Many of the highest-yielding stocks on the market are externally managed, including business development companies. Using leverage, BDCs, which invest in private-company debt and equity, generate returns that frequently top 10% per year. And, like closed-end funds, these companies are required to pay out 90% of their income to shareholders in the form of a dividend. The result is a fat payout.
However, although their dividends may be lofty, these stocks' returns would be a lot higher if not for the fees paid to the asset managers behind the public companies. Most BDCs pay their external managers a fee equal to 1.5%-2% of assets. In addition, the external manager receives so-called "incentive fees" for good performance. In most cases, incentive fees take 20% of profits in excess of a 7%-8% return for shareholders.
Combined, management and incentive fees can take a substantial slice of a BDC's income. The worst offenders will send 40% of profits to the management company, leaving only 60% for the owners -- that is, the shareholders. At that point, you have to start wondering who really owns the company.
What's a good return, anyway?
Management fees based on assets are egregious, but you've heard that story before. All else being equal, low-fee funds (of any kind) usually win. It's true in everything from public equity to private equity.
So let's talk about incentive fees. Their cost is outrageous, and their design is even more so. In particular, I find incentive fees to be a special kind of arbitrary.
I'll start by picking on a long-term winner, Ares Capital Corporation (NASDAQ:ARCC). Its incentive fee kicks in after shareholders start enjoying returns of 7% on their equity, according to its 2013 annual report. But you can go back to the 2004 annual report and find a slightly higher 8% rate-of-return hurdle. The hurdle has barely budged.
Did returns change? Of course. Interest rates, a driver of any lender's returns, fluctuated dramatically through the 10-year period from 2004 to 2013. In some years, like in 2006, when rates were relatively high, hitting an 8% return hurdle on equity should have been relatively easy. (The one-month LIBOR rate crossed 5% in 2006; it sits at 0.15% today). In other years, such as 2009, when many loans had gone bad, similar returns would have been more difficult to achieve.
So that's an obvious problem with incentive fee structures: When rates are high, achieving a static return on equity should be relatively easy. Thus pay doesn't necessarily reflect the difficulty of achieving a particular return. That's a clear flaw in the design of their compensation schemes -- a fact that's not left out in the "risks factors" sections of their annual reports.
Walking down Comparison Lane
It isn't until you compare a great incentive package to a crummy one that you really get a good perspective on the issue.
Markel (NYSE:MKL) is perhaps one of the best companies when it comes to aligning incentives. If you're unfamiliar with Markel, it's a specialty insurer. It insures oddball risks like the cancellation of rich people's weddings and the health and wellness of their horses.
Until recently, bonuses weren't doled out until Markel's managers generated a 12%-plus return on equity over the previous five years. This year, it'll pay bonuses of 40% of base salary for a five-year average compound growth in book value of 6%-10%. And even then, a bonus won't get rubber stamp approval; any bonus for returns in the range of 6%-10% requires a second look from the compensation committee.
The first nondiscretionary bonuses aren't paid until shareholders have enjoyed 11% returns over the last five years. Markel offers varying levels of compensation all the way up to a compounded five-year average return of 20% per year. Talk about setting high standards.
Why bring up Markel? Because it's boring, yet its managers have to create exciting returns before getting big pay packages.
When you compare Markel to externally managed BDCs, the results are revealing:
- Markel, a sleepy insurance company built atop a portfolio dominated by investment-grade corporate debt, doesn't think compounded returns of less than 10% over five years are worthy of guaranteed bonuses.
- Ares Capital Corporation, a business that makes money largely from the high-octane activity of lending to private equity's riskiest buyouts and adding another scoop of leverage on top, thinks you should be impressed by any year in which it earns a return in excess of 7% on its equity.
See? It's only when you compare a company with top-flight pay packages (Markel) to a company with less-than-impressive fee structures (Ares and most other externally managed BDCs) that the excesses become obvious.
For brevity, I've left a few critical points out of the bullets above. For example, Markel's incentive compensation is determined over five years; Ares' is determined over one year. Therefore a single year of poor performance may disallow incentive compensation at Markel for a long time to come, while Ares can count on another chance when it flips over the last page of its calendar.
And at no point will Markel's employees take a full 20% cut of marginal profits in excess of its hurdle. That is, however, the literal interpretation of fee arrangements for externally managed companies. But at this point I'm splitting hairs. The contrast is incredible.
Where do BDCs go from here?
I'd be lying if I said I knew. Frankly, externally managed companies haven't changed much over the past decade. It's hard to imagine the next decade will be any different.
That's not to say I'm not optimistic, however. Newer firms have substantially better fee arrangements than their older counterparts. Likewise, new groups of BDCs are coming to market, backed by asset managers with world-class reputations. In due time, I think many of the industry's leaders of today will be the "also-ran" companies of the future, outclassed in shareholder alignment, reputation, and deal flow.
And as so-called "yield pigs" get their dose of high-yield stocks, I'm hopeful that asset managers will have to compete for new assets on price, rather than ride a rising tide of perpetually growing assets under management for all participants.
I can't guarantee a competitive market. Neither can you. But if there is one thing that every investor should remember, it's that, when it comes to management, you get what you incent. And externally managed companies have a lot of work to do in aligning economic interests with their owners -- the shareholders.