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  • Chris Graham

FEE DISTORTIONS IN MARKETS

Today we’re going to talk about how fees distort markets and how they can impact yield, which is a little more obvious, but we'll also talk about less obvious derivatives of those fees as well that might impact your yield. Then, we'll talk about how fees impact market values, which seems strange, right? How can the market value of a thing change based on the fees that circle around it? Isn’t value intrinsic to the asset? We will cover all of that and then offer some suggestions on what to look out for and how to manage fees in your investments.

First, let’s talk about yield. Just as an example, take hourly rates and transactional fees. The thing you pay your advisors for drives their behavior. If you pay somebody hourly, they will find hours. I learned this early on at 5 years old. My dad hired the neighbor kid to mow our lawn and he spent half a day mowing a Post-it sized lawn. He was meticulously grooming every blade of grass, it seemed. Hourly fees drive hourly behavior and transactional fees drive transactions. These are both kind of out of the investment world for the most part today.

Now, we’ve moved to this assets under management model, which sounds great and it seems aligned at first glance. The big pitch is “Hey, if you make more money, I make more money. we're in this together,” but think about it. If the S&P gets 7%, I work really, really hard and I outperformed by 10% of the S&P, so that’s 7.7% - how much does my fee actually change as the advisor by outperforming? If I did nothing and grow the portfolio by 7% and if I really outperform, I grew it by 7.7%. It doesn't make a lot of difference, but if I take extra risk trying to really grow it, it might actually reduce the baseline fee that I get as my livelihood. For that reason, it’s much better for me to just collect new assets from new clients. I’d be better off getting a new $10 million dollar client, and another new $10 million dollar client, and then I'll triple my $10 million that I had from you. That impacts my lifestyle whereas going above and beyond to grow your portfolio really doesn't. This is why we so often see underperforming assets under management accounts, because the risk for the advisor to grow the portfolio is not consistent with the rewards. It's a much lower reward for the risk to take you grow it versus the risk of losing that lifestyle.


Advisory fees, like annual fixed fees or per service fees, seem to be more aligned, but when you fix the revenue generated by something, then the motive of the advisor is to reduce the cost put into that revenue. Reduced cost and a relatively fixed fee generates more profit. What is the cost for advisor? Time, energy, and effort, so make sure you know what you're getting when you deal with those fees.


Now in expenses, which is more true in private equity fund type investments, but could be over on the public equity marketable side as well (hedge funds, etc.), due diligence is so abusive. For a 2% management fee and 20% of the back end, shouldn't the fund manager be taking the risk of analyzing the investment? But instead, they will transfer their risk using the CYA process and because the expense is borne by the investors, they don’t care about the cost and will overpay for the CPA, the attorney, and financial advisers for the analyst to tell them about the risk so that they can put in their files to be protected from the investors. They are not going to bear the risk of it, and risk transfers are expensive.

Another expense that flows through investors is litigation costs. I might be sensitive to litigation if I'm bearing the cost, but if I’m not bearing the cost, well then I should sue over everything and engage in litigation at a rapid pace.

Advisors: hiring outside advisors to work in the companies as third-party contractors. Who am I hiring and why am I paying them? What's the value add? If those costs are directly borne by the investors, and in a lot of funds they are, then I'm going to hire my buddies and I might do it because they provide value to me in some other way because it's not actually me bearing the cost.


The same goes for manager allocations. There are more lawsuits over this than you can count because managers will take their expenses and push them into the portfolios, so you have some administrative expenses being split up between the fund manager and the portfolios. This practice has resulted in lots of lawsuits with big, institutional PE funds over this matter.

These are all expenses that could directly impact your yield that aren’t always obvious, so you need to be aware of these and look for them in new investments.

So, how fees can impact the value of an asset? The question here is really how do fees distort market values? Which, again, is kind of odd because doesn’t the thing have an intrinsic value, and if so, how could fees distort that value?Well, if you think about fees in terms of risk and reward or return, which we all know are related, there’s also this third element of value. Where we perceive risk also drives value. If you fix outcome (which is really a reward issue) and you make risk low, low risk means high demand and higher demand means higher valuation.High value relative to the outcome means lower yield. On the other hand, low value would be a higher risk asset, so the yield potential is tremendous. Now, if outcomes were fixed, this would be a no-brainer, but the truth is that outcomes are not fixed, they’re more like waves and they get more and more volatile and tighter the further you go with the potential of outcomes being dramatically different the further you go down the scale. A perfect example of this are the credit default obligations during the housing boom. Moody's and S&P rated these as AAA rated low risk. There are actually memos in S&P’s files which were developed as early as 2005, where they actually assess the risk of a housing value drop at 20% as rates extremely high. That doesn't sound like low-risk and actually a 20% drop in value is pretty close to what actually happened. It was right around a 26-28% percent drop in values that caused this kind of chain reaction.So, why would they rate it AAA? Well, the CDO fees they were paid grew 800% during the housing boom. In Moody's shareholder meetings, they actually stated to their shareholders that the quality of their ratings had nothing to do with their profitability. The problem for Moody's is that if they rate them accurately, then everybody goes to S&P and vice versa. For S&P if they rate them accurately, then everybody goes to Moody’s. The profit motive of those companies drove their decisions, or at least influenced their decisions on where to measure that risk. It turns out that we will ignore risk if it impacts our livelihood, and that makes perfect sense. In The Signal and the Noise, they talk about this and Nassim Taleb talks about this in Having Skin in the Game. Even after the crash, Moody's profits were off the charts. Even into 2010, they had an extreme profit relative to the amount of downside they could have borne had they participated in the risk that they assessed, so alignment in measuring risk is really important.

That sort of thing happens in public markets, but also happens in private equity and real estate funds. That 2% fee drives bad risk assessments. So if you raise a fund in a niche market, say a $100 million fund, you deploy that capital, you have success, and then you're raising a $500 million fund and then a $1 billion fund. The problem is that the bigger the fund, the harder it is to deploy capital efficiently into niche markets, so what typically happens is you move upstream to bigger and bigger properties.The competition for bigger and bigger investments is extreme. 82% of financial assets are held by Baby Boomers as they move in a passive investment phase, so all that liquidity in the market plus low-cost debt can lead to constantly chasing deals at bigger and bigger levels and you can get into this competitive bidding situation. Then, if you can't find an investment you think fits your risk profile, what do you do? Do you deploy the capital or give it back? Well, I've just built all this infrastructure based on this 2% fee and that is my livelihood, right? So I need to keep that and I'll go ahead and make bigger bets on the risk. Valuations in PE went from 11 times EBITDA, which is an extraordinarily high, in 2018 to 12 times EBITDA in 2019. There's a reason why Warren Buffett is sitting on a $122 billion dollars of cash, which is his highest cash reserves in the history of that company.


Finding value in an inflated market is difficult and the bigger you get in these funds, the harder it is to ploy that cash. I know of a specific fund that raised $1 billion after raising a few niche funds and made 26 offers on companies in 2018 and won none of them. Now what do you do? You can't give that money back and you have to keep collecting that 2% fee, so now I'm going to take great risk because I don't actually bear the cost of the risk. I get rewarded regardless of the risk I take and that means there's a misalignment. The whole goal is to create alignment in your structures regarding their fees and remember that even third-party fees can impact valuation with a miscalculation of risk. I hope that’s helpful.

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