Strategic Relationship Agreements: Navigating Markets and Enhancing Manager-Investor Relationships

Strategic Relationship Agreements offer fund managers and large-scale investors an opportunity to allocate capital across various strategies and structures in a way that allows nimbleness in moving on opportunities in the market as they present themselves, rather than getting held up in paperwork and negotiations related to contracting.  The result is strong alignments and ease of process for investors and fund managers alike.

Bear markets are the reset button of the financial world.  For some, they create pain and disruption.  For others, opportunities.  They arrive when an unexpected spark encounters a market where valuations are too high and investors are too complacent.  Many investors, however, lack the appropriate infrastructure to take advantage of exceptional opportunities when they occur.  In the investment climate at present, where valuations are high relative to history and sparks are prevalent around the globe, asset managers need a panoply of structures and platforms that will power them through the next market cycle.

Markets have their ebbs and flows.  We only need to look back since the start of the century to see the travails of economic booms and busts.  During the COVID epidemic, there were steep price declines across many asset classes — notably oil, with the global disruption in travel, but for investors who could envision a world beyond the pandemic, there were great opportunities in energy and other market segments.  More than a decade earlier, the late-2000s Global Financial Crisis was an even larger disruption to global financial markets.  This period of market turmoil encapsulated the collapse of two storied Wall Street investment banks: Bear Stearns and Lehman Brothers.  The chaotic market that took down these Wall Street firms created unprecedented opportunities in an array of assets in the public and private markets.

The dot-com bubble’s decline from early in 2000 into 2002 saw a collapse of more than 80% in the Nasdaq.  This included the significant decline of leading Internet companies such as Amazon that fell on a split-adjusted basis from around $4.47 in early 2000 to less than $1.00 by the end of that year.  Amazon stock has since gone up by a multiple of more than 200 times and is now one of the most valuable companies in the world.

Nonetheless, institutional investors are taught to avoid market timing and instead use time-tested tools of portfolio diversification, regular rebalancing, and mean variance optimization to deliver optimal long-term returns over full market cycles.  Prudent portfolio management strategies, to be certain.  Nonetheless, using these tools alone may still allow an institutional investor’s portfolio to see a negative impact from other investors who lack longer-term focus and discipline.  Additionally, rebalancing may be particularly challenging in downturns when significant weightings of an institutional portfolio are allocated to illiquid assets.

Institutional investment: Long-term strategies versus novel approaches

Institutional investors often focus on hiring best-in-class managers in inefficient markets to drive optimal returns for their portfolios.  Amid this contracting process, however, investors may not be capturing all the benefits possible from a selected manager because of the behaviour of other investors in those commingled funds.  Other investors who have liquidity needs may be pulling out capital from an open-ended fund at the same time longer-term investors are looking to increase exposure because of lower valuations and expanding opportunities for outsized returns.  While the selected manager will do their best to balance liquidity demands from investors and protect the returns of the fund, this challenge calls for improved contracting and portfolio infrastructure to solve the problem.  When an investor hires an asset manager, part of the agreement is that the latter will serve as a fiduciary on that fund for the former.  By contracting with a single fund, however, the institutional investor is creating restrictions that limit the manager to the investment policy, liquidity terms and limited scope of opportunities covered by that specific fund.

Reallocations to any new funds or strategies are subject to new negotiations and approval processes that may take several months to a year for approval.  This means investors might lose out on opportunities provided by the market that are known and pursued by their manager, though not in the fund selected by the investor.  This pigeonholing can defeat the purpose of hiring talented asset managers in the first place.  A more ideal union between asset manager and investor would allow investors to reallocate among strategies and funds without the encumbrance of lengthy approval processes and free up bandwidth to meet their mandates of expected returns.  For their part, asset managers would be rewarded on the overall value they bring to the institutional investment relationship, rather than on the performance of a single given fund.  Both parties would be empowered to deliver the best returns possible for their respective constituencies.

Enter the Strategic Relationship Agreement (“SRA”).  The SRA is an agreement that can be viewed as a super side-letter that allows institutional investors the flexibility to allocate across asset classes and strategies based on changing market conditions within a structure that allows for cost-effectiveness.  The associated management and performance fees are calculated in aggregate across investments, leaving fund managers incentivised to take a proactive role in helping their investors allocate across opportunities to achieve their target mandates.  This situation presents a win-win scenario: Investors can avail themselves of the latest, most innovative investment strategies, while fund managers can enhance their capital base and overall liquidity to deal with a challenging market environment and take advantage of evolving opportunities.

Strategic Relationship Agreements: Their history and how they work

The SRA is an agreement that enables institutional investors, such as pension funds, OCIOs or endowments to allocate throughout an asset manager’s strategies and funds as needed, rather than on a fund-by-fund basis.  The SRA outlines specifics on fiduciary duty, as well as sets up an agreement between the fund manager and investor regarding adherence to any policies set in place by the investor’s board or state and local laws.  It also establishes the investor’s expected total capital allocation to the manager’s strategies, sets terms for the relationship and usually establishes a cap on expenses.  The structure allows an investor to tap into the entirety of an asset management firm’s brain trust while resting assured that the firm is working in its best interests.  The structure empowers managers with a strong capital partner to go after attractive market returns and help to position themselves to deliver higher returns to their clients as well as their stakeholders.  It is the contractual foundation to create a strategic partnership focused on mutual success for the manager and their strategic partner client.

