As a trained appraiser, I have long considered the importance of key person risk when assessing the viability of an organization. A related critical issue is whether a succession plan exists and can be implemented with ease. This in turn depends on the existence and quality of talented professionals who understand how to grow a business, navigate complex regulations and focus on customer satisfaction. When a firm has too few successors who can assume a leadership role as needed, there is a risk of poor future performance and a worst-case scenario of not being able to maintain itself as an ongoing concern. On the other hand, installing new executives with a fresh perspective could lower business risks, especially if institutional investor clients have made it clear that they are unhappy with the status quo. A review of investment strategy alone seldom tells the complete story about an asset manager or advisory firm's acumen. An assessment of how the business is run and who is in charge is likewise important.
Consider the recent news about Pacific Investment Management Company, LLC ("PIMCO"). Established in 1971, this Allianz entity has grown into what many would describe as a bond market behemoth. According to a current press release, PIMCO had $1.876 trillion in assets under management as of September 30, 2014. A few weeks earlier, on September 26, 2014, it was announced that co-founder and Chief Investment Officer ("CIO") William H. Gross had resigned, adding that "The firm has a succession plan in place."
Since that announcement, some institutions have decided to terminate PIMCO or put the firm (or some of its funds) on watch, pending further analysis. According to "Arkansas Exits Post-Gross PIMCO as Pensions Review Money Manager" by Brian Chappatta (Bloomberg, October 13, 2014), the exit of Mr. Gross "caused $23.5 billion in redemptions in September from the $201.6 billion Total Return Fund." Skittish clients include the Arkansas Teacher Retirement System ($472 million), California's 529 college-savings program ScholarShare ($262 million) and Florida's State Board of Administration (withdrawing "more than $1 billion that the company manages for the 401(k)-style program that the state offers workers"). It is said that the Texas Municipal Retirement System and Indiana, North Dakota, Michigan and Illinois retirement plan decision-makers are mulling over how best to react to this staff change.
Although cited reasons vary as to redemption requests, at least some appear to be related to uncertainty about trading personalities. Reuters journalists Simon Jessop and Nishant Kumar warn that "With much of a mutual or hedge fund firm's value tied up in the brain power of its employees, as opposed to bricks, mortar and other hard assets, the loss of an important employee - known in the trade as 'key man risk' - exposes the firm to asset flight which can even force it to sell holdings at a loss." See "As PIMCO bleeds assets, Gross shows risk of star culture" (October 2, 2014).
Some companies have gone the route of having marquee employees sign non-compete contracts as a way to mitigate key person risk although they are not fail-safe protective mechanisms. Enforcement of a particular non-compete agreement can by legal venue. Signers sometimes get cold feet. "[S]tar trader Chris Rokos" is seeking to overturn what he deems overly harsh restrictions on his ability to start a new enterprise. See "Brevan's Ex-Star Trader Contesting Non-Compete Restriction" by Laurence Fletcher (Wall Street Journal, August 26, 2014).
Governance is an issue. For an institutional investor that relies on a disciplined selection and review process, a premature exit from a particular fund or fund company could be costly. In "Too Early to Hit the PIMCO Panic Button," Plan Sponsor journalist Jill Cornfield (October 9, 2014) describes the advantages of communicating the duties of an investment committee to plan participants. Such a letter or memo could include an explanation about how committee members pick and review asset management firms. This way, an exit from a fund when a key person leaves will not necessarily come as a big surprise.
The exertion of influence of third parties should not be ignored. In its Morningstar Stewardship Grade report about PIMCO dated September 29, 2014, Eric Jacobson and Bridget B. Hughes wrote that "Continued disruption among PIMCO's independent trustees raises significant concern about the board's independence as well as its long-established setup."
There is no doubt that more news will follow with respect to PIMCO and other investment management organizations that promote the use of individuals with the power to attract headlines.