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Few men, perhaps not even PIMCO’s Bill Gross, have been as farsighted as Dan Fuss when it comes to investing intelligently in bonds. America’s institutional investors have, in turn, bet heavily on Loomis Sayles. The Boston-based manager runs approximately $62 billion in institutional and mutual fund fixed-income mandates, and Fuss has had a hand in virtually every key investment decision, resulting in decades of outperformance—the Loomis Sayles Multisector strategy has 10.52% annualized returns, versus 7.25% for the Barclay’s Government/Credit Index, since inception in 1989. However, there is a fly in the ointment: Fuss is 77 years old.
Asset managers are, by their nature, dependent on key individuals but, as institutional mandates edge ever more aggressively into alternative investments and complex fixed-income deliverables, key-man risk is being elevated to levels never before seen. Yesterday’s asset classes, like long-only equity, over the last decade, have become less and less star-dependent, their investment decisionmaking more a function of process and systematic analysis. By contrast, today’s search for risk-adjusted alpha is transporting asset-owners directly into key-man country.
Loomis Sayles is far from the only asset management firm with a key-man conundrum. Bridgewater’s Ray Dalio, now 62, is renowned for having a hand in virtually every decision, large and small, made by the extraordinarily successful fixed-income manager he founded in 1975. Citadel, which now manages $11 billion, seems still a creature of its founder, Ken Griffin, a notorious micro-manager. Paulson and Co. manages $37 billion, and John Paulson makes the bets. America’s institutional investors give massive mandates to all these firms.
Yet, given the risk, should they? “It’s impossible to avoid key-man risk entirely,” says Roger Fenningdorf, partner and head of manager research at Rocaton Investment Advisors. “We make sure that clients are aware if we perceive there to be key-man risk. In the analysis we do on investment managers, we’re very explicit whether the recommendation is based on an individual or a couple of individuals and we make it clear that if that individual left we would exit.”
The challenge thus becomes not avoiding key-man risk, but managing it. To manage it, of course, it first has to be identified. “One of the key themes is understanding the decisionmaking process and recognizing key decisionmakers,” says Alan Papier, a principal at Mercer. “Identifying key decisionmakers goes beyond a regurgitation of named portfolio managers. It involves in-depth analysis and identification of the individuals we believe whose contribution is significant or integral to the manager.”
Managing key-man risk, consultants say, means thinking through what the demise, departure, death, or decay of an individual or team would mean to the return-generating machinery at an asset manager. This is both an art and a science. The art would come in understanding why, say, Ray Dalio remains so committed to Bridgewater when a less driven individual would long ago have turned to gentler pursuits. The science comes in analysis of compensation and equity ownership. “We look very closely at how key people are compensated, incentivized, and how they are bonded to the company,” says Papier. “If key-person risk is high and flight risk is also high, we would not recommend an investment.”
It has been a rocky decade for Los Angeles-based asset manager TCW Group. How much of its trouble could have been foreseen is the question, as key-man risk has clearly been the source of much of its misfortune. In 1995, a group of five individuals led by junk-bond specialists Howard Marks and Bruce Karsh opted to leave TCW to start their own firm. TCW survived the split largely on the back of one man: Jeff Gundlach, a polarizing figure but unquestionably a fixed-income savant. As CIO, Gundlach steered TCW safely through the ravages of the 2007 housing market collapse: from 2006 to 2009, the TCW Total Return Bond fund that he ran gained an average of 9.1% a year, trouncing his peers. Nonetheless, as the atmosphere at TCW grew increasingly rancorous and word of its sale was circulated, in December 2009, TCW Chief Executive Marc Stern sacked Gundlach. Client response was dramatic—TCW had a drop of $10 billion in assets under management in less than 30 days and an additional $20 billion soon followed it out the door. Worse still was the loss of intellectual capital—45 of the 60 members of Gundlach’s mortgage-backed securities teams left TCW to join him at his new firm down the street. Dueling lawsuits followed, and TCW has rewon much of the ground it lost with Gundlach’s departure. For TCW’s institutional investors, however, it has been a challenging decade, where ignorance of, or reluctance to act on, key-man risk has exacted a price.
