Allocators Need Them. Asset Managers Resent Them. And Everyone Is Afraid of Them.

They’re known, not entirely favorably, as the gatekeepers: the all-powerful investment consultants that advise the world’s most powerful allocators on where to put their money. 

Impress them, and gain access to institutional capital that would be inaccessible otherwise. Fail to do so, and find yourself locked out of lucrative partnerships.

Fund managers say they have no choice but to suck up to the gatekeepers. And they don’t love it. 

One chief executive of a small hedge fund, who asked not to be named, expressed frustration over the amount of time and energy he has spent — so far with minimal success — on investment consulting firms, from filling out requests for proposals to taking phone calls and meetings. Complicating the matter is what he perceives as a lack of transparency in each firm’s manager review process, making it difficult to figure out how to approach consultants more efficiently.

“If a search is going on, you can get three different calls from three different people at the same consulting firm,” the executive says. “You don’t know which ones you need to spend time with, so you talk to all of them — which is more time away from the portfolio.”

But suck up they must. Consulting firms wield disproportionate influence over where institutional investors invest their capital, and these firms advise on roughly two thirds of institutional assets in the United States, according to the latest estimate from asset management research firm Cerulli Associates. Just about every public pension fund in America has at least one investment consultant on retainer, and an increasing number of allocators are giving consulting firms discretionary power through their outsourced-CIO businesses. 

Getting on their exclusive short lists of recommended managers has never been easy. At least based on investment consultants’ own descriptions of their research, it’s a vigorous, extensive process covering everything from how an investment strategy is implemented to how a firm is managed. 

Part of the problem is that there are tens of thousands of funds and investment products seeking institutional capital — far more than any investment consultant could possibly cover. Although the number of staffers dedicated to manager research varies by consulting firm, even the largest firms frankly acknowledge that they do not have the manpower to look at everything. 

The time-intensive nature of these evaluations, combined with the sheer scope of the asset management industry, results in what Deb Clarke, Mercer’s global head of investment research, describes as a “herculean task” for an asset manager seeking a consulting firm’s stamp of approval.

To some extent, these difficulties are by design. Investment consultants, after all, are tasked with identifying the best possible managers for their clients’ assets. If it was easy to win their approval, they wouldn’t be doing their jobs properly.

But there may also be more systemic issues at play. Jilted managers and other critics of the consulting industry argue that the investment consulting model favors the larger, incumbent asset management firms. Smaller and emerging managers, which lack resources to devote to courting consultants, can fall through the cracks.

And yet asset managers are still aggressively wooing consulting firms, which they view as a fundamental component of their overall distribution strategies — especially in the face of mounting competitive pressures arising from the industry’s declining profit margins. The more established asset management firms have staff entirely dedicated to consultant relations in order to win — and keep — coveted positions on consultant buy lists.

“Getting an A rating from a consultant really is a big deal,” says Jeb Doggett, a director at asset management consultant Casey Quirk. 

It’s also nearly impossible. 

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By the frustrated hedge fund manager’s count, it has taken his fund two years or longer to get into consultant databases — in other words, just to reach the point where consultants are actually monitoring his hedge fund, if not necessarily recommending it to their clients.

For a relative unknown aspiring to a spot on a consulting firm’s recommended list, the process to get into these databases can be long, tedious, and immensely challenging. Getting onto a consultant’s buy list is another matter entirely, one that, for the manager, requires regular data submissions, meetings, calls — and a whole lot of RFPs. 

“It can seem like they are endlessly filling out RFPs and not getting selected,” notes Alexi Maravel, institutional director at Cerulli Associates. 

With investment consulting firms facing pressures of their own, getting recommended by them has only gotten harder. The ongoing consolidation of the consulting industry means that managers have fewer shots at getting on consultants’ buy lists, even as the combined consulting firms take on greater influence in the institutional investment community.

“There are fewer, larger, and more important consultants,” Doggett says. “It would be very challenging to win business if none of them are recommending you.” 

Another issue is the volume of information consultants have to sift through. Consider Mercer, the world’s biggest consultant, with more than $11 trillion under advisement worldwide — not to mention the $242 billion managed on a discretionary basis by its outsourced-CIO unit. The firm has about 1,300 people employed in its investment consulting practice globally, including about 135 research analysts.

That dedicated research team maintains a manager database called Mercer Insight, which contains about 6,000 unique asset management firms and 33,000 investment strategies. Of those 33,000 strategies, Clarke estimates that the firm covers only about a third, with a bias toward the asset classes and sectors where they think they can be most useful to clients. 

“You can see what they have to go through just to get selected to be rated by a consultant,” says Clarke. “They have to be well differentiated.”

Mercer assesses client demand and where it thinks it can find alpha, prioritizing where it spends its research budget based on client needs. 

