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Reframing the Buy Side/Sell Side Relationship in Alternatives

  • Northern Trust

Incorporation of alternative investments into institutional portfolios has been on the rise for more than a decade. Greater use of alternatives has been accompanied by a desire on the part of investors for more transparency to try to mitigate the inherent risks, but the lack of data standards and conflicting perspectives can create friction between investors and managers, to the detriment of both.

We sat down with the co-authors of a new paper on how collaboration between the buy- and sell-sides could benefit all involved. The trio represents Northern Trust, which has a bird’s eye view of the playing field from its position as both an administrator and service provider to asset managers and asset owners in the alternatives space. Stuart Lawson, Senior Product Manager, Alternative Assets Servicing, offers his insights from a European perspective; and Paul Finlayson and Matt Smith are Senior Product Managers, Alternative Assets Servicing, in the U.S. 

II: There is always some healthy friction in the buy side/sell side relationship, but one of the points made in the paper is that, in the alternative space, there is unnecessary friction that is detrimental to both causes. Why is that the case? 

Paul Finlayson: Increasingly, the buy side is seeking the same informational efficiency that they experience in public markets. As regulators look at alternative assets, and specifically private equity worldwide, investors are looking for transparency and full access to the nuts and bolts within alternative assets managers’ operations. This in turn raises a question: Does that level of transparency hinder the performance of alternative asset managers?

Matt Smith: A lot of new investors in alternatives are looking for a holy grail – the returns of the private market and transparency of public markets. It doesn’t exist. They want the same level of transparency so that they can consolidate reporting, but it’s just not available.

From the sell side, alternative asset managers have been conducting business in a particular way for a long time. A lot of their energy goes into the initial stage of an investment – the point where they traditionally offer transparency to their investors, saying, “We’ll be making this investment in X, we plan to be involved for X number of years, and here is all the information you’ll need on the target and our strategy.”  But the balance has tipped. The buy side is saying, “We want to understand more than the initial case for investment and periodic updates. We want to know the ongoing dynamics of the investment.”

II: Is there a feeling on the sell side that the expectations for transparency have ramped up too quickly?

Stuart Lawson: From a European perspective, managers want to supply investors with the information they request, but sometimes the requests are unrealistic. You have a full range of real estate assets and private assets, and even hedge fund assets as well, which all behave and react in different ways. So, within their existing infrastructure, it’s not feasible for many managers to deliver consistent data on a broad range of challenging requests.

Smith: In the U.S., the established players are struggling to figure out how to provide increased transparency while still protecting what they believe is their market value, and what they believe is their value-add to these companies and to the investments that they’re making.

Read the full paper on how alternative investors and managers can find common ground.

II: The buy and sell sides often work at cross purposes when it comes to regulatory issues. Could there be some positives if they increased collaboration in this area?

Finlayson: If the goal of regulators and regulations established common ground rules, it could increase information efficiency without destroying the ability of the sell side to do its job in its usual manner – and allow the buy side to get a reasonable set of information to satisfy their reporting needs.

Lawson: It’s important to consider what information the sales side should be expected to share with the market. They want to carefully guard intellectual property which creates their competitive advantage, such as the mechanism they employ to choose a particular investment, and the decision hurdles they go through. They may be happy to share some of that in a closed room with their investors, but that’s a very different scenario to sharing it to the marketplace.

II: Another source of tension arises when managers try to get creative in their use of credit. Lawson: The dilemma arises from different ways of reporting performance. When credit is involved in the mix, it’s important for managers to report on both the investment performance and the performance of the actual investor, and to be transparent about how and where credit is used and what its impact on performance looks like. In Europe, regulators are beginning to think about putting some boundaries around the way credit is used, and providing transparency in the investor reporting pack.

Smith: The vast majority of Limited Partners (LPs) don’t have a problem with a capital call line to help smooth out the streams so that a General Partner (GP) can make an investment in 10 days, even if they can’t call capital in 10 days. The problem comes when a GP has the right to borrow money for a few years without calling capital from the LPs to pay that off.

