Alternative Insight – February 2015

Managed Accounts: The wave is coming

This Insight looks at the pros and cons of managed accounts for private equity investors and managers, and examines parallels to the hedge fund industry, where they have been part of the landscape for much longer.

Separately managed accounts (SMAs), long an established feature of the hedge fund world, have been gaining in popularity with private equity investors over the last few years. Accordingly, PE managers (especially fund of funds) are, perhaps reluctantly, having to grapple with how to structure such arrangements, which typically are more administratively burdensome and command lower fees than traditional funds.

Generally, SMA investors are large, sophisticated institutions, particularly pension funds (U.S. state pension funds being at the forefront) and sovereign wealth funds.

Some recent SMAs in private equity include:

  • AlpInvest ($500m) and Carlyle ($250m) – SMA mandates from Municipal Employees’ Retirement System of Michigan (2011).
  • BlackRock Private Equity Partners – $100m SMA from New Mexico Educational Retirement Board (2013).
  • 3i Group – announced in 2013 that they would not be offering a traditional buyout fund for several years and would focus on managed accounts.
  • Hermes GPE Global Secondary – a secondaries vehicle with a single SMA thought to be worth £250m.
  • Pantheon – has SMA mandates from, among others, two Illinois public employee retirement funds and the Bavarian Chamber of Supply pension fund in Germany.

How do they work?

An SMA is a bespoke investment account, funded by a single investor and managed by a professional manager selected by the investor. Investors in managed accounts get the benefits of private equity investing, but (typically) at a lower cost, with potentially greater control over the investment portfolio and tax benefits that are unavailable to investors in a traditional, co-mingled fund.

Managed accounts can be structured in a variety of ways:

  • Standard account: the investor appoints a single manager to invest in pre-agreed sectors or securities.
  • Multidiscipline account: an SMA with multiple managers, each appointed for its expertise in a particular strategy or asset class, for the account – this allows the investor to diversify the SMA portfolio beyond what a single manager could normally manage.
  • Fund of funds account: an SMA that invests in other funds.

SMAs can also be run in parallel to a traditional fund. The investor subscribes to a manager’s co-mingled fund and, in parallel, appoints the same manager to operate an SMA for it. This combined model enables the investor to benefit from a more customisable portfolio, softer fee terms and a negotiable investment horizon, while the manager increases the potential financial firepower that it can deploy without breaching size or concentration restrictions in the main fund agreement and reinforces its relationship with the SMA investor.

Managed accounts can be organised with individual investment managers or, alternatively, through a managed account platform. The platform can be run by a single manager or by a selection of managers. The manager is able to reduce the burden of running multiple SMAs by delegating the administrative functions to third party providers. Platforms can offer investors lower minimum subscriptions and better redemption rights than might be negotiable in a typical co-mingled fund. Platforms can also offer access to certain sector specialisations or strategies via separate cells or portfolios – the investor can be offered a managed account at the cell/portfolio level of the platform or, alternatively, can hold shares or interests in the platform linked to one or more cells/portfolios, i.e. in a “fund of one”.

Advantages for the investor

  • Control: the SMA investor can tailor investments and asset classes to its specific requirements rather than rely on a more broad brush investment strategy dictated by the manager. Even where the manager has discretionary power, the investor can still maintain a degree of control by directly engaging the administrator and/or depositary, or by terminating the manager.
  • Ownership: the investments held by an SMA are in the name of the investor, even if the manager’s mandate is terminated. Alternatively, they can hold interests or shares in a “fund of one”.
  • Fees: investors have greater latitude to negotiate fee structures that give them more certainty. Management fees are often lower than in a traditional fund.
  • Transparency: the investor has direct access to information about the investments and may therefore find it easier to judge the risks.
  • Withdrawal: it is generally easier to withdraw, and therefore the investor is better able to conform investments to shifts in its appetite for liquidity and risk.
  • Tax gain/loss harvesting: Tax gain/loss harvesting – This is a technique for minimising capital gains tax (CGT) through the selective realisation of gains and losses in the portfolio. For example, an investor could sell a loss-making asset and one that had made a gain, and set off the loss against the gain to minimise (or ideally, eliminate) any CGT liability.
  • Flexibility: rather than detail a strategy in advance in a private placement memorandum and be saddled with it, the manager and the investor can negotiate a strategy and then refine it as and when market conditions warrant a rethink.
  • Long term/reinvestment: an investor may prefer to hold certain assets for longer than the usual 3-to-5 year investment horizon of a traditional PE fund, or reinvest proceeds.
  • Costs: managed accounts often do not need audit or tax services; in additional legal costs are often lower because the documentation is more straightforward. Cost savings are passed on to the investor.

