Ownership limits ‘key man’ risk

Key man risk (KMR) is perceived to be high in the investment management business, particularly with boutique fund managers.

This is because the successful management of an active investment portfolio is highly correlated to the ability of its key operatives.

Asset consultants (including research houses) put great store in the logic of a manager’s investment process and the consistent operation of the investment manager within the investment process framework.

But the qualitative input of key individuals is regarded as extremely important. Experience and consistency of results are perceived to relate to key management individuals, both in terms of managing the investment process and ensuring investment idea generation and focus.

To put this in perspective, it is useful to compare a ‘plain vanilla’ index fund management operation with an active qualitative investment manager.

In the case of the index fund, it would be unlikely for asset consultants to see a need to change the index fund’s rating. This is because the process is not dependent on qualitative input — it is typically systems-driven.

On the other hand, where a senior portfolio manager leaves a qualitative investment management group, the consultant alarm bells ring and the investment rating of the manager comes under review.

The outcome of which, at worst, may be that the manager’s performance track record is wound back from, say, five to six years to zero years. The manager is rated a sell and in essence has to start building market credibility all over again.

So the business impact of KMR is potentially very high. It can ruin investment businesses and on numerous occasions it has done just that.

Over the years, we have seen this happen time and time again. It has been an ongoing feature of the investment management industry worldwide, and this country has been no exception.

The perceived inability of active managers to consistently add value over long periods owes much to KMR over the past 60 to 70 years.

This has played a significant role in encouraging institutional clients to abandon active managers in favour of passive (index) funds during that time.

Boutique benefits

Boutique managers have been a feature of the US market for many years (since before World War II, for example, Capital International).

However, since the 1980s, boutiques have taken off and are a significant force in the US market.

It became apparent that as a business model for delivering superior outcomes for customers, it left the institutions a long way behind.

Aligned with client interests, locked into the business by the glue of ownership, free from institutional distractions and in charge of their destiny, boutiques have attracted and retained an ever-increasing share of world savings.

KMR is far lower in this environment than the traditional institutional model.

Around the world, the most successful investment houses are those that have built a unique, focused investment management culture.

Until 10 years ago, when there were very few boutiques in this country, investment management was undertaken within financial institutions (primarily banks and insurance companies).

Inevitably, the main business of the institution is the main priority of that institution (for example, banking in a bank).

Investment people perceived that they were round pegs being forced into square holes within the institutional framework.

This contrasts with the opportunity provided to these professionals by boutiques. In essence, the boutique structure has significantly lowered the risk of key people leaving, and this is one of the main reasons that key industry stakeholders tend to like the boutique structure.

For example, Perennial’s approach is to enable key investment managers to own significant equity in the separate companies specifically set up to house their investment business, that is, they direct and run their own businesses.

Their success in managing money for clients determines the financial outcomes for the investment managers both in ongoing dividends and the capital value of the businesses where they own equity.

Naturally, this ownership culture binds people very strongly to the businesses compared to what was on offer in the marketplace 10 years ago.

This has improved the alignment of interest between service providers and clients who use boutiques.

Our clients like the model because they know that there is a very strong commitment on the part of key players to make a success of their operation and keep improving it.

Clients are aware that KMR is minimised in this situation and with it the risk of underperformance through staff disruption.

Institutional appeal

There are plenty of examples where institutions offer differentiated and appealing services, such as managers with a highly quantitative bias, where investment processes are highly structured and not as reliant on key individuals.

However, over time there is probably no reason going forward why these individuals could not spin themselves out into a boutique.

Boutiques are still exposed to KMR; however, it is possible to manage this effectively.

As boutiques mature, founders will inevitably retire. In the Australian market today this generally seems to be a long way off, but it needs to be addressed early on.

Ownership is the glue that keeps people in place. At the end of the day, it is clearly in the founders’ interests to build an enduring and growing business to ensure their equity value is maintained over time.

KMR in Australia has changed over the past 10 years. Boutiques are generally structured such that they have lower KMR than financial institutions.

A key question going forward within the boutique fraternity is how to handle intergenerational change in such a way that keeps KMR low.

At the tail of the field, in a KMR sense, are the financial institutions with the constant threat of key players wishing to embrace the boutique model.

Michael Crivelli is executive chairman at Perennial Investment Partners .