The SRA model gives investors the leeway to reject any fund or strategy that their asset managers present, meaning that the investor is not just buying what the fund manager is selling.  They evaluate the recommendation relative to their present holdings, impact on total portfolio, and other available opportunities.  This puts the fiduciary duty on the manager to present ideas and investments that best fit an investor’s target return objectives and risk profile.  Once an SRA is in place, fees related to a specific investment become somewhat immaterial, as the SRA supersedes individual fund or deal fees.  Rather than measuring the performance of a given fund, the asset manager’s performance is measured across the entire relationship of funds and strategies to which the investor has allocated.  In addition, by signing on to a wider set of funds, the investor faces a steeply reduced amount of paperwork, approvals and public hearings when deciding to allocate to a different strategy.  This allows stakeholders to take advantage of market opportunities as they arise.

What type of fund manager or investor can benefit from the SRA?

SRAs are now utilised by large allocators, including pensions, endowments, and sovereign wealth investment funds (“SWIFs”).  These programs have discovered the value of the agreements in running some of their key manager relationships.

These agreements also create an additional opportunity for smaller managers when marketing to large institutional investors.  Some large allocators, including SWIFs, may have standard investment bite sizes that are too large for even a mid-sized asset manager’s funds.  The SRA creates an opportunity for a large SWIF to make its standard-sized commitment to a smaller manager.  In this instance, the SRA works as a multi-year agreement to invest in multiple funds and co-investments under a single contract while retaining control of approving the managers recommendations for various funds and direct investments.  The process allows for the development and insight of a true partnership for investing and navigating across challenging market conditions.

The structure of SRAs and considerations for investors

When developing a Strategic Relationship Agreement, the investor and asset manager work out the general terms to guide the relationship such as the types and classes of investment the manager is allowed to recommend.  The SRA encompasses the investor’s overall stipulations, though certain private investments may require an additional side letter to address any issues specific to the fund.  This process is cost effective compared to what would be needed to invest in multiple individual funds and strategies with the manager.  From there, the investor, usually its CIO, approves which investments are going into the SRA following due diligence by their team on the specific recommendations presented to them by the investment manager.  The initial SRA approval tends to outline the maximum amount to be allocated to the asset manager over a given timeframe, with the investor retaining control over the allocation process.

Overall, the SRA lends a level of transparency and fee efficiency befitting the scrutiny accorded to the most sophisticated institutional investors.  The investor and manager negotiate fees and other stipulations on an SRA-wide basis.  Moreover, as the investor has wider access to an asset manager’s strategies, the management and performance fee rates tend to be lower, as the larger and broader investment relationship is taken into consideration.  Compliance concerns are acknowledged at the outset as well.  Having to do this extensive onboarding process for each individual fund or direct investment can create delays under traditional contracting that often invalidate time-sensitive investment opportunities–especially during fast-moving dislocations.

Key Benefits of SRAs for Allocators:

• Enhanced alignment of interest;
• Structural flexibility to take advantage of market dislocations;
• Positive selection bias for co-investments;
• Fee and contracting cost savings;
• Access to actual liquidity of assets; and
• Fiduciary language at the relationship level.

Key Benefits of SRAs for Asset Managers:

• Enhanced relationship with investors;
• Flexible strategic capital in market dislocations;
• Compensation/carried interest on co-investments;
• Contracting cost savings;
• Access to investors who are too large for investing in their fund; and
• Greater contracting flexibility.

The Academic origins of the SRA

As is the case with many strategies and approaches to institutional investment, the SRA has been vetted by academics and been battle tested in the field.  It is becoming a key part of the conversation in developing optimal relationships with large, knowledgeable institutional investors.

After the publication of an article in the Journal of Securities Operations & Custody by Thomas Hickey III, retired partner and Chair of Fund Formation at law firm Foley & Lardner and his team, Hickey was invited to speak on the topic at Harvard Law School by Professor Holger Spamann and Associate Manish Mital.  From reading the article, they believed the structure of the agreement could be game-changing for institutional investors and their contracting with managers.  Since 2014, a class on hedge and private equity fund contracting at Harvard has included the topic, with Hickey as a regular lecturer.

James Perry, the co-creator of the SRA — and incidentally, the author of this article — now spearheads an internal team at the Maples Group overseeing the SRA, helping both sides of the table understand how the structure unlocks value and designs the tech and operational support to provide for seamless reporting and accounting – across borders and structures.  Both Hickey and Perry have written and presented on the topic on several occasions.

Being able to tap into the latest market-beating strategies when needed — and having the leeway to do so — helps investors make the most of their allocations.  On many levels, the SRA is a perfect tool.  When there is a market movement, the SRA allows investors to be the first to respond — meaning lasting benefits for all who participate in those well-managed institutional investment funds.

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