8 Factors to Determine If an Investment Fund Manager Is Putting Investors First
Lots of managers say, "Investor First," but it is only when you dig into the fund documentation, the Private Placement Memorandum, Operating Agreements, and the Subscription Agreement, and really spend time understanding the management team, fees, and fund details can you better assess if this is the case. With that said, EVERYONE, please always read your fund documents. They are literally the rules to the "game" for mutual funds, hedge funds, fixed-income funds, syndications, and other private investments. In my career, I have literally read hundreds of documents that cover a wide range of investments. If Institutional investors study the documents and ask questions, don’t you think you should as well? Regardless of the investment platform, I want to walk through several factors for investors to consider when reviewing fund managers to see if they are putting investors first.
1. Fees
a. Management Fees: These are the fees paid to the fund manager to cover the general costs of being the manager of the fund. When you look under the hood of manager costs, many managers are becoming wealthy off just the management fees. As an investor, you certainly want to make sure the manager can pay their bills. The management fee is not a "compensation scheme" that is not in line with the investor's return and the risks being taken to obtain that return.
b. Incentive/Performance Fees: This is the fee paid to the fund manager for performance. Some managers will charge this on total performance; hopefully this practice is very rare. Most incentive fees are charged on the returns that go beyond a particular hurdle. For example, if the fund has a hurdle return of 8% and the fund posts a return of 12%, the manager will collect an incentive fee on the 4% return above the 8% hurdle. Investors might ask, is this fee warranted? In many cases, yes. Alternative investment platforms usually have some sort of unique edge, whether that is knowledge, network, or often a combination of both. This edge is one of the key elements that should be identified in a manager, and then the investor can determine if the extra layer of fees are justified.
c. Fund Expenses: The forgotten expense. For some reason, many fund managers don't talk about this fee, and it is not even listed in the general jargon of fees. Many fund managers will say their fee structure is "2 & 20." That implies a 2% management fee and a 20% incentive fee. What is mentioned in the legal docs but not brought up in conversation is the fund's expenses and what the investor is paying for. This can really cost you if you are oblivious of it. The most opaque form of fees that encompasses fund expense is the "Pass Through" structure. The fund manager calculates all fees as a whole and passes that on to the investors to share on a pro-rata basis. I have seen some funds have a total pass-through expense of 9% plus. That seems like a big number, and it is, but that number in isolation does not tell you if the fund is good or not; it just implies the manager is sharing all fees regardless of nature with the investors. At least historically and in my due diligence, this has not been the right approach to use when striving to align yourself with the investor's interest. As an investor, be sure to understand what you are paying for in fund expenses. All the fund expenses should be directly related to the operations of the fund and not include additional items that really should be captured by the management fee. You can review this in the details of a fund audit.
d. Interest Rate Skims: This is particular to real estate debt. In all my years, I never saw anything like this in Hedge Funds or Venture. This skim is basically a fee in the form of an interest rate spread, which the fund manager is not paying the investors. For example, the Fund writes a piece of debt at 15% to a borrower, the fund then authors a piece of debt to the investors that only pays 9%. In effect, the Fund has taken a 6% fee on that trade. I have read a series of PPMs that have this structure in place. As an investor, you are being exposed to a risk that warrants a 15% return, but you are only being compensated 9% for that risk. If this practice is in place alongside all the other fees, I think it is an understatement to say that this is not in alignment with the investor's interest. Read your fund documents as this fee is usually spelled out in the fees section.
e. Formation Costs: It is standard practice for the fund managers to pass along the cost of the formation of the fund to their investors. There is no written rule of what is fair. Often, teams that have not formed funds before or rely solely on their legal team to build the fund docs are easily exposed to a large fee. As an investor, ensure the cost of formation is not too prohibitive to the returns of the fund. Many fund documents are templated now, and the cost has fallen drastically. With that said, some structures do cost a bit extra; be sure to determine if your fund manager has been prudent with the expenses of building the platform.