A small-cap equities manager, then, stands a better chance of getting in front of a consultant than, say, a manager investing in large-cap U.S. stocks. As the consulting industry continues to consolidate, it will get “harder and harder to get an investment consultant’s attention, especially in asset classes that are out of cycle or less in demand,” according to Doggett.

Even among the managers and strategies that consultants do actively monitor, only a small fraction actually make it past the evaluation stage and into client portfolios. Take hedge funds, for example. There were 9,956 hedge funds operating at the end of 2018, according to the latest industry estimate from Hedge Fund Research. At Cambridge Associates, global investing head Noel O’Neill estimates that the 150-person research team covers just over 2,000 of those hedge funds.

“We have a very good understanding of about 25 percent of the hedge fund world, and of that 25 percent, we invest with about 10 percent,” he says. “We’re down to recommending 2 to 2.5 percent of the entire hedge fund universe.”

The team at Cambridge continuously monitors the remaining 1,800 or so hedge funds in its database, keeping an eye out for any standouts that might deserve to be upgraded to the list of recommended managers. Likewise, the top-rated hedge funds are watched closely for any activity that would necessitate a downgrade — the departure of a star portfolio manager, for instance, or an unannounced deviation from the original investment strategy.

That still leaves close to 8,000 hedge funds that are not under consideration at all. Those hedge funds might try to market themselves to Cambridge, but will get filtered out by a screening process meant to capture what O’Neill describes as “things we don’t want to spend time looking at.” That screen makes it possible for Cambridge’s research team to focus only on funds that fit the description of what one might call “institutional quality.” But, as O’Neill openly admits, it’s not perfect.

“In a process like that, you do miss things,” he says. “We will miss things that will turn out to be good.”

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Some things will pretty much guarantee a manager will never get on consultants’ buy lists.

Fraud or securities law violations are obvious deal breakers, but managers can also get dinged for what appear to be serious governance issues or flaws in the investment process. One red flag cited by every current and former investment consultant interviewed for this story was extreme turnover, which can simultaneously threaten future investment performance and indicate possible cultural problems at an organization.

“If the full team left or every key member of the team left the firm, especially overnight with no good succession plan — that’s the kind of thing that can significantly downgrade a manager’s score very quickly,” says Stephen DiGirolamo, a managing director at Wilshire Consulting.

Another make-or-break requirement is an asset manager’s track record — specifically, how long that track record is.

Asset managers “have to have a three-year track record to be in a consultant database,” according to Cerulli’s Maravel. Exceptions might be made for emerging managers, or asset classes that are “more up-and-coming and more esoteric,” according to Casey Quirk’s Doggett. But in general, three years of performance data is the rule.

Especially in private markets — where an investment can be a 12-year-plus commitment — investment consultants want to be certain about a manager’s abilities before they recommend that manager to a client. At Meketa Investment Group, the private assets team looks for managers with “robust” and “relevant” track records, according to managing principal John Haggerty.

“The track record may be impressive, but was generated in the aftermath of the Great Financial Crisis — and if that’s not the market environment we project to see going forward, then it has less relevance,” he explains. Whether or not the portfolio manager who executed the strategy is still around also plays into a track record’s “relevance,” according to Haggerty.

“One thing that’s really important to us is making sure the manager is proven,” he says. As much as investment consultants talk about past performance not being indicative of future returns, analyzing performance results is still the most quantifiable method they have of evaluating a manager’s investment ability. Managers don’t necessarily have to have produced blockbuster returns to get onto a consultant’s buy list, but they do need to have performed in line with expectations.

“Part of our qualitative assessment is to understand the investment philosophy and process, and understand when that process should outperform,” says DiGirolamo. “There are times when different strategies are going to be out of favor. To us the biggest red flag is not underperformance, but performance that doesn’t align. A strategy that outperforms when it shouldn’t is sometimes more of a red flag than vice versa.”

That said, delivering crazy-good returns is surefire way for a manager to get attention.

“If there’s been success on the surface, that will spark the more in-depth, qualitative type of analysis,” DiGirolamo notes.

Beyond having the requisite track record, asset managers hoping to get on an investment consultant’s recommended list must also meet the Goldilocks standard of assets under management: They can’t be too small, but they can’t be too big either.

“If a strategy gets too large in terms of assets, that could be reason for termination, because they might not be able to invest in the areas of the market that made them successful,” says Mitch Dynan, director of public markets manager research at Meketa. But if a strategy has only a few investors, that can also be a red flag. “If they are overly dependent on one client or a small number of clients,” that can be a problem, Dynan adds.

