Essays on Risk July 2014

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Managing Relationships with Investment Managers: Are You Monitoring the Most-Favored-Nation Clause?

2 Steven M. Harding, CPA Essays on Risk

Many organizations with a fiduciary responsibility have at their disposal the best risk management personnel,

advisors and tools of any organizations. Often though, they have not monitored fully their relationships, including

vendor compliance with MFN clauses.

Superior relationship

management is

the most important tool

that management has

to control risk.

Managing Relationships with Investment Managers: Are You Monitoring the Most-Favored-Nation Clause?

3 Steven M. Harding, CPA Essays on Risk

The fund used its considerable leverage---assets-under-

management (AUM), name cachet, potential for additional

business---to get MFN fee treatment. Your legal support team

carefully worded the language. Everyone agreed on it and put

in the contract, and…that was the end of it. It’s been

forgotten ever since.

Sixty years ago Peter Drucker said, “What gets measured gets

managed.” Make no mistake, management fees get

measured…and managed. But who is doing the measuring and

by what standard? The focus of this short paper on MFN is

whether the fee in your agreement is being calculated by the

stated fee schedule or, as should be the case, by the stated

fee schedule including the application of MFN.

Investment management fees are paid with member money.

That means that the fund fiduciaries have a clear duty to

monitor them. Most pension funds rely on external

investment managers and the MFN provision helps to get the

best price, that is, as long as it’s followed. Controls are usually

set up to recalculate fees before they are paid. But, the

information needed to evaluate the application of MFN is

generally not available to those performing the recalculation.

Most likely, the MFN provision is not being checked.

Why is this so? Assumptions and presumptions are likely

being made, such as… ‘the investment manager agreed to

provide us MFN status, therefore, we must be getting fees

that are equal to or better than their other customers.’ In

fact, there are probably as many different rationales made by

pension funds for not checking on MFN as there are made by

investment managers for not complying with the MFN

provision. Frankly, it’s awkward to ask about it. Some people

may feel uncomfortable asking whether the investment

manager is being honest about the fee calculation. Such

feelings have no place when it comes to preserving and

protecting the assets of the fund.

If you have been able to secure MFN pricing, chances may be

that it’s because you have committed a lot of money to the

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Managing Relationships with Investment Managers: Are You Monitoring the Most-Favored-Nation Clause?

4 Steven M. Harding, CPA Essays on Risk

investment manager. That means that the fees, which are

based typically on AUM, will be significant relative to the size

of your pension fund. In fact, incremental overcharges

resulting from non-compliance with MFN, even when

measured in a few basis points, can amount to significant

dollars for the fund. These fee overcharges go straight to

fund performance!

MFN clauses should not be forgotten…they should be audited.

Who has the responsibility to monitor compliance? Has

internal audit looked at this area? It is the fund’s

responsibility to make sure the investment manager is in

compliance with the MFN provision. Relying simply on

periodic manager certifications does not cut it. The manager

is not incentivized to monitor it. If a MFN clause is present,

then arguably you have the right to audit it.

How might your manager violate the MFN clause? On the

devious side, it’s plain and simple: he/she won’t get caught

because he/she knows no one is looking at it. Less deviously,

rationalizing behavior may occur such as, “There’s a good

reason why we gave someone a better price”; “We manage

other mandates for them”; “They’ve been with us since way

back when”; “They get a non-profit, government, education,

prompt-pay discount, etc.” Also, if newer personnel from the

investment manager become involved in negotiating fees,

they may have simply made an error in giving a lower fee to

another client. The investment manager may have ‘lost

control’ of its pricing matrices over time.

What really matters is not the rationale or the reason, but

rather, what the MFN clause says. Contractually, it does not

matter how the investment manager views the fee. What

matters is how the MFN clause holds up to examination.

Practical ways to manage and monitor MFN:

1. Hire an independent compliance audit firm to perform

the examination of the MFN clause and determine

whether there is an overcharge.

2. Require that future MFN clauses contain a provision for

audit and require that the investment manager pay for

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Managing Relationships with Investment Managers: Are You Monitoring the Most-Favored-Nation Clause?

5 Steven M. Harding, CPA Essays on Risk

the audit if an overcharge is found. (This alone can

strengthen voluntary compliance.)

Red flags to look for:

1. The investment management agreement (IMA) containing

the MFN provision is out dated, indicating: Market

conditions, e.g., competition, technology, have changed

over time. These typically change the fee structure for

newer customers.

2. The MFN language is broad or vague.

3. A significant new investor was added recently; this,

combined with changes in the manager’s relationship

management team, can be a red flag.

4. No one has ever checked on the MFN provision.

Based on the results of the audit, open a discussion with the

investment manager and ask for a refund of the overcharges.

Then, consider negotiation and possibly settlement.

Depending upon the reason for the overcharge you may then

decide to modify, restructure, or terminate the agreement.

You should not be too concerned when asking for a refund of

overcharges. Here’s why: It’s the members’ money…you really

don’t have an option to leave the money on the table.

Consider that the investment manager has also likely

benefitted from the MFN provision by gaining additional

volume, longer term agreements, and avoiding delays in the

negotiation with new customers due to pricing matters.

If you would like help reviewing your fund IMAs for

compliance with its MFN clauses, please contact the author.

About the Author

Steve Harding is an audit and assurance Principal with Marvin and Company, P.C., in Albany, N.Y.

Steve can be reached at (518) 250-4586 or smh@marvincpa.com.

About Marvin and Company, P.C.

Marvin and Company, P.C. is a firm of certified public accountants and consultants that has

provided accounting, audit and tax services since 1923. The Firm is an independent member

firm of the BDO Alliance USA.

About the BDO Alliance USA

The BDO Alliance USA is a nationwide association of independently owned local and regional

accounting, consulting and service firms with similar client service goals.

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