5 Qs WITH A DEALMAKER
Good morning, Term Sheet readers.
Peter Kraus took the helm of investment management firm AllianceBernstein at the height of the financial crisis. It lost more than 40% of its assets under management in 2008.
As the new CEO, Kraus tried to slow the bleeding by slashing fees and diversifying investment strategies. But there was one thing that was much harder to recover — client trust. In his decade at the firm, Kraus saw more clients moving their assets to passive investing funds, meaning they didn’t believe that human portfolio managers could outperform the market.
For context, flows out of actively managed U.S. equity mutual funds spiked to $264.5 billion in 2016, while flows into passive index funds and ETFs were $236.1 billion, according to data provided by the Vanguard Group and Morningstar. That marked the greatest calendar-year asset change in the last decade.
In his last few months at AllianceBernstein, Kraus attempted to launch a performance-fee fund to re-gain control and earn back client trust. Securities and Exchange Commission officials approved the concept. But in April 2017, AllianceBernstein’s parent company abruptly fired Kraus and his team after a reported clash over management style and succession plans.
Now, Kraus is back with a new venture that aims to address the problems he saw plaguing the asset management industry. With $4 billion in seed capital from Italian insurer Generali, Kraus will attempt to turn the industry’s standard fixed-fee structure on its head.
His new firm Aperture Investors employs a performance-based fee fund model. In other words, it will charge base fees comparable to low-cost ETFs, and investors will only pay additional fees if the funds outperform the market. There are no fixed fees, which is the industry standard at the moment. At Aperture, portfolio managers’ compensation will be tied to their performance. (See the formula behind the strategy here.)
In this wide-ranging interview, Kraus talks about misaligned incentives in the asset management industry, what happens when you tie compensation to performance, and why his industry peers hope he fails. Read much more in the full Q&A here.
TERM SHEET: In your last months as the CEO of AllianceBernstein, you employed a similar performance-based fee strategy. How did you come up with this model in the first place?
KRAUS: I had been thinking about this for five years, and I came to this issue because I think the asset management industry and its clients are going in different directions. I think clients are saying, “I don’t trust you anymore.” It’s been evolving for a long period of time, but it has become prevalent in the last five to 10 years. It took a while for me to believe that it was a structural as opposed to cyclical issue, and over the last few years, it’s become completely clear to me that it’s a structural disadvantage. There are two main reasons for that.
One is that asset managers are paid a fixed fee and that incentivizes the growth of assets as opposed to the performance of those assets. It’s true that if you don’t have performance, you can’t gather assets, but the range of performance you can have is quite wide, and you’re paid no different depending on that range. You are paid differently if the assets grow.
There’s a clear, unambiguous, inarguable maxim that the more money you manage, the more challenging it is to perform. So you have a fee structure that actually incentivizes the company and the manager to grow assets, which undermines the very performance that the client is hiring the manager to produce. That does not seem to a be good thing.
But it’s always been that way, right?
KRAUS: It’s always been that way, and this leads to the second problem, which is that over time alpha (or “outperformance”) has become more challenging. This is an important point — alpha didn’t go away, but it’s become more challenging. The number of people who can actually create alpha is smaller yet the barriers to entry remain the same. People got paid this fixed fee whether they performed or they didn’t, and the dollars of savings that are pursuing managers has grown significantly over 30 years. Thirty years ago, the pool of capital that you applied to the capital markets was smaller, the capital markets were smaller, and the information was more slow to develop. Today, the latency factor is much shorter, there’s more money relative to the capital markets, and the markets are more efficient.
All of that leads to bigger challenges for active managers, but it doesn’t lead to the elimination of alpha. So the second big problem is that people and institutions never own one manager — they tend to over-diversify the number of managers. What happens is that over-diversification affects risk. The problem with lowering your risk is that you also lower your return. You can’t get return without risk.
So how do you plan to solve these problems?
KRAUS: What we’re saying to the world is that every manager you pick at Aperture is there because they believe they can perform, have a proven track record with performing and are voting with their feet (meaning they don’t get paid unless they perform). They’re also attempting to produce performance that’s going to increase their income, which means they’ll optimize their risk.
What we’re saying to people is, “Look, if we don’t perform, you just pay the ETF fee.” Don’t take on too many managers. Take on managers where you have a higher probability that they will perform because they only get paid if they perform. Don’t have 100% of your assets in them. Have 50% of your assets in them and have the other 50% in passive.
The good news about passive is that it’s a valuable tool, but it’s a tool. It gives you exposure to the market at a low cost. Now, your manager can focus on creating alpha, and if you just pay the manager for alpha instead of market exposure, now you have something that works.
If compensation is directly tied to performance, doesn’t it incentivize the manager to take outsize risk in some cases?
KRAUS: The concern people have with performance-based fees is that it engenders too much risk. What you want is people to take risk, you just don’t want them to take too much. And “too much” is a silly term because, well, what’s too much? “Too much” is only determined in the past because when you’re taking the risk in the present, you don’t think it’s too much.
What should define “too much” is a set of financial incentives that actually encourage risk-taking notwithstanding the return. The traditional high-water mark structure in a hedge fund engenders that behavior. People think it protects them, but it doesn’t. Why?
Let’s say I’m a hedge fund manager. Last year, I made $10 million, half of it’s deferred, but it’s only deferred for time, there’s no clawback against it. The next year, I lose 5%, I don’t get paid anything. The next year, in order to get paid, I have to make back the 5%. You, the client, think that’s great. But what do I think? I think I’ve got to take more risk. That’s a bad place to be.
At Aperture, we don’t have high-water marks. We reset every year. If you’re down 5%, you start the next year at zero. If you’re up 5% next year, you actually get paid. But over three years, you have to earn the client the return that generated the compensation in the first year.
And if you don’t?
KRAUS: Then you lose some to all of your deferred, which is half of your compensation. Let’s say you make a $10 bonus in Year 1, so $5 will be deferred. At a minimum, your return needs to match the benchmark for the client in Year 2 and 3, otherwise you lose some or all of $5. And by the way, of the $5, at least $2.5 is in the fund. So if you look at compensation over time, at any point in time, the manager has half of their compensation or more in the fund, so their money is actually at risk too.
There are two things that are causing the manager to be careful about risk — one is their own money and two is their deferred.
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