Industry observers suggest that consultants may also eschew smaller managers simply because it is more efficient for them to focus on asset managers with a higher capacity for new investors. “If a consultant has the option of a multibillion-dollar fund manager that has successfully raised multiple prior funds, they will do that almost every time instead of a new or smaller fund manager that might be more difficult for them to scale within their network,” says Jason Lamin, chief executive of technology firm Lenox Park Solutions.

Lenox Park operates a cloud-based networking platform called RoundTables, an invite-only service that seeks to “democratize access to capital” by connecting institutional investors with managers referred to them by their closest peers. Lamin is among those who believe that the traditional investment consulting model is biased against small asset management firms, making it difficult for emerging managers, as well as fund management firms owned by women and minorities, to break into the industry. It’s a viewpoint that’s supported by a recent survey of hedge fund managers conducted by HFM Insight: According to the survey’s findings, the larger a hedge fund is, the more likely it has received a spot on an investment consultant’s buy list.

Among hedge fund managers with less than $200 million under management, only 11 percent said they had managed to get a coveted spot on a consultant’s buy list — even though 60 percent reported that they were actively campaigning for consultant approval.

At the opposite end of the spectrum, just about every $3 billion-plus hedge fund manager seeking a consultant’s recommendation had been successful, with about 80 percent reporting that they were on the buy list of at least one investment consultant. 

Even if investment consultants were not incentivized to favor bigger funds, the larger asset managers would still be at an advantage simply because they have more resources to devote to courting consultants. Cerulli reports that the average asset manager has the equivalent of three full-time employees dedicated to consultant relations. But for upstart and lean managers, that burden often falls to the lead portfolio manager or the chief investment officer.

“It’s a very difficult proposition for a smaller, more emerging manager to get in front of investment consultants,” Maravel says. “They don’t have consultant relations professionals; they’re smaller and more nimble, focused on the investment side and not on marketing.”

Managers can try appealing to investors directly — but attempts to circumvent investment consultants can hurt a manager’s relationships with the consulting firms, damaging their chances of winning business from them in the future. Even when it’s the investor approaching the manager, the hedge fund CEO says he asks the investor to facilitate communications between his firm and their consultant. “You don’t want to just go around them,” the CEO says.

This unwillingness to do anything that might alienate a consultant is proof of the “very strained, one-sided relationship” between asset managers and investment consultants, according to Lamin.

“I’m not sure investment consultants ever really get accurate feedback from [general partners], because then you’re just shooting yourself in the foot,” the Lenox Park CEO says. “It’s a relationship where GPs are just constantly having to grovel at investment consultants.”

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If groveling doesn’t sound appealing, there are segments of the institutional marketplace where consultants hold less sway — and areas where their influence is waning. 

Endowments and foundations are known for being more independent — especially the larger funds, which tend to have investment staff of their own focused on sourcing managers. Insurance general accounts have also historically been less dependent on investment consultants for manager selection.

Cerulli’s Maravel says corporate pension funds now are increasingly engaging managers directly rather than leaning on their investment consultants. “I’m not saying consultants don’t have a major role in advising corporate defined-benefit plans,” he says. “But as more corporate defined-benefit plans derisk, they are asking asset managers with whom they have existing relationships to construct derisking glidepaths and run liability-driven investing strategies for them.”

Investment consultants have also not been immune to many of the problems faced by asset managers, including lower long-term returns, downward pressure on fees, and the rising popularity of passive strategies, to name a few. At the same time, the traditional advisory model has begun to be supplanted by discretionary management, with assets under full or partial discretion by outsourced-CIO providers reaching $1.56 trillion in 2017, according to Cerulli.

Technology is poised to be another disruptive force, as firms like Lamin’s Lenox Park attempt to edge in on the intermediary industry. Currently, Lamin says his company’s limited partner clients manage a collective $800 billion — putting Lenox Park not that far behind a major investment consultant like Wilshire Associates, which has just shy of $1 trillion under advisement. (Lenox Park’s clients, of course, will likely not fire their main consultant anytime soon.)

Consulting firms have responded to these and other competitive pressures by turning to M&A, merging with competitors to acquire scale, bolster their alternatives expertise, or build out their OCIO platforms. Recent examples include Meketa’s planned merger with Pension Consulting Alliance, Mercer’s Pavilion Financial and Summit Strategies Group acquisitions, and Aon Hewitt’s purchase of the Townsend Group.

According to Cerulli’s research, asset managers have reacted by shifting from a regional approach to consultant relations to a tiered approach that prioritizes certain consultants above others. “Tier one” consulting firms can include those with large or desirable client bases, as well as those with OCIO platforms, which, according to Casey Quirk’s Doggett, are viewed by distribution professionals as one of the most important growth areas in the institutional market. 

“Even while there’s all these changes going on in the consultant business model, institutional asset managers still consider the consulting community to be a very important constituency for them,” Maravel says.

The groveling may not be so avoidable after all.