Balancing Profitability and Fee Oversight in Challenging Markets

Management Practice Inc.’s Sara Yerkey on boards navigating the 15(c) process when fund assets decline

Independent directors found themselves squeezed during 2022, under pressure by the SEC to scrutinize fund fees and profitability while also facing upward fee pressure caused by poor market performance and declining assets at many firms.

Shrinking asset bases can cause average basis-point charges to rise, leaving fund directors with the unenviable task of looking for a middle ground that will keep fees low enough to avoid the attention of regulators but not so low as to erode profitability for the fund and firm.

What is the best way to handle those competing concerns during contract renewal discussions?

First, many factors may contribute to any basis point increase in fees. Increases may result from a failure to obtain previously reached breakpoints in advisory fee schedules or from having non-advisory fixed fees spread across fewer assets in the case of non-unitary fee funds. Fund expenses may also increase for reasons unrelated to fluctuating assets, such as changes in third-party agreements.

If assets are declining quickly, the independent directors may want to review the impact on fees before a scheduled annual contract renewal to ensure they are comfortable with any potential increases and the possible need for new or updated expense caps or waivers.

Benchmarking fees to similar funds can provide some external validation as well. Expense increases stemming from a loss of scale will either similarly impact peer funds or show up in changes in the fund’s relative expense rankings.

Fee changes and benchmarks don’t provide a complete picture, however. Boards also have to consider how asset changes can affect the adviser’s ability to provide investors with the promised level of service.

This is where reviewing the fund’s and the adviser’s profitability in combination with fees becomes paramount. The firm’s financial stability allows the adviser to retain high-quality investment, legal and compliance personnel and support essential risk management, trading and operations functions.  Profitability at larger firms may be less sensitive to AUM loss than at smaller firms. However, every fee assessment must consider the specific circumstances of a fund and firm.

Preliminary 2022 Profitability Trends

While benchmarking fund fees can be straightforward, profitability benchmarks are a trickier – but still useful – tool for boards.

Assessing profitability becomes especially complicated when taking into account drastic changes in market performance, product demand, and corresponding revenue and expense trends. Before starting a profitability evaluation, it is essential that directors have a logical and repeatable calculation methodology, process documentation, and board materials.

However, directors can also gain helpful perspective by using comparable data to observe how economic and industry trends are impacting other firms.

One such available benchmark is a survey of publicly reporting firms that are primarily engaged in asset management. While these are operating margins for firms and not individual fund advisory margins, influences impacting both margin types and levels can be the same. Also, discussing how firms compare to those in a benchmark depending on market impact on AUM, product demand, average fee rates and corresponding revenue and expense trends can lead to useful comparisons.

For these publicly reporting firms, preliminary year-end financial reporting showed a material drop in margins for the 12 months ending Dec. 31, 2022, compared to the year prior.

Average trends for these firms for 2022 vs. 2021 include:

  • Ending AUM declined 15%
  • Average AUM declined 6%
  • Revenue declined 9%; contributors:
    • lower average AUM
    • performance fee decline
    • asset mix shift to lower-fee strategies, products, and channels
  • Operating expenses saw a slight decline:
    • Variable expenses such as compensation and distribution declined
    • Base compensation increased due to inflation and employee retention and attraction efforts
    • Travel and marketing expenses increased as Covid-related restrictions ended
    • Expenses, even variable expenses, may not be immediately reactive to revenue changes
  • The combination of these factors (and others) has led to an average decline in operating margins of 15% (5 percentage points)

These are a few examples of recent trends. Understanding the additional influences on margin changes for these specific firms helps clarify what may be logical for the firm and the funds the directors oversee.

A relatively small, non-diversified firm with significant outflows in combination with market depreciation may expect large margin drops at both the fund and firm levels. However, the directors may anticipate margin improvements if the same small firm had alternative products that attracted flows and reduced expenses through variable staffing expense reductions, reduction in lease space or other items. There is a different profitability discussion for every strategy, size, product, distribution method and a combination thereof.

With the SEC scrutiny of fund fees and profitability likely to continue, it will be important not only to consider these factors in relation when assessing each fund but also to bear in mind that all Gartenberg factors are best evaluated in combination when assessing each fund during the annual contract renewal. Directors should use diligent oversight and their intimate knowledge of the products, the firm, and current market influences to make the best decisions for fund shareholders.