Serving Multiple Masters: When Investment Firms Go Public

Marc Rubinstein

11 Jan 2022, 10:32 PM IST

Principal-agent problems occur whenever people delegate responsibility. In the investment business, they're especially pronounced. When a customer gives a manager funds to invest, she expects they’ll act in her best interest but can she be sure? This is a question clients of TPG Inc., the 30-year-old private-equity firm, may be pondering as it goes public.

Over the years, a range of devices have been developed to keep managers on track.

There’s the law, of course, specifically the U.S. Investment Company Act of 1940 which declares that, “the national public interest and the interest of investors are adversely affected…when investment companies are organized, operated, managed…in the interest of directors, officers…rather than in the interest of…such companies’ security holders.”

Then there are fee structures. The industry convention is to charge fees as a percentage of assets under management; that’s not ideal because it rewards size rather than performance, which is only one driver of asset growth (the other being marketing). A complementary approach — to charge fees as a percentage of performance — is inherently asymmetric since managers are rarely willing to return fees when performance lags. Sometimes, customers require that managers “eat their own cooking” to signal that interests are aligned.

It’s all very complex. But add in another stakeholder group and the situation gets even more tangled. Historically, most investment firms were structured as private partnerships, so the only conflicts they had to resolve were between customer and manager. Once they started going public, though, a whole new axis of conflict opened up. Ask the chief executive officer of an investment firm whether he looks at his fund’s net asset value, his assets under management or his stock price before heading home for the evening and you may get a different response depending on whether you’re a client, an employee or a shareholder.

This is the situation TPG – founded as the Texas Pacific Group in 1992 -- faces this week as it seeks to go public. Its S-1 prospectus contains seven and a half pages of risk factors detailing its conflicts of interest. In essence, they are the same ones Blackstone Inc. faced 15 years ago as one of the first private-equity partnerships to go public. Blackstone co-founder, Stephen Schwarzman, spells out the challenge in his 2019 book, “What It Takes”:

As a private firm, we had fiduciary duties to our limited partners—the people who gave us their money to invest… But as a public firm, we would have an added duty to our shareholders. The limited partners were used to investing their money and waiting years while we put in the work. Public shareholders would track the value of their holding every second of every day. The interests of both wouldn’t always be aligned.

Such misalignment of interests is something John Bogle, founder of The Vanguard Group, balked at. Bogle is most famous as the pioneer of passive investing, but he also held strong views about the ownership structure of investment firms. As CEO of Wellington Management before launching Vanguard, he questioned whether public ownership suited the firm’s mutual fund shareholders. In 1971, he expressed his reservations at an annual gathering of his firm’s investment professionals. “A man cannot serve two masters,” he said. It was high time, he added, that any conflicts between the profession of investing and the business of investing be reconciled in favor of the client.

Four years later, he set up Vanguard to do just that. Bogle adopted a mutual structure, whereby fund investors would own the management company. The structure is the reason Bogle didn’t make as much money as he might have done, given his firm now manages $7.2 trillion. But if it wasn’t for the structure, he may never have developed the idea to promote passive fund management. He writes in his memoir:

None of our competitors in the mutual fund industry wanted to start a low-cost (indeed “at-cost”) mutual fund. If “strategy follows structure,” a nominal-cost index fund was perfect, and singular to our new firm.

Vanguard is largely unique among investment-management firms. Most remain owned by their managers or by public shareholders. But Bogle’s observation that “strategy follows structure” applies to them as well. Since going public, the strategy pursued by private-equity firms has shifted in favor of outside shareholders.

As private partnerships, their earnings were much more oriented towards performance fees. But public shareholders place a higher value on more predictable recurring management fees. The result: In the past five years, fee-related earnings have increased from around a third of Blackstone’s total earnings to around two-thirds. In the public domain, these firms have also gone for growth. At the time of its IPO, Blackstone had under 3x more assets under management than TPG; it now has nearly 7x more.

TPG plans to handle its emerging conflicts via transparency. It proposes to split its earnings stream into two buckets: a more stable one, comprising fee income less salaries and administrative costs, together with a fifth of any performance fees, for public shareholders, and a more performance-related one, comprising the other four-fifths of its performance fees, for partners.

The plan may contain conflict for now. But over time, TPG's strategy may yet shift as it falls under the influence of its new masters.

More From This Writer and Others at Bloomberg Opinion:

Three Steps to Yield Financial Happiness: Teresa Ghilarducci
Sure Buyout Firms Will Bend for a $21 Billion Deal: Chris Hughes
Vanguard’s New Bond Chief Goes on the Offensive: Brian Chappatta

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Marc Rubinstein is a former hedge fund manager. He is the author of the weekly Net Interest newsletter on financial-sector themes.