Finlayson: The position from the buy side, through the voice of the Institutional Limited Partners Association, is credit use should accrue to the benefit of the buyer. You get inflated Internal Rates of Return because of the money not actually flowing in at the time of the actual investment, so you get a big disparity between the levered and unlevered rate of return. The biggest point of concern for most investors is the pace at which the GP achieves their preferred return, and then captures carried interest on a portion of the profits sooner. Some argue that’s a negative for the asset owner and benefit to the seller. In many cases, investors don’t realize they agreed at the outset to give the general partner the ability to do this. But the world has gotten a little smarter about it all, and many limited partnership agreements are now clearer on it up front. 

Smith: This is an area where it behooves GPs and LPs to work together rather than to feel like they’re forced into a solution. If GPs and LPs come together, they can possibly avoid restrictive legislation that could cause problems for everybody.

II: Fees are seemingly an endless source of friction between investors and managers.

Finlayson: Carried interest cast as a fee is a problem. Carried interest is not necessarily a bad thing. Casting it as a fee rather than an appropriation of profit can spread misinformation to those who are unfamiliar with the asset class, including many investment committees and sometimes other asset owner decision makers. Those who are making investment decisions to go into alternative assets understand hurdle rates and understand the mechanics of private equity. It becomes a political hot potato when it reaches the asset owner decision maker level, where they may not have the background on how these different fee mechanisms work within private equity. The buy side shares the pain because it creates a level of oversight that requires resources to pursue, track, and report fees, and answer related questions. Globally, public funds respond to freedom of information act requests from anybody interested in how the general public’s money is being invested. Transparency is a very time consuming and expensive process.  

Lawson: If the industry as a whole can reach some kind of a consensus on measuring transparency and thorough fee disclosure, it will save a lot of that pain.

II: Within the alternative space, as it relates to due diligence, is there fear on the sell side that investors will misunderstand the controls that are in place?  

Lawson: Due diligence means a lot of different things to different people. When investors want to come into a shop and review the process the manager goes through in selecting investments it makes a lot of managers nervous. The process is complex and involves a large degree of judgment, and a number of different committees and decision gates along the way. Private equity is an area where risks can be mitigated but not removed, and that requires judgment. As part of the business model you might expect a number of investments to fail, but by accepting that you also select some that outperform by sometimes significant multiples. The challenge for the manager is to explain the nuance and logic of the process – why the decision goes forward, why the judgment applies, so that investors come away confident that controls are in place.  

Smith: As an example, if an LP is coming from the public market and they want to see independent third-party valuations on all of their private investments, it’s a struggle for the GP to provide because they’ve always been the one closest to their investments. To bring in a third party is expensive and time consuming.

Finlayson: Due diligence is increasingly looked at as an ongoing exercise, where either the asset owner themselves or their agent inspects the operation, understands the integrity of the process, the valuation process, the audit process, the systems, disaster recovery, business continuity, all of those aspects. And today you add cybersecurity to the list. That can be a huge budget eater because it’s an ongoing battle. For some boutique alternative asset management firms, it can really cut into their pockets, and likely has to be outsourced.  

II: Thirty years ago, the idea that cybersecurity would be an issue would have been unimaginable for most people. Point being it’s difficult to clearly see the future. That said, were you to make a checklist of things to move the collaboration between the sell and buy sides forward, what would you recommend?

Finlayson: Continue educating the buy side. The better the buy side can articulate their requirements and needs at the onset, the less friction there will be.

Lawson: Industry standards of transparency that are mutually agreed upon by the buy side and the sell side, and that can be globally applied. That as a framework will diffuse a lot of the potential tension. In particular, the managers will take comfort that they’re not being asked to divulge commercially sensitive information.

Smith: At the end of the day, these are partnerships. I’m not sure where we started seeing an “us versus them” attitude, but if both sides work together nothing bad is going to come of that. That’s exactly how it’s supposed to work. For example, clear data management policies and strategies for private equity managers are a crucial factor to their ongoing success. The houses that manage this well will move ahead of those that do not. The private equity industry is already

looking at data management policies of any business they invest in. Data management will be a key theme for years to come.

Read the full paper on how alternative investors and managers can find common ground.

This information is not intended to be and should not be treated as legal advice, investment advice, or tax advice. Readers, including professionals should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel. The information in this report has been obtained from sources believed to be reliable however Northern Trust accepts no liability in respect of accuracy and completeness of this information. All information contained herein is subject to change at any time without notice. Any person relying upon information in this report shall be solely responsible for the consequences of such reliance.

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