with stakes in their own strategies. Self-investment aligns manager interests with those of investors and incentivises managers to stay.

We don’t believe that key man risk is a sufficient concern to prohibit investors and advisers investing in boutique funds. As stated above, it is not just a problem for boutiques. Despite the preventative efforts of firms, managers may still depart for a multitude of reasons – some predictable, others unexpected. Investors and advisers can therefore address key man risk at the portfolio level. Diversification across more than one fund in a sector can help protect against unforeseen events. Fortunately, investors and advisers should also have time to make a change should an unforeseen event like the departure of a portfolio manager occur. In most cases, the portfolio will be constructed with at least a medium-term horizon, so investors do not have to be forced sellers. They can wait, digest the situation, and assess the new hires and compare them against alternatives. 

So although key man risk is a viable concern, if it is adequately addressed and exposure is managed appropriately, it should not deter investors and advisers from investing in funds – boutique or otherwise.

STANDARD & POOR’S 

Boutiques tend to be more reliant on key individuals than many of the big-brand managers, as well as those managers employing more systematic or lower tracking error styles of management. This is often attributed to boutiques having fewer resources and greater investment flexibility, but also the stock-picking prowess or simply the profile of the founders. However, the back-up and succession plans of the big-brand managers can become irrelevant if multiple investment professionals “jump ship” together. 

While dependence on individuals is typically higher at a boutique (particularly early-stage boutiques), we believe the likelihood of departures within a boutique is generally lower, given meaningful equity ownership and the other motivating factors that often lure individuals to the boutique model. That said, the rise of the profit share model has had the desired outcome of improving retention within the industry more broadly. 

Despite improved industry retention, high-profile departures and leadership changes will continue to occur irrespective of a manager’s ownership or operating model, as an inevitable outcome of the broad range of factors that drive personnel turnover, including retirements. Given this, it’s perhaps unsurprising that some advisers and dealer group researchers are more reluctant to invest in boutiques, believing the consequences of departure are often much more significant and disruptive to the investment offering and even business sustainability, in the case of significant redemptions. 

A related concern is where an individual is forced to wear too many hats, particularly within a boutique. This can distract them from their portfolio management and research responsibilities, but also reflect inappropriate separation of duties as far as compliance, oversight, trading, etc. The mitigant is for all managers to be adequately resourced relative to the demands of the investment process and the prudent running of the firm. As such, we’re very cognisant of the various non-investment functions being performed by individuals within both boutiques and non-boutiques, and ensuring that appropriate infrastructure and resourcing is in place – be it through professional third-party providers, in-house expertise, or both. 

It follows that the source of a manager’s key person risk (KPR) is often also their key competitive strength. Taking steps to mitigate or even avoid KPR may make good business sense from a fund manager’s perspective, and even for an adviser, but it also has the potential to compromise a manager’s ability to meet its objectives by diluting the influence of its best investment staff. At a time when there is significant cynicism in the ability of large-cap biased Australian equity managers to add value after fees, the exclusion of boutiques on the basis of KPR would reduce access to some of the best available and aligned investment talent. 

The key is understanding the sources and magnitude of KPR and therefore the potential implications of a specific departure – be it to portfolio management, stock picking, team culture, idea generation, leadership, industry expertise, etc. By doing so, gatekeepers should be better informed to act decisively when appropriate (where possible) in the event that this risk manifests.

S&P Fund Services has advised that their business activity will cease as at 1 October, but meanwhile, it is ‘business as usual’ and PortfolioConstruction Forum is satisfied with the integrity of the analyst opinion provided.

ZENITH

Key person risk is always a key issue to assess as part of a manager’s organisational structure and investment team make up. A heavy reliance on a key person is common in boutique funds management organisations, but can also exist in institutionally owned asset management firms. Outstanding, highly experienced and well performed investment personnel are not easy to replace in any asset management business. 

In Zenith’s view, key person risk of itself is not a reason not to invest. In fact, as many of the better performing funds can carry a level of key person risk, to avoid it entirely would, in our view, result in significant missed investment opportunities and consigning investors to average to below average investment returns. In reality, if investors want exposure to the better managers and funds, in the majority of cases, this will result in taking on some level of KPR.

As this is the case, the issue then becomes to clearly identify the key person or persons and assess the risk of them departing. This involves a review of the measures the manager has in place to retain key people, including remuneration levels and structure, equity ownership, private wealth invested in the funds, etc. Identification of key person risk and an assessment of the effectiveness of the retention structures can then be made. 

The existence of KPR should then be assessed as part of the final rating and clearly communicated in the research report. In addition, it is also necessary to communicate the likely result on the rating if the key person or persons were to leave and the likely impact on the rating and course of action if this was to occur. 

In summary, Zenith believes the existence of some key person risk is a consequence of being invested with high quality fund managers, so to avoid it entirely is not in investors’ interests. The real issue is identifying it, highlighting the risks to investors, and taking immediate and appropriate action in the case where that person/persons leave. 

VAN EYK

Key man risk has two aspects. It can be defined as the risk that your money is locked into an investment with a manager who then loses their key manager. Alternatively, it can be the risk that a key manager is overworked and does not have adequate support around them to enable them to take periods of rest and recuperation, or to cover them if they are needed to spend material amounts of time marketing their fund to try to grow their business. 

If the key person was unable to perform their role due to, for example, marketing commitments, they would need a good right hand man to keep the investment process going in their absence. Arguably, however, technology these days gives managers the ability to do three or four tasks at once, enabling investment managers to direct the fund remotely.

