This article is authored by MOI Global instructor Mark Walker, Managing Partner at Tollymore Investment Partners, based in London.
Institutional investment management is broken. Asset gathering business objectives and gold-plated cost structures magnify the imperative to grow AuM. Investment firms led by marketers rather than investment managers create strategies tailored to what will sell rather than what works. Large pools of management fees are required to fund large, expensive, teams designed to convey analytical edge. Pressures to justify high management fees discourage investment professionals from acknowledging ignorance or mistakes and create an action bias that is antithetical to good investment outcomes.
Money management is a very scalable business model. It is possible to raise significant capital without commensurate increases in resources, rapidly increasing the profitability of the investment firm and substantially enriching its owners. Managers’ and investors’ fortunes are typically not aligned. This is a barrier to sound investment decision making. A simple way to weed out the managers that back themselves is to consider the presence and power of incentives. Managers without insider ownership are less incentivised to limit the size of their fund, therefore limiting their achievable investment results. In our view, and in the case of most institutional money managers, the components of stewardship reflect a product to be sold rather than a strong belief in the strategy.
There are ways to enrich the owners of an asset management business that are consistent with compounding the capital of your investors. Incentive principles should allow for the enrichment of GPs together with, and not at the expense of, LPs. The manager’s compensation should be driven by the compounding of his own capital in lieu of fees on additional capital. Sharing of investment returns in excess of appropriate hurdles lowers pressure to grow beyond the strategy’s investment capacity.
The creation and promotion of investment strategies that will sell result in niche investment universes predicated on analytical edge, primary research methods, or proprietary idea generation funnels, all of which look ‘differentiated’ in a pitchbook. The latest incarnation of this pitchbook mentality comes in the form of ESG investing mandates.
Investors last year ploughed a record $21bn into ‘socially-responsible’ investment funds in the US, almost quadrupling the rate of inflows in 2018. The surge in popularity of companies with the best social, environmental and social governance scores in recent times has resulted in a crop of ESG funds, eager to attract some of the cyclical capital flows to this bucket.
Attempts to quantify art through an obsession with measurement creates bubbles, disincentivises first principles thinking, and makes capital allocation and manager selection processes less efficient by making them more data driven. But data can be falsely empowering, unaccompanied by thoughtful qualitative review of a manager’s capacity and incentives to do a good job.
The shoehorning of ESG frameworks into existing asset management programmes and the surge in new ESG funds extend the already warped incentives in the investment management industry. Stocks with strong ESG scores are bid up as these capital inflows are put to work. Are investment managers, guided by the desire to grow assets and the employment of a quantitative ESG scoring framework, and absent the facility to think independently about the sustainability and reasonable governance of companies, and the investment merits of their equity, being socially responsible by directing endowments’, charities’ and pension funds’ capital to this more richly valued subset of the global investment universe?
ESG’s commonly accepted synonymity with ‘sustainable investing’ is especially perplexing. Who wants to own unsustainable businesses? What is investing if not the purchase of part-ownership of sustainable, flourishing enterprises? What long term business owner, managing capital for investors with long term, sometimes perpetual, investment horizons, would like the company she owns to be run by dishonest, self-serving managers misaligned with company owners, to treat employees poorly, create negative externalities, and exploit its customers? The studious long-term investor must consider the company’s relationship with all its stakeholders. At a minimum, understanding the strength of these relationships is central to mitigating risk of permanent capital erosion. Ideally, these relationships confer a lasting unfair business advantage, difficult to replicate by peers merely paying lip service to regulators and investors requiring the completion of ESG checklists. The items on these checklists must be measurable. This encourages the quantification of factors which are qualitative. How can one quantify, or score, whether, and the extent to which, social media companies exploit their users to the detriment of their health? Can these checklists consider and measure the enormous and compounding positive externalities created by modern platform businesses? An appreciation of the relationship between a company and its stakeholders is a qualitative, subtle, and effortful endeavour. The interrogation of business ethics and the capacity for company managers to make the right long-term decisions are at the heart of serious investment programmes. The employment of an outside analytics firm to bestow credibility on an ESG framework is no part of this.
Any investor with an interest in owning sustainable businesses must recognise that company boards have broader responsibilities to consider environmental and social issues. They will also understand that these duties do not dilute their fiduciary obligations to equity holders. Rather, they are a necessary part of satisfying them. Decisions to create large positive externalities and forge win-win outcomes – non-zero-sumness – take time and often come at the expense of traditional short-term measures of shareholder return. But these are the decisions that determine corporate vitality and staying power.
The broad disregard for long term win-win outcomes is a function of short holding periods. Company ownership changes hands on average every few months, vs. eight years in the 1960s. This is a by-product of investment constraints deeply embedded in the institutional money management industry, such as short-term capital, manager/investor misalignment, career risk and asset-growth agendas. These constraints cannot be addressed with an ESG checklist.
Just as truly special corporations seek to thrive under the principle of win-win, so must investment management firms create more value that they consume. Incentive structures should make it sensible to forgo additional management fees in lieu of excess returns on insider capital. Frameworks for economic profit-sharing should reward acceptable performance and coordinate manager and investor enrichment. These include the employment of hurdles to make weak performance cheap and strong performance expensive. Investors should receive most of any outperformance generated, not just most of the absolute return. Fee structures should therefore allow fund managers to talk about integrity with some legitimacy. Too many managers charge egregious fees with the sole purpose of enriching themselves at the expense of clients.
Tollymore enjoys trusted relationships with long term investment partners. Partners who can think like business owners rather than stock market traders and understand that a common stock represents a fractional interest in real assets. Great investment partners are a competitive advantage: an evolving, mutually appreciative and increasingly resilient relationship is an enabler of greater and more sustainable value creation. Our goal is to accumulate wealth by investing in high quality businesses for the long term; it is not to predict share price movements.
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About The Author: Mark Walker
Mark Walker is the Managing Partner of Tollymore Investment Partners, a private investment partnership investing in a small number of exceptional businesses to compound clients’ capital over the long term. Prior to founding Tollymore Mark was a global equity investor for Seven Pillars Capital Management, a long-term global value investing firm based in London. Mark joined Seven Pillars from RWC Partners, where he was part of a two-person team managing a newly launched, long term global equity fund. Prior to that Mark worked as an investment research analyst for Goldman Sachs and Redburn Partners. He is a qualified chartered accountant, and graduated from Edinburgh University with a First Class MA Honours degree in Economics, graduating first in his class.
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