Why Captive Investment Manager Due Diligence Matters
John M. Foehl | November 22, 2017
Investment management firms are growing larger and more complex. Low interest rates and the corresponding pressure on investment management fee schedules have ostensibly exacerbated this trend. As a result, investment management firms have shaved expenses, including the transactional costs associated with trading.
A recent Wall Street Journal article written by Justin Baer and titled "How a West Coast Trading Network Spawned a New York Pension Fund Scandal" tells a cautionary tale of how this drive to reduce costs can spin out of control. For captive insurers, which rely almost exclusively on external investment managers, the need to conduct preliminary as well as ongoing due diligence matters.
The Wall Street Journal article concerns Navnoor Kang and Guggenheim Partners. The following excerpt provides a peek inside the rather opaque relationships that develop between traders for investment management firms and the brokers who provide the securities bought and sold by these firms.
The connections Mr. Kang established with brokers during his years on the West Coast with investment firms Guggenheim and Pacific Investment Management Co. [Pimco] would play a critical role in what prosecutors alleged was the biggest public pension fund scandal in the U.S. of the past decade....
Some of the bond salespeople in Mr. Kang's orbit during the early part of his career later provided Mr. Kang with meals, vacations and other gifts in exchange for more trading business with the New York pension fund, according to U.S. prosecutors.
At Pimco and Guggenheim, Mr. Kang bought and sold bonds through a network of brokerage firms. Not long after Mr. Kang started work in Guggenheim's Santa Monica, Calif., offices, his new boss told him and other traders they needed to meet salespeople regularly over drinks or dinner.
This description of relationships between fixed income traders at investment management firms and the brokers that supply the inventory necessary to trade is accurate. In fact, fixed income desk traders are encouraged to cultivate relationships with various broker/dealers. The logic behind these symbiotic relationships is sound and is not unique to investment management. Personal relationships matter and can be beneficial in many workplaces.
For investment managers, the ability of their traders to secure allotments to new issuance, garner better execution pricing, or move odd lots or distressed debt may hinge on these relationships. Correspondingly, there has been growth in the compliance aspects of fixed income trading, both internally within each fixed income management firm and externally by the Securities and Exchange Commission. As such, compliance is not infallible and investment management firms like Guggenheim work to minimize disclosures of instances of incomplete compliance. This sometimes allows bad actors to continue working within the industry, leading to the problems outlined in the Wall Street Journal article.
Given this fact, it becomes even more imperative for prospective captive insurance clients to conduct adequate and ongoing due diligence of the investment management firms they seek to retain. Let us consider some basics surrounding investment manager due diligence.
First, it pays to employ an independent third party to conduct the initial due diligence screening process. The captive insurer should involve an individual in this process who has a significant insurance investment asset management background. While a captive manager or general counsel may offer to provide this type of analysis, his or her expertise in the investment management field is likely a sideline and ultimately may involve some of the same due diligence issues the captive is seeking to eliminate in the first place. An insurance investment manager should be selected based on merit and not on the relationships the manager has with other professional service providers employed by the captive. (Editor's note: this is true for all service providers retained by the captive.)
There is a very useful article published in CFA Institute Conference Proceedings Quarterly titled "Avoiding the Pitfalls: Best Practices in Manager Research and Due Diligence." Although the article was published in June 2010, the advice it contains remains valid. The author, Brian Tipple, identifies the original "four Ps" of the due diligence process, as follows.
He also suggests the addition of a new set of four Ps, as follows.
The article is an easy read and should serve as the basis of a discussion with the investment adviser who the captive retains to assist in the due diligence process. By having a dialogue around these eight attributes, the board and the investment adviser can surface those that are of major importance to the captive insurer.
Frequently, "performance" as an attribute is used as the initial screen to arrive at the list of potential investment managers. However, as Ben Carlson points out in the Wealth of Common Sense article titled " Why Money Manager Due Diligence Is So Difficult," performance is not a great screen for a number of reasons. He comments as follows.
Everyone uses the disclaimer that past performance is no guarantee of future results, but it's definitely the standard that everyone uses to make their future allocation decisions. Tom Brakke recently shared a great post on this subject that really hits the nail on the head here:
If you ask those involved in manager selection how much performance counts in their decision making, you tend to get an answer like "around twenty or thirty percent," and sometimes even less. However, if the very first step in the evaluation process is a performance hurdle, in actuality performance becomes the primary governor on the entire effort and is therefore the dominant factor. Without past performance, you don't get into the ring.
It's no wonder why allocators start there. Nothing compares with the ease of a performance screen to cut the universe of possibilities down to size. (In fact, many screens include [myriad] performance metrics that make the constraints very tight, as if being more precise in filtering redeems the flawed premise of the exercise.) Faced with a large number of potential managers, nothing culls the herd quite so quickly as screening, even though that means that many prized bulls of the future are left out and a lot of bum steers who were lucky in the past are kept in.
The fact is that investment manager due diligence is hard when done correctly. But spending the time up front to conduct the process correctly, a captive insurer is less likely to become enmeshed in some of the compliance problems surfacing with more frequency in today's ultracompetitive money management business.
John M. Foehl | November 22, 2017