Sometimes key-man risk asserts itself when transactions occur. Gary Brinson, the son of a Seattle bus driver and a pioneer of asset allocation, engineered a $100 million management buyout of the asset management arm that he ran at First Chicago Corporation in 1989. The creation, bearing its founder’s name and with his fingerprints on every investment decision, became one of the more innovative and successful firms of its generation. Swiss Bank Corporation, which was itself shortly subsumed by UBS, bought Brinson Partners in 1995 for $750 million, a transaction that made Brinson and a handful of key principals extremely rich and, in the final analysis, disinterested in the future of the firm they no longer owned. Brinson’s extraordinary skills as an asset manager never outlasted his eponymous firm.
Key men can seek flight; they can be fired; they can become wealthy and more interested in managing their own assets. They also can be perceived to lose their touch. Legg Mason learned this to its cost when Bill Miller, he of the golden touch who ran Legg’s Capital Management Value Trust fund, seemed to forget how to pick stocks amid the turbulence of 2007 and 2008. The fund dropped 55% in 2008 and its long-term performance—and Miller’s stellar reputation—was shattered. With Miller’s reputation went investors’ capital—by 2010, the Value Trust fund had only $4.2 billion from a peak of $21 billion. Despite respectable performance in recent years, assets remain stagnant.
Of all asset classes, hedge funds have perhaps the most acute key-man problem. They more often than not are founded by a single individual who personifies a style and a security-picking expertise that defines the firm. This mattered less when hedge funds were an insignificant part of overall institutional exposure, or when hedge funds reached the institutional marketplace through funds of funds. That is now no longer the case. Bridgewater, for one, has institutions clamoring for its deliberately curtailed capacity. “It is self-evident that hedge funds as an asset class do carry with them a concentration in skills that lends itself toward more key-man risk,” says Kevin Mirabile, former Chief Operating Officer of the hedge fund of funds Larch Lane Advisors and now a finance professor at Fordham University.
The sway of key men at hedge funds hardly needs illustration—Bernie Madoff was the quintessential key man, whose singular if criminal abilities were perhaps only exceeded by Charles Ponzi himself. But there are more germane examples. Chris Shumway started his hedge fund in 2002 after leaving Tiger Management—which itself foundered when Julian Robertson decided he’d had enough—with five employees and $70 million. By early 2011, he had 95 employees and managed more than $8 billion. In November 2010, Shumway announced that he was moving from chief investment officer to become the fund’s chairman and that Tom Wilcox, a portfolio manager, would become the new CIO. Investors reacted sharply; convinced that the only key man at Shumway Capital was the one whose name was on the building, they rushed to the exits. Soon, Shumway closed its doors to outside investors.
Hedge funds pose another key-man challenge: Many still are headed by the individuals who founded them, and Father Time slows down for no man, no matter how wealthy. “We’re still living with the first generation of hedge fund managers,” says Fordham’s Mirabile. “It’s still in question whether hedge funds can outlive their founders. A lot of hedge funds are on the precipice—do investors want to invest with the next generation?”
Yet, perhaps, key-man risk should be approached from exactly the opposite direction. “People place an inordinate emphasis on key-man risk that is not deserved. People are afraid of a guy getting hit by a bus—that doesn’t happen a lot,” says Paul Greenwood, a Managing Director at Seattle-based Northern Lights, which takes minority stakes in asset management firms. “The average institutional investor stays with a manager for seven years—the odds of something happening to the key man in seven years is low.”
Indeed, says Greenwood—who made his reputation selecting asset managers for Russell Investments’ multimanager program—asset owners are looking at key men completely backwards. If they identify a key man, he says, they should look at it as an asset, and not a liability—the benefit comes by simplifying the decision to terminate relations “in the off chance that an individual does get hit by a bus.”