Advantages for the manager

  • Sales: by offering a wider range of options, the manager can expand its investor base and revenue streams. A new manager can use SMAs to quickly establish a track record and win credibility with investors.
  • Accounting: as noted above, auditing obligations are less onerous compared to a traditional fund.
  • AIFMD: managed accounts are not considered to be an “alternative investment fund” and therefore should not fall under AIFMD, meaning lower operational costs and a lighter compliance burden (e.g. the asset stripping restrictions, remuneration rules etc.
  • Reinvestment of proceeds: means that the manager has the prospect of retaining and growing assets under management for much longer periods.
  • Continual fundraising: the manager can take money in at any time rather than packing fundraising into a six to 12 month closing period at the start of a new fund.

Disadvantages for the investor

  • Costs of oversight: the investor may need more specially-trained staff to supervise the manager and monitor the SMA’s investments/performance.
  • Time and attention: SMAs are typically smaller than co-mingled funds, charge lower fees and do not pay carry, so the manager may not devote as much time and energy to an SMA compared to a traditional fund. Also, a fund manager is often contractually required to devote all or most of its business time to the fund’s affairs, whereas the manager may have several SMAs on its books.
  • Access to deals: The SMA investor should ensure that the manager has a robust allocation policy so that the SMA receives a fair allocation of deals available to the manager’s funds and other SMA clients, as well as co-invest and other rights.
  • Alignment: unlike in a fund, the manager does not commit its own cash to an SMA. However, the interests of investor and manager can be more closely aligned by having the manager co-invest alongside the SMA generally or, if the investor has combined an SMA with a commitment to the manager’s fund, the manager could co-invest in assets where the fund does not invest. However, the manager should ensure it has exit rights in case the SMA holds the investment indefinitely, e.g. by getting a put option after a pre-determined time at an externally determined fair market price.

Disadvantages for the manager

  • Administrative burden: as it conducts transactions over multiple accounts, there will be a higher administrative burden on the manager; but this can be partly alleviated by using a managed account platform (see above).
  • Transparency: due to the greater transparency attaching to managed accounts, there is a risk of exposure of the manager’s investment strategies.
  • Termination: removal and other termination provisions tend to be less manager-friendly in an SMA compared to a fund LPA.
  • No Carry: with SMAs it may be difficult to structure a traditional carry arrangement, unless undertaken through a ‘fund-of-one’ structure.

Conflicts of interest

If a manager advises one or more SMAs alongside a traditional fund, there are potential conflicts of interest between the SMA and the fund. As mentioned above, PE equity funds typically seek to exit their investments in 3-5 years, but the SMA investor (generally a big institutional investor) may wish to hold the assets for a longer period. This conflict may manifest itself in, for example, decisions on capital expenditure in the fourth year of an investment, where the SMA investor might prefer long-term focused capital expenditure, whereas the fund might not agree, given its shorter-term perspective.

These conflicts of interest can be addressed in one or more of the following ways:

  • The manager sets up different teams to advise the SMA and fund respectively. The teams should be kept apart with information barriers (previously known colloquially as ‘Chinese walls’).
  • One of the co-investing parties agrees in advance to be a passive investor.
  • The SMA routes part of its overall subscription through the fund, to ensure that both the SMA and fund are at least partially economically aligned.
  • The SMA exercises its own rights in the portfolio company (either as a shareholder or through a nominee director), separately from the fund. Alternatively, if only one board seat is available (such as when the investment is a minority holding), the fund and the SMA can settle on a mutually acceptable nominee director to take that seat. Additionally, the parties can require that the nominee director has a veto on significant reserved matters at the company level.
  • The fund and SMA enter into a co-investment agreement in advance to govern their relationship, which could include any of the above provisions and/or a list of veto matters for each co-investing party.

The changing landscape

Although managed accounts have long been the domain of hedge funds and large institutional investors, we are increasingly seeing enquiries and activity on the SMA front from savvy mid-market investors looking to tailor their private equity portfolios. Fund managers, in turn, are responding to demand and actively pursuing SMA mandates. Managed accounts, it seems, are here to stay.


 

Alternative Insight is produced by MJ Hudson’s private funds lawyers. We provide expert legal advice to fund managers, other financial sponsors, investors and advisers on the formation, structuring, investment into and regulation of private funds, managed accounts and similar vehicles. Our practice covers the full spectrum of alternative assets, including private equity, venture capital, hedge funds, private debt, real estate and infrastructure. Clients praise our entrepreneurial approach, commercial outlook and dedication to helping them achieve their objectives, regardless of the obstacles.