Practical Capital 2022

Welcome to Practical Capital, our guide for family office executives.

Welcome to the second edition of Practical Capital; our guide to the structural, legal and operational aspects of looking after family investments. As you might remember, we created this publication because we felt that these aspects of managing capital often go overlooked. It’s easy to capture people’s attention with investment opportunities, less so with the nuances of a fund term sheet. But funnily enough, now that the fear of missing out that so dominated markets last year has turned into straight forward fear of capital loss, these nuances have suddenly come to the fore for many investors.

Today, we’re in an environment in which it’s easy to feel out of control; living costs are spiralling, markets are volatile, and some investors have found themselves exposed to risks they didn’t see coming. That’s why the pieces in this publication have one theme in common; they are about agency. There might be precious little you can do to offset the cost of your heating bill, but there are ways to protect against inflation in your investment portfolio. And while our industry doesn’t always make it easy to understand fees, risks or liabilities, getting to grips with them can help make sure that you’re paying the right amount, for the right level of risk, at the right time.

One thing we often say to new clients and the people who service and support them, is that our industry should never make them feel like a passenger; owning and investing capital should be an empowering experience. The jargon, the paperwork and the complexity of structures can all help to obfuscate that essential fact, as can volatile and unpredictable markets. But knowledge is power; what we hope you find within these pages is a useful, practical guide to the numerous ways that can help to ensure that you’re not overpaying, overexposed or under protected from a range of financial and operational risks.

Richard Adams
Partner, COO & Compliance Officer

Hiroko Atherton
Partner, General Council

Fees and transparency: how to make sure you’re paying for manager skill

When people think about manager selection, they typically think about the fun bit; grilling managers. The series of meetings where you sit face to face with an individual or team of investors, working out whether they have the talent, integrity and fastidiousness to wield your capital successfully in the marketplace. The reality is that the human-to-human aspect is only a fraction of the real work of manager selection. The part that’s far less exciting, but no less important, is making sure that you’re paying the right amount, for the right strategy, at the right time. There are times when its more sensible to pay lower fees for passive market access, and there are times when active management is more attractive. Even within managers and strategies, some are worth paying more for than others. Track record can tell you a little about whether their fees are justified, but you have to do some digging to make sure that you’re paying for manager talent, and not solely for the infrastructure around them.

So what kind of things can you end up paying for? Unfortunately, it’s a long list. In Europe for example, if you’re not buying funds wholesale as a professional buyers (as we do), then you can pay distribution costs, which is similar to the difference between buying something from a supermarket, and directly from the producer. You can also pay for all kinds of manager infrastructure, everything from manager salaries when investing in multi manager platform funds, to the costs of the research that the manager themselves buys to help them make investment decisions. Mifid II has forced firms to be more transparent about many aspects of costs, but outside of the UCITS universe there’s a lack of common standards for fee structuring and disclosures, which can make the job of finding out what you’re paying for surprisingly complex.

What could be included in a TER (total expense ratio)?

  1. Headline fund fee

    1. This will differ depending on the share class – make sure you are getting the best deal

    2. Founders share classes are always the lowest

    3. The remaining share classes are often tiered by investment size

  2. Performance fee

    1. Common theme across hedge funds and many active managers

    2. Look for clawback and hurdle rates

  3. Underlying manager fee

    1. Always in fund of funds structures

    2. These will include a “headline fee” but may also include performance fees

  4. Operational/admin costs

    1. Set up costs

    2. Ongoing management costs

      1. Administration fees

        1. E.g. Transfer agent, fund administration, custodian/sub-custodian and depositary fees

      2. Fixed fees

        1. Auditor and director costs

        2. Regulatory expenses

    3. Trading and execution

      1. Brokerage fees, foreign brokerage fees and tax (e.g. stamp duty)

      2. Fees charged on the execution of separate asset classes can differ substantially

Top three tips for examining fees

  1. Look under the hood at custody and trading

    Custody jurisdictions for both you and the manager can have an impact on fees, for example in some jurisdictions you’ll have to pay stamp duty and other kinds of charges on your capital.

  2. Run a trading fee health check

    It’s important to know what the manager’s trading fees are likely to look like, both in terms of trading volume and trading structure. You can assess the former by asking about historic portfolio turnover, and the latter by assessing fixed fees like how much the broker charges for foreign exchange spread, fixed income dealing and more.

  3. Think about future fees

    TERs are helpful, but they are also backwards looking in nature, they aren’t fixed. For example a growing fund might enjoy benefits of scale as it gets bigger, bringing down costs for investors over time, while a shrinking fund is likely to become more expensive.

Side pockets: friend or foe?

Pockets are ingenious things. They’re built to conceal; to house all manner of objects in as unobtrusive a way as possible. In fact, when women first began to sew them into their clothes in Victorian Britain there was moral outrage; what nefarious things might they be hiding there? Why do they need them in the first place? We might no longer be asking these questions about women, but they’re being reincarnated in an even more surprising place today; hedge funds.

Back in the re-invented early noughties, before the 2008 crash prompted a vast swathe of restrictions on fund structures, hedge funds packed all sorts of investments into the funds; liquid, illiquid, it really didn’t matter, they more or less had complete freedom to invest in what they liked. Today, if managers decide that they want to start buying less liquid assets, they don’t have the same freedom to so do within their main strategies, so they have re-invented an old friend; side pockets. These are segregated portions of the fund that don’t carry any liquidity restrictions. Previously they were often included by default and hidden away. Now they are mostly optional, clients are often asked to proactively opt into different levels of side pockets. If no express limits are set, which is most often not the case, managers can use them to invest in whatever they like. At worst, they can lock up your capital indefinitely, with no terms on them whatsoever. At best, the term will be much longer than the original liquidity profile of the fund with a very different investment objective. So, are they a good thing, or are they – to paraphrase the Victorian moralists – using them to conceal things they shouldn’t have in the first place?

