Capital Requirements for Mutual Fund Investment Advisers - March 2011 Print E-mail
Written by C. Meyrick Payne, Management Practice and Ian Campbell-Laing   

     The recent economic crisis has caused some mutual fund directors to ask for guidance regarding how much, if any, capital is needed to manage a mutual fund advisory business. This is an unusual question as most fund industry observers have always assumed that mutual fund management was more a function of capability than capital. Nevertheless with the report of the Financial Crisis Inquiry Commission, hot off the press, perhaps it is time to explore whether mutual funds are part of the shadow banking system and thus subject to systemic strain. Furthermore the demise in September 2008 of the Primary Reserve Money Market Fund was, in part, the result of the manager, the Reserve Group, not being well enough capitalized to sustain $1 per share net asset value, such that when its Lehman Bonds became impaired, it “broke the buck”. And it was the first to do so in over fourteen years.

     Banks typically have capital requirements on their assets (i.e. loans that they have made) because if they go bad, they need capital to prevent contagion from spreading to other customers. Thus different classes of assets (loans from the bank’s point of view) have different capital requirements to reflect the relative risk. The amount of risk weighted assets (RWAs) then impacts the bank’s key capital ratios, the latter of which are stipulated by regulators. However the Basel Accord, which codifies international agreements about capital adequacy, does not specifically call for capital requirements on liabilities (deposits in bank parlance) because there is little or no risk as the bank holds the funds. The capital requirement stems from what banks traditionally do with the money: lend it out. 

     Now let’s think about mutual funds. Under the 1940 Investment Company Act, a mutual fund is a stand-alone corporation with its own assets, liabilities and board of directors. The board contracts with an investment adviser to manage the money (it also contracts with other parties, who may or may not be related, to distribute the fund, hold its securities, and keep track of its liabilities to the shareholders). In this analysis we are only concerned with the capital required to serve as the investment adviser. There are numerous laws to ensure that the readily redeemable liabilities of the fund itself (i.e. shareholder deposits) are matched with easily saleable liquid assets (i.e. marketable stocks and bonds), with some portion typically held in cash for day-to-day needs. An open end mutual fund has, after all, the ultimate short term liabilities (i.e. on demand) and the cash equivalent assets (readily marketable securities). There may also be an easily accessible line of credit to provide liquidity if it is needed.

     So now the question is how much capital, if any, does it take to manage someone else’s money (i.e. that of the fund)? What hard assets are necessary? The answer, in principle, is very little: an office can be leased, computers rented and software programmed relatively inexpensively.  The capabilities needed are research, which can be acquired with credits from placing trades, and investment expertise, which is, of course, the most important asset but imbedded in the managing executives. Compliance is also vital and has become increasingly expensive. So well qualified, experienced human capital is the key ingredient as opposed to financial regulatory capital.

     It is interesting to note that investment management is one of the few businesses where working capital is not particularly important. After all there is no inventory, minimal receivables (fees are typically paid as a deduction from the stockholders balances) and little cash reserve (the fund itself has to maintain sufficient liquidity to handle redemptions).

     But this is not the whole story. A fund is expensive to manage if it is not of sufficient size to throw off enough fees to pay for the costs associated with registering, maintaining, investing and controlling. This was historically said to be $100 million, but with the new compliance requirements it may now be closer to $200 million. If too small, a fund may require expense waivers or expense caps to remain competitively priced.

    In addition, the manager of a fund is required to make good if there are mistakes or errors in the operation of the fund; for example, pricing errors or trade errors that disadvantage the fund shareholders. Furthermore the directors of a fund should be able to expect a manager to make good for avoidable errors such as imprudent investment of collateral received in a securities lending transaction, or for any financial penalties imposed relating to transgressing the regulations.

     The appropriate level of capital to run a mutual fund is likely to be a typical fixed/variable function. For a small fund complex with one or two funds of less than economic size, the necessary capital might be as much as 4% of the assets under management. For larger complexes with multiple funds in excess of economic size, the capital invested might be as little as 1/10th of 1% of the assets under management. Consider that 1/10th of 1% represents only about 45 days of the annual advisory fee for a typical equity fund; hardly a burdensome capital commitment for such an important business.

     Let’s now consider how that capital might be provided. A large well established financial conglomerate would have no trouble sustaining shareholders’ equity of $1 million per $1 billion of mutual fund assets under management. A small, family run company or partnership might not have this level of capital because the owners are unlikely to have paid in capital or retained earnings in these amounts. They certainly would have preferred to avoid paying taxes while accumulating annual profits, when they could just as easily paid out bonuses to absorb the tax liability. For a small firm, the needed capital might be provided in some other way, such as a personal guarantee.

     Our firm has analyzed the ratio of shareholder equity to assets under management for a range of publically traded wholly investment managers. Our conclusion is that the capital supporting $1 billion in assets varies greatly depending on the investment manager’s participation in the capital-intensive aspects of asset management such as distribution, shareholder services, trading activities, technology and real estate investments. Also impacting this ratio is the choice of products and management style.

     The answer to the question of how much capital is necessary changes substantially depending on the underlying variables and there is no simple calculation. However, when functions such as distribution and shareholder services are internal operations, which typically are people and technology intensive, the capital required to operate successfully continues to rise.

 

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