As an example, Greenwood cites a firm that has a team of senior investment decisionmakers. “In fact, that’s a riskier proposition, because of how they make decisions. If something is not working, how does the end client figure out what is going on? How do they sort through the complexity of the interpersonal dynamics involved with making decisions? I would argue that to have a lone decisionmaker is actually an asset for the end client. They probably selected the manager because of that person’s ability—not because of a track record that was produced by a whole cast of characters. I would rather put my money where it’s crystal clear where the value is coming from than situations where that is much more vague,” says Greenwood.
This sanguine attitude toward key-man risk comes with important caveats. The first is that key men play a larger role in active decisionmaking processes. “It matters a lot as to how decisions are made,” says Greenwood. “Think of a very active investment process where they have 150% turnover and there’s a key man involved. If it’s very reliant on him, it’s a process vulnerable to change. Contrast that with a manager with 15% turnover. Because they’re making fewer decisions, they can make it less dependent on one person. Let’s say it’s a key man in private equity. Why is he a key man—because he has great relationships, because he’s a great investor? Most private equity firms make so few investments that they are less vulnerable to the loss of a key man. More decisions equal more risk.”
A second—and more crucial—caveat is that asset owners can only afford to embrace key-man risk if they can redeem their capital quickly. Recognizing that an untimely bus accident has changed a manager’s ability to generate returns means little if an asset owner can’t withdraw capital after it happens. As a consequence, asset owners need to consider two factors before investing with a manager if they want the ability to quickly unwind their investment: capital lock-up periods and key-man provisions.
Lock-up periods go hand in hand with key-man provisions—if there are long capital lock-ups, managers frequently will provide provisions through which investors can pull their capital if something happens to a key man. “Key-men provisions are more associated with longer-term investing, like private equity, than with hedge fund investing,” says Fordham’s Mirabile. “Not all hedge funds will offer key-man provisions. Provisions can be as simple as notice—if something happens to the key man, clients need to be made aware of it. In some cases, they can provide special liquidation or redemption rights but, since hedge funds’ investments range anywhere from monthly to annually, the redemption period matches the portfolio itself. Unless you’ve given the hedge fund special lock-ups, you’re generally not given liquidation rights. You act on key-man information by redeeming, and if the portfolio can be normally liquidated quarterly then it’s no problem, as you can redeem on the next redemption cycle. If the portfolio is liquid, that is your way out.” Importantly, asset owners also must be aware of the key-man provisions that a manager has given to other investors. “Understand what provisions, if any, the fund has given to other investors,” says Mirabile. “If demanding investors have extracted these provisions, make sure you get them as well.”
That deals with the “bus accident” scenario—but what of the issue of succession? In an industry that relies on ego, the men whose names often grace their building can monopolize the oxygen within a firm, making an orderly succession difficult at best, impossible at worst. This challenge throws any number of firms into sharp relief, of which Bridgewater is only the most prominent because its investor base is so institutionalized. Moore Capital (Louis Bacon), Tudor Investment (Paul Tudor Jones), Citadel (Ken Griffin), D.E. Shaw (David Shaw), Millennium (Israel Englander), and AQR (Cliff Asness) all have larger-than-life founders who are, with varying degrees of success, looking to turn their investment practices into businesses. “Some firms are taking appropriate steps to build management structures to replace their key men and some are not,” says Fordham’s Mirabile. “Only time will tell whether they can survive their founders.”
As for Dan Fuss, Loomis’ institutional investors can always head for the exits if performance starts to lag. But—Loomis executives stress that he has a strong team behind him, and Fuss himself seems to have few doubts about his own staying power. “My feet are planted firmly in the markets today,” he says. “I remain a fully engaged investor and continue to meet and speak with institutional clients on a regular basis, and we have a robust and talented team here backed by deep firmwide research.”
Of course, you’d be hard-pressed to find an asset manager who wouldn’t echo Fuss’s sentiment that he isn’t really a key man, especially if they seek to manage institutional assets. Whether or not this is true will be difficult to decipher until the Fusses, Griffins, and Dalios of this world actually exit—and, when they do, it will be the investors unversed in key-man risk left shouldering the burden.