The Arranged Marriage

Fun fact: Eli Lilly Jr. (1885-1977), the great American industrialist, trained pharmaceutical chemist, and noted philanthropist, failed as an outsourced-CIO (OCIO) allocator. In Lilly’s defense, he really tried. The largest section, by far, of his 16-page will stipulates in painstaking legal detail how the trust—funded with 10% of Lilly’s fortune—was to be managed by three professional trustees. The winners of this early (and massive) OCIO mandate: Merchants National Bank of Indianapolis, Indiana National Bank, and American Fletcher National Bank and Trust.

Recognize those names? Neither does the trust’s beneficiary.

The partnership between an institution and its OCIO involves far greater intimacy, trust, and stickiness than a typical provider mandate—or at least it should.On August 13, 2014, the Christ Church Cathedral of Indianapolis—where Lilly was baptized and attended services all his life—sued JP Morgan for fraud, breach of trust, and breach of fiduciary duty. The church accused the financial giant of “intentional mismanagement and self-dealing” while acting as trustee of its assets, which it inherited “through a series of bank mergers and consolidations.” JP Morgan, which hadn’t been hired, also couldn’t be fired.

The OCIO nightmare Christ Church and JP Morgan’s relationship has descended into represents an extreme negative case, but one born of several industry realities.

Number one: Commit to marry. The partnership between an institution and its OCIO involves far greater intimacy, trust, and stickiness than a typical provider mandate—or at least it should. And as between spouses, the terms of engagement vary enormously. “Sometimes the OCIO relationship is literally passing all responsibility to the vendor,” explains Jack Hansen, CIO of risk-management overlay shop Parametric Clifton. “They become our client, and we only take direction from them; other times, the OCIO becomes a strong advisory relationship where they will effectively craft the change, and then an authorized party of the client will have the last sign-off.”

Number two: Contracts matter. Eighty-seven-year-old Eli Lilly could not have predicted the implications of regulatory overhauls, M&A activity, and market evolutions that were still decades away when he signed his will in 1973—which is why an outsourcing agreement struck today for a perpetual trust almost certainly wouldn’t require a court ruling to get out of.

Number three: Consolidation happens. Companies worldwide announced more mergers and acquisitions last year than in any 12 months since 2006, according to Invesco data. The deals were larger, as well: 40 out of a total of 34,000 surpassed the $10 billion mark to count as “mega-deals”. And, unlike the last cycle, much of the activity pursued strategic, not purely financial, aims. These trends continue apace in 2015, Invesco says. Finally, as every investor is all too aware, debt is cheap.

The OCIO market’s low barriers to entry and a promising growth outlook have spawned an abundance of providers: Brand-new upstarts (e.g. Spruceview Capital, founded 2014), established consulting firms (almost all of them), and asset owners themselves (e.g. Verger Capital née Wake Forest University Investment Office).

“It’s a very highly competitive environment,” says John Nawrocki, head of OCIO for Rocaton Investment Advisors, which began as an investment consultancy. “Outsourcing is a zero-sum game, and each provider is not only competing in its own segment, but also in the entire industry.”

In this eat-or-be-eaten sphere of finance, care to hazard a guess as to where Goldman Sachs Asset Management (GSAM) ended up? 

On the acquiring side, obviously, with a bolstered team and additional $18 billion under supervision—provided all clears as expected this summer on its acquisition of Pacific Global Advisors (PGA). The deal, announced in April, joins two preeminent members of America’s OCIO establishment under the full-service umbrella of Goldman Sachs. The majority of PGA’s staff will be fully absorbed into GSAM’s outsourcing division, according to group chief and Managing Director Kane Brenan.

The 14 or so institutions—nearly all corporate pensions—that had hired PGA after painstaking due diligence now find themselves wedded instead to GSAM. Yet far from ignoring that tension inherent in OCIO M&A, the mission to absolve it drove GSAM’s entire acquisition strategy, according to the firm. In other words, Brenan and his team viewed potentially miffed or upset clients and staff as an instant no-go. After all, that’s primarily what they’re paying for.

“The clients are critical to this,” says Craig Russell, GSAM’s head of institutional business in the Americas. “On a list of considerations, it’s primary. We want clients to be excited about this.”

“First of all, full transparency. Talk to them from a platform that they’re excited to be a part of. Be very upfront with clients and make sure they feel part of the transaction.” —Kane Brenan, GSAMAnd likewise for the staff of an acquisition target, Managing Director Greg Calnon points out. “The people and the philosophy behind managing pension portfolios: With PGA, we see complementary and seamless interaction on those two fronts,” he continues. “From a client perspective, we don’t think that they’ll notice a lot of difference.” But they’re sure to notice—and remember—how they heard about it.

Christ Church’s lawsuit, for example, attests to the endurance of first impressions and the fragility of clients’ trust in a new fiduciary. Following its 2005 purchase of former trustee Bank One, “JP Morgan assured Christ Church that there would now be continuity of the financial team responsible for the trusts,” then-worth $35 million, the complaint states. “Sometime in 2006, JP Morgan informed Christ Church of the bank’s decision to transfer the Christ Church trusts from its institutional management group to its private wealth management group.” The client, handed off once again, was decidedly not excited about it.

The lawsuit continues to work its way through the courts. JP Morgan says it plans to defend itself vigorously “against this meritless complaint”. Regardless of how the case turns out, the situation represents a clear failure of an OCIO relationship and the risks embedded in provider transitions.

GSAM’s Brenan, the palpably media-trained OCIO leader, earns points for openly acknowledging these risks. For his team, successful acquisitions come down to a client communication modus operandi.

“First of all, full transparency,” Brenan says. “Talk to them from a platform that they’re excited to be a part of. Be very upfront with clients and make sure they feel part of the transaction. Get their buy-in and get their input.” With PGA’s clients, he says, “We have found they are quite excited about their existing team—and the majority of their existing team is transferring over to GSAM.”

And all without a single lawsuit.