Achieving Alignment with Investors

Authored by Jonathan Needell, President and Chief Investment Officer

August 19, 2021 (reposted from LinkedIn article published on April 16, 2018)


The investment management business has not defined risk well and therefore has not aligned employees and money managers with investment performance. This post will discuss briefly how to properly align investment managers with their employees and most importantly both with investors and capital.

From an academic perspective, risk measures have focused on volatility. Conceptually and intellectually this makes some sense: If a price fluctuates often and to a large degree, particularly compared to the market, there would seem to be a greater likelihood that a fluctuation in value would result in a very real actual result of capital loss. However, this ignores two significant factors that mitigate risk. An investment can generate cash flow (lessening the price volatility in a given period); and the entry price or valuation of an investment (an attractive price compared to intrinsic value) can also lower risk, without lowering volatility. Even a total return volatility measure breaks down when cash flow becomes significant. If you receive 100% of your capital back in cash flow during the term of the investment, wouldn’t you perceive the volatility of principal differently? It can happen in real estate and other high cash flow investments.

Risk should be defined by assessing the possible permanent impairment of capital. The best way to understand that risk (and attempt to mitigate it) is by having the assessor (investment manager) have actual capital at risk.

For example, let’s compare two investment options. First, buy a blue chip stock at a ten multiple and a 4.5% dividend yield. Second, buy another blue chip stock at a twenty multiple and a 1.5% dividend yield in the same sector with similar growth prospects. To simplify, they both have similar daily liquidity, stable and professional management, and a beta (three month and five year calculation) equal to the market. Current academic risk assessments would measure both stocks at a beta of 1.0 and a similar risk. (Keep in mind I am not professing that one stock is a better return prospect than the other, but rather focused on risk assessment.) Intuitively, a value oriented investor (versus a momentum investor) would believe the first stock is a superior protection of invested capital. I would argue that the investment manager who is aligned on the downside with “skin in the game” is likely to pick the lower risk investment. You want that behavior ingrained in the culture of the investment manager you entrust with your capital.

To properly align investment managers and employees with investors, there needs to be a direct link to the loss of principal and capital gain; not just with capital gain as occurs with a profits interest, and not to AUM growth (See Why Traditional Fund Managers are Speculators). That way, managers making investment decisions are thinking and therefore acting as an investor and not just a manager for a fee (speculator). Even if the allocation to a certain strategy turns out to be a mistake, the aligned manager should have a better probability to outperform the market on the downside when compensation is reduced due to principal losses. The manager and employees will work to protect their own capital from principal losses.

The AUM or fee manager is misaligned when the management fee is worth more than the prospect of gain and in particular the personal loss of principal by the manager, decision makers, and employees of the manager. Every manager should invest capital (hard dollars) in funds they manage. The risk is that at some point the size of the Fund has a management fee with a value that outweighs the prospect of potential capital loss of the co-investment.

Compensation of the principals and employees of an investment manager should be tied to loss of principal to align investment decisions with investors. This is loss alignment.

Not only does the co-investment by the manager in the Fund need to be substantial relative to the size of the Fund (maybe three times the annual fee), but the employees of the manager need alignment for the thousands of decisions made daily. Employees who are “knowledgeable employees” under SEC rules should receive a significant percentage of annual compensation in units of funds they help manage instead of cash bonuses. This can help achieve alignment with investors for all decisions, not just decisions made by principals. That way, compensation is tied to principal loss and everyone is focused and aligned to protect principal.

For questions, contact investor relations at investorreporting@kimc.com or 949-800-8500.                   

*There are no guarantees that any specific investment strategy will be profitable or equal to past performance levels. All investment strategies have the potential for profit or loss.

Photo Credit: www.cartoonstock.com

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