Many of our asset management clients frequently express interest in exploring potential lift-outs of investment teams or individual portfolio managers. In an industry characterized by innovation as well as continued margin pressures, having scale and a clearly-defined future growth strategy is more important than ever. The ideal lift-out scenario sought is virtually always the same…the team needs to have a top quartile track record of 5+ years, portability of that track record (with client assets likely to follow), an ability to relocate to a new firm’s headquarters, a willingness to take a significant pay cut, etc.
With more than 10 years’ experience executing investment team lift-outs and acquisitions, we’ve accumulated a fair amount of knowledge about key considerations to keep in mind when exploring such scenarios. If there is one overarching takeaway from this experience, it is that rarely (if ever) does such a perfect scenario play out. In fact, that vast majority of potential partnerships never make it to the finish line. Executing a lift-out requires a number of pieces to exhibit strong alignment in order to be successful. In an effort to help educate those who might be considering such an effort, we have attempted to capture some of the key aspects below where discussions tend to break down. Our hope is that this information leads to more productive partnership discussions for all going forward.
1) Have A Realistic Timeline
While asset managers (and recruiters) would like lift-outs to happen in short order, they usually stretch out over a lengthy period, with a duration of 6-12 months or even longer in some cases. The initial “getting to know you” courtship phase can play out in as little as several weeks or take several months depending on each party’s level of comfort. Both sides must have a high degree of confidence that the partnership aligns well with their goals and can yield significant growth over the long-term. Following the courtship period, a deeper due diligence period ensues to understand all operational aspects of the team (portfolio management, trading, compliance, risk, legal, accounting, vendor relationships) and how those functions would be replicated within the new asset management firm. Once the due diligence process concludes, a term sheet or partnership agreement is drafted, reviewed, and signed to consummate the deal at which point legal counsel becomes more involved, formalizing terms and kicking off the legal filings and client consent process (if the team owns its track record and client relationships) which typically takes several months. All told, what seemed to be moving along quite rapidly at first can take significantly longer on the back-end. Establishing a timeline or project plan from the start is a good idea to help ensure the process stays on track.
2) Insure Cultural Fit
If you have read our earlier blog piece, you may recall our belief is that cultural fit is the most commonly underestimated and challenging aspect of any new hire. As it applies to lift-outs specifically, it also the most frequent reason that potential partnership discussions ultimately break down. As everyone knows, first impressions matter greatly and many times lift-out parties either hold back key information, lack preparation, or appear disinterested in introductory conversations. This is a deal-killer. Discussions should instead be characterized by open information sharing and candid conversation about the potential opportunities and concerns regarding any partnership. Transparency about what each party ultimately desires from any partnership should be brought forward so as not to introduce any surprises down the road. A client who we recently executed a lift-out for informed us that one of the reasons their partnership went forward was that during either the second or third meeting with the team, both sides had a very frank conversation with each other about what strengths each side brought to the table as well as what they didn’t like about each other. This allowed them to establish an atmosphere of trust and honesty early on which is key. In the end, the asset manager must have conviction in the team’s character and that their investment philosophy is consistent with the organization’s culture. At the same time, the team must have confidence that the asset manager’s interest in the team’s needs is genuine and that the organization will be able to deliver on its promises to help scale the product(s).
3) Be Willing to Share the Risk (Structuring the Deal)
There are many options when structuring a deal, depending on whether it is a lift-out or outright acquisition, and designing the right structure is critical to making any deal work. For the purposes here, we are assuming it is lift-out of a team or individual. Lift-outs require a significant capital outlay and it is unlikely for most partnerships to be profitable in the first year (or two). The investment team members being lifted out must understand that their new firm is unlikely to match their current compensation structure as a result. In fact, the vast majority of lift-outs require a considerable step back in pay at the outset, with the promise of greater pay over time as the product scales. For those unwilling to accept such a structure, a lift-out likely won’t work. As an example, we were recently approached by a portfolio manager running a $1 billion US small cap equities portfolio who was considering departing his firm with the intent of growing a new product of the same kind elsewhere. When discussing a pro forma budget, he shared that his annual compensation was $1.5 million and that he’d be looking for that same level of compensation guaranteed by his new firm, even after hearing our explanation that it wasn’t possible. He unfortunately chose to remain firm on this point which cost him several potential partnership opportunities.