Key man risk would be an issue if you were faced with the situation of not being able to withdraw your money from a fund when the key man left or became incapacitated. If the fund you are invested in allows you to withdraw your money quickly, then this threat is mitigated – and we would say to investors to seek as much key man risk as possible. Get exposure to that key man and reap the benefits.

However, people, like stocks, have good and bad periods. Ideally, we would prefer to see depth in a team, which would provide the right environment for key investors in that team to shine, while also providing sufficient diversity of views, and diverse sources of alpha. To that extent, we would suggest that a better exposure would not be to a key man but to a key team or key process. At van Eyk, we like to see key people with a talented team and a good process around it. That process should not be too bureaucratic so as to enable members of the team to express their skills and provide diversification and backup for the key managers in the team.

LONSEC

The concept of KPR is a prevalent factor when assessing investment approaches that rely on the investment prowess of a single individual. However, provided those risks are appropriately mitigated, Lonsec does not believe this should deter investment. 

KPR is often present in the Australian small cap landscape, with a number of boutiques housing individuals who have opted to branch out from institutions to tread their own path. It is common to find a key individual singularly responsible for portfolio positioning and the development and oversight of the investment process. In these cases, investment outcomes are heavily dependent on that individual, leaving the business exposed to the risk of reputational damage and commercial loss should they leave. 

Similarly, in the hedge fund sector, individuals can have a highly influential role in the investment outcome due to the wide opportunity set and sophisticated investment mandate. The sector tends to attract seasoned investment minds with broad depth of market experience and confidence in taking a contrarian macro view (eg, Kerr Neilson at Platinum Investment Management). While it is difficult to replace those skills, there are features Lonsec looks for to generate increased comfort with KPR.

• How is the individual tied economically or commercially into the business? Is there an element of performance-based incentive in remuneration? In the case of boutique firms, preferably the individual has some ownership in the business, as business owners are likely to be more motivated and engaged in making a success of the firm.

• Alignment of interest with investors – does the portfolio manager have skin in the game? In optimal cases, the portfolio manager’s personal wealth is co-invested in the fund. The hip pocket can be a great performance motivator. 

• Is there a prudent risk management strategy to incorporate a designated backup portfolio manager for investment strategies? Co-portfolio manager teams of two or three are reasonably common in small caps, offering the business greater flexibility in terms of succession. 

Lonsec is likely to hold diminished conviction in an offer with insufficient policies and processes in place to deal with KPR. 

However, succession planning is not solely an issue for boutiques – the risk also extends to institutional managers (eg, John Sevior’s departure from Perpetual) and requires strategic planning. 

The transition of portfolio management responsibilities of the Aviva Investors High Growth Shares Trust from highly regarded Ian Lang to Richard Dixon in 2007 is an example of a high KPR fund where succession planning was shrewdly handled. Given Lang’s investment experience and the sophisticated shorting techniques employed in the fund, there was a significant risk that capital would flee once Lang moved on. Nevertheless, a smooth transition eventuated with Dixon working closely with Lang for a number of years, and also running an institutional version of the product, giving clients the opportunity to gain comfort with the new head’s investment approach.

Lonsec believes that KPR is highly relevant when assessing investment products, but in the right circumstances, it can be a risk worth embracing.

MERCER

There has been a strong and sustained rise in the number of boutiques investment firms over the years, particularly in Australia and most notably in Australian equities. This trend reflects a natural evolution where large mainstream firms can struggle to manage their substantial size of assets, such that talented investment leaders and some of their team can elect to run their own firms.

In a mainstream firm, while there can be some evidence of the talented and high profile star fund manager, these leaders are generally supported by substantial teams. The costs of a large team are able to be amortised over a correspondingly large revenue base. If the leader departs, it is always possible that the next most important people in the team can step up to manage the investment process. In theory, at least, this implies that there is a lower level of key man risk. 

The opposite applies in the case of a boutique. The typical team size is lower, with a correspondingly larger reliance on the leader who is typically the founder of the firm. The boutique will generally manage a much lower level of assets for a smaller number of loyal clients who have a more direct relationship with the investment team’s leader.

As such, it is undeniable that the efforts of that leader have a great influence on the investment and business fortunes of the firm. The leader may have a small number of key deputies or may have a more diverse team that provides critical mass of idea generation and/or cross checking on portfolio construction. However, under either scenario, the influence of the key man is substantial.

In addition to investing considerations, there are also non-investing factors that stem from the leader’s perception of how a business should be structured. The firm is likely to have been fashioned to fit with the likes and dislikes that the founder has experienced over a career in the investing and/or other industries. This will have its clearest manifestation in terms of factors such as the reward and ownership structures. Overall, the importance of the key man in a boutique is substantial.

The downsides of a key man in a mainstream firm are different from those that apply in a boutique firm. In the former case, the major risk is a flight risk (to another large firm or to a boutique). The boutique situation has relatively low flight risk by virtue of the typically high level of equity ownership. Key man risk in a boutique is more likely to be a dominance that the leader has over investment and staff issues, possibly with limited cross-checking of decisions in these areas. 

On balance, however, the notion of key man risk is really a necessary condition for participation in the highly incentivised and focused investment equation that is boutique funds management. There are some downsides to any business structure, but the key man risk in a boutique would seem to be an acceptable risk to take on.