Firstly, side pockets as we are seeing them today are often optional, and in many cases they are actually driven by client demand for higher returns or for a manager to explore an alternative investment space. Long term investors might want to give their managers the freedom to find truly long-term investments with the potential to create higher returns without the pressure to realise the value within a certain timeframe. And – unlike in a private equity fund - if there aren’t any opportunities, they don’t have to use the capital. The downside is almost always the lack of initial clarity on investments terms and also the potential for mission creep compared to the original investment mandate of the fund. An investor will be focused on the hard terms of their main class of shares, not the terms of a phantom 10% side pocket that may or may not realise in the future. There are also structural elements to consider, for example, is the performance fee payable on illiquid assets? Or are you going to only pay fees on realised assets, like you would in a private equity fund? Is it a positive search by the manager for additional investment opportunities and are side pocket investments required to be designated as such on day 1, or a safety net for the manager when liquid investment fails later in its life? Because this is a developing concept, some of these commercial, legal and operational concerns are still being worked out by managers and investors alike.

So how we do see them? Broadly speaking we’re comfortable with the concept, but extra scrutiny is required as an investor. It is two sets of investment terms that need to be reviewed. When run well, they can give help boost long term returns by giving talented managers the bandwidth to seek out interesting opportunities. When run badly, they can leave you with structural risk, and exposure to illiquid assets without the investor protections you’d get in a liquid fund. So as always, it’s a case of buyer beware.

Three things to consider when thinking about allocating capital to a side pocket

  1. Make sure that the strategies are being run separately

    What we want to see from managers running these strategies, is that the two programs are being run professionally, and that each has the people infrastructure to do so. In some cases managers could simply be moving assets they’re struggling to sell into the side pocket, instead of actively seeking opportunities. Ideally, you want to see separate teams running each part of the portfolio. Critically, there needs to be a requirement that side-pocket investments can only be designated as such on day-1.

  2. Avoid mission creep

    A huge number of managers are creating side pockets at the moment, so chances are you’ll be offered these opportunities by managers that already know and trust. That can create a trap, as you might not notice that with every fund they’ve launched, they’ve moved away from the original strategy that you invested in. It’s important to analyse each new fund with fresh eyes, and not be taken along a journey that you didn’t sign up for.

  3. Make sure they have the right skill set

    Liquid and illiquid assets are not two sides of the same coin, they require different approaches, skill sets, and training. If a manager is going to move into illiquid strategies, you need to see that they’re investing in the right people and infrastructure to do it properly.

Trading: a brief guide

As the name of this publication suggests, we wanted to offer practical ways to help families and their associated advisors make good decisions with their capital. While manager selection, macro analysis and investment opportunities are central to a good strategy, they can all be undermined by a trading platform that is not up to scratch. Here, we explore the key tips to look out for when structuring your own in-house trades.

Our trading tips

  1. Understand the cost of execution across asset classes
    1. E.g. bond trade and foreign exchange fees are included in the spread
    2. Options can often be more expensive
    3. Are brokerage rates based on number of contracts?
    4. US brokers may quote as cents per share, with European brokers often quoting as a % (basis points)
  2. The use of limit prices on trades helps to control your execution and give safeguards against sudden market shocks. Discuss trades with your broker in advance to understand the trading routes open to them on exchange, dark pools, OTC etc.
  3. Research the liquidity of the instrument you wish to purchase/sell before doing so
    1. May need to entertain trading directly with market makers where liquidity is low
  4. Always check your contract note to ensure the details match with the broker confirmation on price and charges, and challenge fees – they aren’t always correct!
  5. Pay close attention to then market you trade in – different jurisdictions have different tax schemes (e.g. Swiss stamp duty)

Inflation protection: can you build it yourself?

Inflation is clearly a key issue at the moment. While there is little you can do to offset the increased cost of living, there are ways to protect against inflation in your investment portfolio. Buying inflation linked bonds or third-party products designed to beat inflation is one option, but sophisticated, institutional investors have even more options to safeguard portfolios from the effects of inflation. Early this year, we worked with banking counterparties to structure a direct inflation protection swap on behalf of each of our clients. This is an attractive option that few private investors explore directly but can be highly cost effective and efficient when managed well. Here, we explore the process behind it:

We wanted to implement a sophisticated inflation protection across a number of client portfolios where protection is still cheap and for clients who couldn’t execute swaps directly. We created a solution for our clients without charging extras fees. We worked with three investment banks to obtain best pricing for an investable security that multiple clients could invest in with ease, and at low cost.

These were the steps taken:

  • Our Chief Investment Officer negotiated the fee rate and product type with the bank to ensure it met our clients’ needs
  • We worked with 7 different client custodian banks to ensure that each and every one was set up to make the trade
  • We connected the banks with the global bank’s trading desk via Bloomberg and hosted a series of calls to ensure that all parties were aligned
  • We worked with the counterparties to provide daily liquidity and daily pricing, even though the note was intended as a long term holding

For family offices with the size and relationships to carry out these kind of trades themselves, we think this is a very attractive way to protect portfolios from inflation. Those without the bandwidth to do so themselves have the opportunity to partner with managers who can take on the work for them, as we have for a large number of our clients.

All information and opinions expressed are subject to change without notice. Advice is given and services are supplied by Capital Generation Partners LLP and its affiliates (“CapGen”) on the basis of our terms and conditions of business, which are available upon request. No liability is accepted or responsibility assumed in respect of persons who are not clients of CapGen, unless expressly agreed in writing.

This does not constitute investment advice or an offer, contract or other solicitation to purchase any assets or investment solutions or a recommendation to buy or sell any particular asset, security, strategy or investment product.