As far as compensation structure, most lift-outs include some combination of base salary and bonus as compensation. Minimum compensation guarantees are common for the first two years, either on a flat basis or using a step-down approach in Year 2 if certain performance metrics (e.g. peer group or information ratio rankings) or other conditions aren’t met. A third component, and perhaps the most important one in insuring that proper incentives are in place for the investment team is the revenue sharing component. Revenue shares can take many forms whether from the first dollar of revenue or above a pre-determined threshold(s). It can also be calculated based off gross revenue or net revenue, factoring in expenses like marketing. Like most other aspects, the percentage of revenue share varies widely, though we most commonly see a revenue share range between 15-25% of revenue.
Regardless of structure, all parties must be willing to share in taking the risk. After all, the new partnership is essentially a start-up business that requires not only patience but flexibility and an entrepreneurial mindset if it’s going to be successful.
4) Determine if the Track Record is Portable (or not)?
“Porting” or moving an investment team’s existing track record is easier said than done. First, teams exploring a lift-out must adhere to professional conduct standards while employed by their current firm. Those standards apply to things like not divulging confidential information or soliciting clients and employees of that firm. Second, GIPS portability standards require that certain conditions be met as far as consistency of the team’s investment personnel and investment process, availability of documented performance records underlying its GIPS composite, and disclosure that the team’s previous performance was attributable to a prior firm. For those who may have interest, there is a well-regarded article written by law firm K&L Gates which provides an excellent overview of such requirements.
Although it is not usually the case, in some circumstances a team may have ownership of its track record or their current firm may be willing to part with the track record in the event they no longer intend to support the strategy. We have also seen a number of situations where clients have chosen on their own accord to follow an investment team to a new firm, which is usually driven by: (a) long-tenured relationships tied directly to an individual investment team member such as the lead portfolio manager, or (b) a high-profile team with an exceptional long-term track record. Establishing a new track record from scratch takes time and can set back the marketing effort for a period of up to three years until a performance record for that timeframe is available. All scenarios to scale the product’s AUM as quickly as possible should be considered to alleviate potential client concerns regarding asset concentration risk.
5) Have a Clear Marketing Approach
Once the track record viability has been determined, establishing a clear marketing approach early on is crucial to hit the ground running in terms of building assets. An assessment must first be made to understand which prospects represent the greatest potential (both short and long-term), then overlay that information with how it aligns with the firm’s current distribution resources and relationships. Can the new firm leverage existing relationships to cross-sell its client into the new strategy or possibly open up new doors that were closed up to that point? Another key topic to consider is what types of investment vehicles (separate accounts, mutual funds, CITs, etc.) will be offered. The answer is typically dictated by client needs given some require access to multiple product types. Costs and regulatory considerations must similarly be taken into account, particularly as it applies to 1940 Act products.
Asset managers can also have diverse opinions about how involved they would like their investment staff to be in marketing products. In some organizational cultures (e.g. small investment boutiques), investment team members take a more active role in marketing their strategies and participating in client meetings. In others, that role may be handled by a product specialist or client portfolio manager with the intent of allowing the portfolio management team to focus on its core objective of delivering alpha. While neither structure is necessarily “wrong”, the marketing approach should be right-sized and ultimately be driven by the individual needs of the client.
6) Determine Other Resource Needs
Finally, one of the more forgotten considerations in any lift-out, particularly as it applies to budgeting, involves other resources required by the team. While the more obvious resources such as office space and systems are factored in, other needs such as benefits, T&E budgets, research resources, portfolio optimization tools, local market custody accounts, etc. are often overlooked. This further assumes that the team can utilize the existing infrastructure of their new firm as it applies to trading and accounting systems, legal and compliance support, research management and reporting. In any event, each of these items can add considerable cost and should be included for budgeting purposes.