Note: The Kirkland Capital Group only charges a management fee for the Kirkland Income Fund and separately lists fund expenses. Further, the management fee is only charged on investors' capital that is applied to loans. Although it does require a particular edge to run the Fund, we felt it best not to charge our investors any other layers of fees. Rather, the fund manager charges the borrower fees for originating the loans. Our Fund Expenses are kept minimal to ensure the best possible net return for our investors given the nature of the investment and any macro events. We spend a great deal of time performing due diligence on our service providers to ensure the best cost benefit for the fund and its investors. With our experience of building funds, we kept formation costs to a minimum. So low that the manager decided to pay the formation costs and pass no additional fees to the investors.
2. Transparency
A fund manager should strive to be as transparent as possible. There are some strategies that require an increased level of opaqueness. This means if the investor were told what the trade was or the particulars of sourcing and mechanics of the trade, it could hurt the fund, and in turn, its investors. As an investor, you need to amply educate yourself about the investment to determine what transparency is prudent. At the very least, you should obtain regular monthly updates on the fund, the investments, industry updates, and any macro events that could affect the portfolio. This transparency comes in the form of monthly newsletters and investor calls. Generally, transparency in the fund financials is obtained annually via the audit. Funds that are registered will also send out Form ADV annually, which is the public disclosure regarding the Fund.
As a rule, when funds would tell me they could not discuss trades or let me sit with traders to discuss active trades, I simply told them if I could easily reverse engineer your strategy by just spending 30 minutes with your trader, then you really have no edge or moat protecting the fund strategy and will most likely lose the ability to generate outsized returns as the trade becomes crowded.
Note: Kirkland Capital has monthly newsletters and conducts quarterly webinars for its investors. We also have an annual audit of the Fund, and that report will be posted for investors via our Investor Portal. As all the current investors have heard me say, we can show everything regarding the fund except the loans that are in progress. We even requested from our Fund Administrator that investors should be able to obtain position-level detail of the properties that are collateral for the loans in the fund via the Investor Portal.
3. Operations
One fact about fund failure is that roughly 66% of funds fail due to operational weakness that can lead to fraudulent behavior or breaches in confidentiality. Control of cash is paramount, and the ability to move money should always have at minimum dual control. No one person should be able to move large dollar amounts out of the Fund.
These systems can be established with your bank and treasury departments. In the post-2008 world, it has become normal to integrate third-party operations as augmentation and oversight. This can be difficult for smaller funds to implement as these integrations can be costly. Note, if a small manager is not using third-party administration, they might be doing you, an investor, a favor. The cost of administration is a Fund expense that is carried by the investors in that fund. Loading too many expenses to the fund can damage investor returns.
As an investor, ensure that the manager is taking other precautions to ensure the safety of capital. In today's world, cyber-attacks are real and common, so ensure the fund has proper protections in place to secure sensitive information. If the fund has an Operational Due Diligence document and Business Continuity Plan, request these documents so you can better understand how the fund is operationally aligned with its investors.
Note: Kirkland Capital has always had dual control on cash movements between the partners. The Fund Administrator also monitors these cash movement requests. The Fund Administrator is there to augment middle and back-office functions as well as be an impartial third party monitoring the operations of the fund to ensure compliance and alignment with investors. The manager stores investor information in secure cloud locations that have highly restricted access and requires multifactor authentication. The Fund Administrator also stores fund-related information in a secure and separate location as a potential back up if needed.
4. Compliance
The fund manager should develop a culture of compliance that integrates into the operations of the fund. Compliance and Regulations are the first steps to building ethical actions within a Manager. This is extremely important for so many reasons, and we do not have time to cover that here!
The managers cannot just demonstrate a thorough understanding of regulations and compliance; it must be shown in the company's actions. The manager should strive to have a compliance manual implementation process and an education process that flows to everyone at the company. In some cases, funds may need to outsource this compliance function when there is no internal knowledge base. If drafted and correctly implemented, this compliance culture will guide the manager and its employees to not only understand their fiduciary duty to the investors but have processes and procedures that support this duty continuously.
Note: Kirkland Capital has operating procedures in place that define a code of ethics and compliance process to ensure everyone has knowledge of laws but also ensures understanding of compliant actions, which are always taken, that align with the best interest of investors and avoid potential conflicts of interest.
5. Education
Managers should constantly be educating themselves. It is essential that managers educate their investors.
This education covers the basics of investing, specific natures of the investments managed, broad industry, and macro events that can affect the fund. This education helps the investors better understand what is happening in the fund. It also allows them to know if the investment style is correct for them as their life changes. Risk is everywhere and comes in many forms and will undoubtedly cause an uncertain and undesirable event for a portfolio of investments at some point.
