The separation of funds and managers: a theory of investment fund structure and regulation.

• Author: Morley, John
• Position: III. Explaining the Separation of Funds and Managers A. Exit Rights and Performance Incentives d. A Note on Imperfections in Exit Rights through Conclusion, with footnotes, p. 1256-1287

d. A Note on Imperfections in Exit Rights

Many readers will object that exit rights in investment funds are not always perfectly free. In private equity funds, for example, investors must wait for liquidation, which typically occurs every five to ten years, and can sometimes take longer. In hedge funds, investors face initial lock-up requirements, which force them to keep their money committed for a fixed amount of time when they first invest, and also occasionally face "side-pocket" arrangements that allow managers to restrict redemptions with respect to portions of the funds' portfolios. In mutual funds, investors often lack the time or financial sophistication to monitor their funds and redeem as necessary. Investors in all types of funds must realize and pay taxes when they exit.

I have addressed some of these objections in detail elsewhere and have explained why they may not be as serious as they initially seem. (69) For present purposes, however, it is enough to stress that my point here is not to say that exit rights are perfect. Rather, my point is to build a framework in which we can understand the effect of variations in the strength of exit. The general pattern observed above is that as exit rights become weaker, control rights and other contractual protections become stronger, and as exit rights become stronger, control rights and other protections become weaker.

This framework is useful for explaining many previously inexplicable phenomena. It tells us, for example, why private equity investors demand so many more contractual protections than hedge fund investors do. This understanding will also explain below why closed-end funds are so unpopular. The idea, basically, is that closed-end funds offer no exit rights to compensate for their restrictions on control.

It is also important to keep these restrictions on exit rights in perspective. Even if exit is costly or uncertain, it can still diminish the value of control. So long as exit remains even a possibility--though perhaps a costly or difficult one--voting will be less valuable than it would be if exit were not a possibility at all (as in ordinary companies). If exit diminishes the value of control to fund investors even just partially, then fund investors will be more likely to give up control to management company investors than if exit were not a possibility at all.

2. Performance Incentives

   Although exit is the most important of fund investors' substitutes for control, it is the not the only one. In private equity and hedge funds, investors are further protected by extremely powerful performance incentives. Managers' fees are tied to funds' performance, (70) often giving managers around twenty percent of a fund's positive returns. (71) Managers are also often required to invest their own money in the funds. These incentives take the place of control by encouraging managers to act in investors' interests even in the absence of control.

   The natural variation in the strength of these incentives across different types of funds also helps to confirm the observations above about the role of exit. Performance incentives tend to be strongest and to receive the greatest emphasis in the types of funds that offer the weakest exit rights. Mutual funds--which have the strongest exit rights--rarely charge large performance fees. (72) This is consistent with the theory that exit and performance fees are substitutes for one another, as well as for control.

   2. Unusually Strong Preferences for Precision in Risk-Tailoring

      With this understanding of control rights in place, let us now consider a second reason for the separation of funds and managers: fund investors place an unusually high value on precision in the tailoring of risk. They wish only to be exposed to the risks of investment assets, and not to the risks of the management businesses that administer those assets. Returning to the product analogy, we might say that one of the products that fund management companies sell is a willingness to bear operational risks in return for a fee, so that fund investors can enjoy exposure only to the risks of investment assets.

      Consider, for example, S&P 500 index mutual funds. Roughly speaking, these funds hold shares in the five hundred companies that comprise the S&P 500 index. These funds offer no discretionary management, and so their only purpose is to make exposure to these five hundred stocks easy and convenient. This is only possible because of the separation of funds and managers.

      If an S&P 500 index fund did not separate its investment assets from its management assets, the fund would have to employ its managers, secretaries, and other workers directly. It would also have to own its operational assets, such as computers and equipment, and sign operational contracts, such as leases for office space and employee health insurance. As a consequence, the fund's value would reflect not just the fluctuations in the value of the S&P 500, but also fluctuations in the markets for office space, secretarial labor, health insurance, and so on. In the end, the risks associated with these fluctuations would amount to a kind of new stock holding for the fund, creating, in effect, an "S&P 501" fund.

      The separation of funds and managers solves these problems by giving operational expenses to the management company and making the management company's shareholders the residual risk-bearers for these expenses. A typical S&P 500 index fund, for example, signs a contract with its management company under which the fund receives its operational services in return for a contractually specified fee, which generally will not fluctuate with the management company's actual operational expenses.

      The separation of funds and managers further tailors fund investors' risks by insulating funds from the management company's creditors. If a management company becomes insolvent, its creditors have no claims against the funds. This suggests that separation may have important risk-tailoring functions even when the residual risks of operating expenses are small in comparison to investment risks. Although fluctuations in the cost of secretarial wages might not have mattered to investors in Lehman Brothers' hedge funds, the risks created by Lehman's bankruptcy surely did. Because advisory businesses are often part of much larger businesses, the insulation that the separation of funds and managers provides from managers' creditors is crucially important.

   3. Economies of Scope and Scale and the Operation of Multiple Funds

      This last observation leads us to contemplate a final motivation for the separation of funds and managers: it facilitates the simultaneous or serial management of multiple funds. As noted above, it is quite common for management companies to operate multiple funds simultaneously or serially over time. And many management companies also operate other lines of business, such as investment banking, commercial banking, brokerage, and so on. The motivation, presumably, is that by operating multiple funds and other lines of business, management companies can achieve economies of scope and scale. (73) These economies ought to benefit investors as well as managers, because managers who achieve these economies can use the savings to compete for investors by promising lower fees and better returns.

      Returning to the product analogy, we might say that the separation of funds and managers enables fund management companies to operate multiple funds in much the same way that product manufacturers operate multiple product lines.

      The separation of funds and managers facilitates the operation of multiple funds and other lines of business in three ways: first, it prevents liabilities and residual earnings risks from spilling between one fund or business line and another; second, it allows management companies to continue as going concerns even when their individual funds have liquidated; and third, it enables the efficient resolution of conflicts of interest among multiple funds by giving management companies the authority and incentives to resolve these conflicts efficiently.

1. Preventing the Spillage of Risks Across Funds

   First, the separation of funds and managers limits the spillage of risks across funds and between funds and other business lines. It does so by preventing creditors of one fund or business line from seizing other funds' assets and by insulating each fund's investors from fluctuations in the profitability of the other funds and business lines.

   In essence, the simultaneous management of multiple funds simply strengthens the argument about risk-tailoring above: as a management company operates a greater number of funds and other business lines, the potential risks to investors become larger and less correlated with the investors' desired investment risks. The need for distinctions between the risks of any one fund and the risks of the management business becomes more urgent.

   Management risks can be substantial. When several financial conglomerates, such as Lehman Brothers and Washington Mutual, collapsed during the financial crisis of 2008, only the separation of funds and managers prevented creditors of these conglomerates' far-flung businesses--including their mortgage trading businesses--from seizing assets in the funds these conglomerates managed. Less dramatically, the risks associated with residual earnings--as distinct from liabilities--can also be important. Goldman Sachs's profits, for example, depend primarily on the success of far-flung and diverse business lines that are almost entirely uncorrelated with the success of any particular Goldman mutual fund. Investors in Goldman's mutual funds therefore naturally demand insulation from these risks.

2. Maintaining Management Companies as Going Concerns

   The separation of funds and managers also facilitates the operation of multiple funds by allowing management companies to continue as going concerns even after...