Profitability in the Current Regulatory Environment May 27, 2015 A Mutual Fund Directors Forum Webinar
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Profitability in the Current Regulatory Environment
May 27, 2015
A Mutual Fund Directors Forum Webinar
Today’s Speakers
Sara Yerkey
Partner,
Management
Practice
2
Susan Wyderko
President & CEO, Mutual Fund
Directors Forum
(Moderator)
Kelley Howes
Of Counsel,
Morrison &
Foerster LLP
Topics for today
1. Background on profitability: Judicial precedents
and objectives for analyzing profitability
2. Current regulatory focus, implications and
Board responsibilities relating to profitability
3. Benchmarks for assessing reasonableness
3
Judicial precedents: the Gartenberg line of cases
• In order to find a violation of Section 36(b) of the 1940 Act, a fee must be “so
disproportionately large that it bears no reasonable relationship to the services
provided and could not have been the product of arm’s-length bargaining”
• The Gartenberg court identified several factors that a board must consider in
reviewing advisory agreements – including profitability of an adviser
• Securing the lowest possible fee is not required: a board demonstrates its
fiduciary responsibility by diligently and independently considering the
Gartenberg factors
• “Where a board’s process. . . is robust, a reviewing court should afford
commensurate deference to the outcome of the . . . process” (Jones)
4
Understanding the objectives of analyzing fund profitability
• A thorough consideration of the Gartenberg standards enables a board
to demonstrate a robust process
• High profits earned by the adviser are not necessarily indicative of an
excessive fee and can be justified based on the quality of services
provided by a highly qualified and conscientious adviser (Schuyt)
• The adviser is entitled to make a fair profit; a “cost-plus” contract is not
intended (1970 Senate Report)
• Consideration of profitability enables a board to evaluate the financial
stability of the adviser
• Boards can also use this information to identify any differences – and
potential conflicts – inherent in side by side management and other
management activities
5
Current Regulatory Environment and Implications
• Recent enforcement action In the Matter or Kornitzer Capital
Management
• Disclosure obligations – proxy statements and shareholder
reports
o How the board evaluates the adviser’s costs and profitability from its
relationship with a fund
o Boilerplate is not sufficient
• OCIE will request information considered by a board when
making its determinations
6
Director Responsibilities – Profitability
• Request fund-by-fund profitability and an explanation of the methodology
used to create the analysis
• There is no “right way” to calculate profitability, but methodology should
generally be consistent from year-to-year
• Trending profitability should be included to provide fund insight
• Request further information and ask questions until any concerns or questions
are adequately addressed
• Board’s responsibility is oversight
7
Profitability Benchmarks • Limited specific guidance – a facts and circumstances analysis
o Schuyt court found a significant pre-tax profit supportable in light of all of the facts
o Court pointed out that it was NOT holding that such a profit margin could never be excessive: “In fact, under other circumstances, such a profit margin could very well be excessive”
• Profitability should be evaluated excluding marketing and distribution
• Profitability of funds is not publically reported and not available for fund comparisons
• Responsibility of assessment and diligence continues to fall on the board
o Key is that the board be qualified, conscientious and fully informed
8
Assessing fund-level allocations:
• Possible Methodologies:
o Directly charged (fund specific)
o Average assets
o Revenue (assets * management fees)
o Effort (implies time tracking)
o Square footage (occupancy)
o Fund flows
o Trade execution
o Number of people
• Procedure Emphasis:
o Documentation
o Year-over-year consistency
9
Potential Influences on Profitability • Asset size
• Product mix (equity, fixed income, mmkt) and fee levels
• Active vs. passive managed products
• Compensation structure (fixed, variable, performance) and incentive component
• Distribution method (direct, platform)
• Client channels (institutional, retail, high net worth)
• Sub-advisory agreements
• Sub-administration
agreements
• Number and size of
accounts
10
Fund-by-Fund Advisory Profitability
71%
50%
45%
2%
49%
55%
0% 10%
20%
30%
40%
50%
60%
70%
Equity
Alternative
Fixed Income
Money Market
Total Complex Advisory Profitability
Current Industry Avg. Advisory
Profitability
Illustrative Advisory Profitability by Product and Total Advisory Profitability Benchmark
11
Summary of Pre-tax Profit from Advisory Activities (excluding distribution) of Selected Publicly-held Companies
Significantly Engaged in Mutual Fund Management
12
Fund families typically earn higher margins on advisory functions, less on shareholder
servicing and lose on distribution
13
49%
10%
-30%
25%
31%
-40% -20% 0% 20% 40% 60%
Advisory
Shareholder Services
Distribution
Total Investment Profitability
Current Industry Avg. Investment Profitability
Illustrative Fund Channel Profitability and Comparative Benchmark
Summary of Pre-tax Profit on all Investment Activities (including distribution) of Publicly-held Companies Significantly Engaged in Mutual Fund Management
14
Questions?
15
16
[email protected] 216 West Hill Road, Suite 200
Stamford, CT 06902
Phone: (203) 973-0535 Fax: (303) 882-3514
www.mfgovern.com
Sara Yerkey
Kelley A. Howes
5200 Republic Plaza
Denver, CO 80202-5638
Phone: (303) 592-2237 Cell: (720) 397-1075
www.mofo.com
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