The President of the Board of Trustees of a large pension fund remarked to me last week that she was not concerned about the brokerage, conference fees and other compensation her fund's consultant was earning from the fund's money managers. The conflict of interest created by the pension consultant receiving compensation from the fund's managers, while serving as the supposedly objective evaluator of these managers and any new managers the fund might hire, was not troubling to her for two reasons, she said.
First, as she saw it, "everyone in this business is dirty." By "dirty" she did not mean everyone was necessarily involved in illegal conduct; rather, it became clear she was referring to the prevalence of conflicts of interest in the industry. Second, she was not concerned about her investment consultant's alternative sources of compensation because she was confident the amount of any undisclosed compensation was insignificant. Her consultant had assured her the firm's involvement in brokerage was limited. According to the consultant, the firm only operated the affiliated brokerage as a "convenience to its clients who were interested in commission recapture and similar cost-reduction services." Finally, in the President's opinion, since the fund's Board members had also attended the consultant's annual client conference that money managers had paid $50,000 each to attend, there was no need for any additional disclosure regarding manager payment of conference fees.
Prevalence of Conflicts of Interest
The trustee's remarks struck me as remarkable reasoning. The investment management and securities industry is clearly riddled with conflicts of interest. Conflicts exist within securities firms, such as between research analysts and investment bankers or between a firm's proprietary trading and trading on behalf of customers. Conflicts also can be found when firms pursue different lines of business through affiliated companies. For example, some money managers engage in business with affiliated brokerages, including executing of customer trades and purchasing of IPOs underwritten by the affiliate for customer accounts. Some pension consulting firms have affiliated brokerages and money management firms. Given the pervasiveness of conflicts in the industry, is there any reason why a pension trustee should be especially concerned about consultant conflicts?
Basic Rules for Handling Conflicts of Interest
There are a few rules which apply to handling conflict of interest matters which are really just common sense. The first rule is that conflicts should be avoided where possible. If the product or service can be obtained from a source that is not subject to a conflict of interest, that source should be given preference. In other words, conflicts should only be tolerated where necessary. Absent a showing of necessity, go with the provider that does not pose the risk of harm the other provider, subject to the conflict of interest, poses. Second, the greater the degree of influence the individual or firm exercises over the investment outcome (or alternatively, the greater the risk of harm such an individual or firm poses), the greater the degree of scrutiny that should be brought to bear and the less conflicts of interest should be tolerated. For example, while we may tolerate an elected official investing in equities with limited disclosure, we would be far more concerned with Alan Greenspan's personal investing. Many investment professionals and pension trustees fail to keep these rules for analyzing conflicts in mind. In summary, when possible, conflicts should be avoided and only the least potentially harmful conflicts should be tolerated.
Should We Tolerate Pension Consultant Conflicts?
If you apply the above rules to pension consultant conflicts of interest, the correct course of action is obvious. There are many highly qualified consultants who are truly independent. Thus, it is not true that the conflicts of interest related to the alternative lines of business certain consultants pursue are unavoidable. How significant are the risks involved? The consultant occupies a unique position. He or she is the one expert the trustees of a pension fund rely upon for objective advice on virtually any matter involving investment of the fund's assets. The relationship between consultant and pension client is one of utmost trust and confidence. As a result of his role as an objective guide, the consultant arguably exerts the greatest degree of influence over the investment process. So significant is Board reliance upon consultants' opinions that we have seen Boards accept assurances from their consultants that even the most outrageous self-dealing scenarios involving the consultant should be of no concern to the Board. In summary, the potential for harm is so great when consultants are subject to conflicts that consultant conflicts should be avoided most of all. Any hint or suggestion that the consultant's ability to provide independent, objective advice may be compromised should be thoroughly examined before it is dismissed.
Investigating Consultant Abuses
The opportunity always exists for pension consultants to derive financial benefit in connection with the decisions of their pension clients. The greater the degree of influence the consultant has, the greater the opportunity for financial reward. Thus, consultants often seek to enhance their influence with funds through a variety of devices such as limiting manager access to fund boards and selective disclosure of information regarding managers to boards. Another common device for enhancing influence is withholding information regarding matters to be decided by a board until immediately before or at the meeting where a decision is required. Since the board has not had an opportunity to consider the matter, it is likely to "rubber stamp" the consultant's recommendation. We have found that consultants are generally very astute regarding the procedural devices they can employ to enhance their influence over the decisions of their pension clients. Pensions, on the other hand, are often oblivious as to these procedural shenanigans.
Seven Ways Consultants Financially Benefit From Funds
There are myriad ways in which a pension consultant may derive financial benefit from a pension fund it advises. When we investigate consultant abuses on behalf of pensions we look for the following methods of financial enrichment, some of which are legitimate, while others raise serious concerns.
First, a consultant may receive an expressly stated annual contractual fee or retainer. This fee may be paid directly by the client or indirectly with the fund's brokerage commissions through "soft dollars." In some cases, believe it or not, the consultant's fee is structured such that the consultant receives all brokerage the fund's portfolio generates as its fee. That is, the consultant's fee is limited only by the amount of turnover a pension's portfolio generates. This open-ended or unlimited fee structure is common among broker-consultants at the large wirehouses who tend to prey upon smaller funds. It obviously encourages the consultant to "churn" managers.