This education helps investors build proper expectations and be prepared when a world event does affect the portfolio. In my career of managing investors' money, I have found that if investors are aware and understand the risks, and when one of those risks has an undesirable occurrence, the investor can make an intelligent and rational decision that is not based on fear and emotion. The act of education builds understanding and trust that better aligns the manager with investors in good and bad times.
Note: One of KCG's core missions is education. We continuously read articles about investments, risks, real estate, and idiosyncratic events that could affect the portfolio. We try to convey this information to our investors through social media, newsletters, and publications like this one. Our team has been involved in investor education and networking for over 16 years through various groups that span the globe. If you are looking for education-based networks in investments, please see the Chartered Alternative Investment Association (caia.org) and CFA Institute (CFAinstitute.org) or check out our Investor Education Blog for educational topics created by the Kirkland Capital Group team.
6. Empathy and Understanding of Investor’s Needs
Whether it is a first meeting or the twentieth, Managers need to listen. Managers should be able to effectively communicate the factors that affect the investors. If managers do not listen how could they accurately address the investors' questions and concerns?
In this ever dynamic and sometimes chaotic world, those concerns might change, and the manager needs to be open to those changes. One important step is for the manager to take the time to assess the investor's risk tolerances, liquidity needs, return goals/objectives. If possible, the manager should learn things about what the investor currently owns and how the fund will fit this existing portfolio.
Note: Having managed money for over 25 years and dealing with both individuals and institutions, it is our primary goal throughout the investment process to learn about the investor and ensure we understand why and how this investment will work for them. We are also cognizant that for some, this investment might be their first investment into the alternative investment universe. We take the time to work with the investors and ensure they understand the documents. We also check if they need help completing a subscription document and answer any questions they might have. We call this the Investor Journey, and we want to ensure we are there to be an attentive guide.
7. Flexibility
Ability to adjust fund particulars to be dynamic in the face of global macro-occurrences. I want to be clear I am not talking about Style Drift.
Style Drift is where a fund manager realizes that the original premise of the fund will no longer generate the desired investment profile. This practice can be detrimental if a fund is investing in structures that are no longer in line with the original premise of the fund and hence are exposing investors to risks they are not aware of or desire.
I am instead referencing to flexibility which ensures the manager and the fund continues to stay aligned with investors while continually investing in related products with similar risks or changing a structural nature of an investment to capture an opportunity for investors while mitigating or maintaining a risk in the investment.
Note: An example of this flexibility, in March 2020, as the pandemic began to take grip, we saw that deal flow begin to slow, and the fund was experiencing choppy deal flow, and we believed this could continue perhaps for an extended period. In response, the Manager declared that management fees would only be charged on deployed capital. This allowed investors to not suffer expenses on a capacity-constrained investment universe that was under a new stress. Another example was that we recognized a growing concern regarding rent collections and eviction moratoriums, so we took the opportunity to adjust our loan terms to require a certain amount of interest prepaid at the time of closing. This allowed us to mitigate some risk of interest collection in a time of uncertainty.
8. Culture
Does the manager's culture match the previous factors to ensure investor alignment? The Managers Mission, Vision, and personal aspects should align not only with the investment but hopefully with the investor's objectives as well.
The motivation to earn a return and protect the principal is an easy one to find mutual alignment. As an investor, be sure to assess whether the manager's culture aligns with ideals and objectives beyond just performance. This is a qualitative process that will help build understanding and comfort with the manager over time.
Note: At Kirkland Capital Group, the founders are investors in the Kirkland Income Fund and are committed for the long run to our mission of providing an investment platform that will provide enhanced return while mitigating risk. Our mission also involves being a better business partner. We work with our brokers and borrowers to ensure that they are obtaining what they need to best facilitate their business and investment. Beyond that, we have a culture of knowledge. The founders, as well as current and future staff, must have that internal desire to learn more and face subjects unknown, then desire to share that with the company and our extended family of investors. All together, we are a community.
Lots of fund managers say, "Investor First." Now you have eight areas to consider when assessing a private investment's fund documentation and the management team to determine not only if it truly is Investor First but if it fits with your own investment strategy.