Second, a consultant may receive an agreed upon fee (in addition to an annual retainer) for special projects, such as manager searches or brokerage studies.
Third, a consultant may receive brokerage from the fund's money managers related to the accounts they manage for the fund. Note: even if trade confirmations do not state the consultant's affiliated brokerage's name that does not mean that the consultant's brokerage has not received the commissions. There are ways to conceal what party ultimately receives the commissions.
Fourth, a consultant may ask for and receive additional brokerage from other accounts of the fund's managers. Where the plan sponsor has already instructed managers to direct brokerage to the consultant related to the fund's account to pay the consultant's fee on a "soft dollar" basis, the consultant is in a strong position to ask for additional brokerage from other accounts of the fund's managers. Simply put, the consultant's entitlement to brokerage related to the fund's account has already been established by the client. Not having to ask managers for that brokerage, the consultant has the leverage to ask for additional commissions from the manager in return for bringing the account to the manager. Soliciting brokerage from other accounts managed by the fund's managers is a popular strategy when the consultant knows he will be questioned by the plan sponsor regarding any brokerage received in connection with the fund's accounts. In this fourth situation the consultant is earning additional compensation from the manager, not the fund itself. However, the consultant's status as gatekeeper to the fund enables the consultant to effectively negotiate with the manager for this additional brokerage. The manager, on the other hand, knows he must keep the consultant happy and hopes to obtain additional assets to manage by giving additional brokerage to the consultant. Therefore, it is appropriate to consider this additional brokerage paid to consultants in estimating the total compensation a consultant derives from its relationship with a fund.
Fifth, the consultant may earn additional brokerage from terminating managers and funding new managers. For consultants that charge "search fees" in addition to annual retainers, both commissions and search fees are possible when they recommend terminating a manager and hiring another. Again, the consultant benefits from "churning" managers.
Sixth, the consultant may receive cash payments from the fund's managers, including venture capital and real estate managers or the custodian. This may be an agreed upon one-time, up-front placement fee and/or an ongoing fee, including a percent of the profits. Where the money management fees are unusual and high, the question arises as to whether the consultant may have received some portion of the manager's fee, one way or another. Recently consultant participation in the fees of defunct hedge funds is attracting scrutiny.
Seventh, the consultant may sell marketing consulting services to managers (including how managers should market themselves to consultants) and host conferences where managers can meet pension clients of the consultant. Note: the fees consultants charge managers for marketing consulting services and conference attendance are well in excess of usual marketing consulting services and conference fees. For example, while sponsoring a typical investment conference may cost between $5,000 and $10,000, sponsoring a consultant's conference will cost $50,000 or more. With respect to this final category of fees, these fees are not derived from funds directly. However, the consultant's status as gatekeeper to pensions enables it to persuasively solicit such fees and these fees should be included when estimating total consultant compensation derived from funds.
As a result of all the above devices, the fees pensions actually pay, directly and indirectly, to consultants are ten or more times greater that the amount they think they are paying. It's an elaborate ruse and pension officials almost universally have refused to look behind the façade to examine what's really going on. Our investigations reveal pension consulting fees today are dramatically understated. Consultants with no means of enhancing the compensation they derive from funds are forced to compete regarding the stated fee for such services, with those who are skilled at surreptitiously "working the relationship for all it's worth." This is unfair and penalizes the firms with the greatest integrity. In our opinion, we would like to see the stated fees significantly increase and surreptitious compensation outlawed. (For the record, we do not provide consulting services to pensions, only investigative services.)
In this case the trustee was willing to believe her fund's consultant had limited brokerage operations without having been provided with any evidence substantiating this claim. As we have discussed before, all brokerages are required by the SEC to submit independently audited financial statements annually. While brokerages are not required, for reasons that make no sense to us, to disclose their full financial statements to customers, they are required to provide customers with summary financials. These summary financials are useless for due diligence purposes. Pensions, however, have the leverage to demand the full audited financial statements of the brokerages affiliated with their pension consultants and should do so before they are satisfied that their consultant's brokerage activities are not significant. Good luck.
It is likely that the independently audited full financial statements of brokerages affiliated with pension consulting firms are the most closely guarded secrets in the pension industry. No pension trustee we've ever met has seen the financial statements of the brokerages of the largest pension consultants. Disclosure of these financial statements may answer once and for all the question of just how significant is the brokerage activity of the leading pension consulting firms. If such activity is minimal, then disclosure should be painless. In my conversation with the President of this pension I challenged her to obtain the full audited financials of her consultant's brokerage. While she assured me this would be a simple task, she has yet to obtain these statements from her consultant. We would now like to open this challenge up to the entire pension community. Can anyone obtain the full audited financials of the brokerages of the largest consultants? If you can, please contact us. Next month we may publish the results of this broadly disseminated request for information.
If we don't take steps such as these today to uncover unscrupulous activity occurring at the highest levels of pension asset management, then pension funds will likely be the next Enron. Public funds in particular, which are not governed by ERISA and have lay boards, should be especially diligent in this era of heightened scrutiny of financial matters to investigate consultant conflicts.
Setting Standards For The Investment Management Industry
