Managing Relationships with Investment
Managers: Are You Monitoring the
Most-Favored-Nation Clause?
Steven M. Harding, CPA




You’ll be such a special customer to us that we’ll agree to give you most-favored-nation status!
                              
                               Boo-yah!
The fund used its considerable leverage---assets-under-management (AUM), name cachet, potential for additional business---to get MFN fee treatment.  Your legal support team carefully worded the language.  Everyone agreed on it and put in the contract, and…that was the end of it. It’s been forgotten ever since.

Sixty years ago Peter Drucker said, “What gets measured gets managed.” Make no mistake, management fees get measured…and managed.



But who is doing the measuring and by what standard?  The focus of this short paper on MFN is whether the fee in your agreement is being calculated by the stated fee schedule or, as should be the case, by the stated fee schedule including the application of MFN.
Investment management fees are paid with member money.  That means that the fund fiduciaries have a clear duty to monitor them.  Most pension funds rely on external investment managers and the MFN provision helps to get the best price, that is, if it’s followed.  Controls are usually set up to recalculate fees before they are paid, but the information needed to evaluate the application of MFN is generally not available to those performing the recalculation. Most likely, the MFN provision is not being checked.





Relying simply on periodic manager certifications does not cut it.















Based on the results of the audit, open a discussion with the investment manager and ask for a refund of the overcharges.
Why is this so? Assumptions and presumptions are likely being made, such as… ‘the investment manager agreed to provide us MFN status, therefore, we must be getting fees that are equal to or better than their other customers.’  In fact, there are probably as many different rationales made by pension funds for not checking on MFN as there are made by investment managers for not complying with the MFN provision.  Frankly, it’s awkward to ask about it. Some people may feel uncomfortable asking implicitly whether the investment manager is being honest about the fee calculation. However, such feelings have no place when it comes to preserving and protecting the assets of the fund.
 
If you have been able to secure MFN pricing, chances may be that it’s because you have committed a lot of money to the investment manager.  That means that the fees, which are based typically on AUM, will be significant relative to the size of your pension fund.  In fact, incremental overcharges resulting from non-compliance with MFN, even when measured in a few basis points, can amount to significant dollars for the fund.  Such fee overcharges reduce fund performance.

MFN clauses should not be forgotten…they should be audited.  Who has the responsibility to monitor compliance? Has internal audit looked at this area? It is the fund’s responsibility to make sure the investment manager complies with IMA provisions, including the MFN provision.  Relying simply on periodic manager certifications does not cut it. The manager is not incentivized to monitor it. If a MFN clause is present, then arguably you have the right to audit it.

 How might your manager violate the MFN clause?  On the devious side, it’s plain and simple:  he/she won’t get caught because he/she knows no one is looking at it.  Less deviously, rationalizing behavior may occur such as, “There’s a good reason why we gave someone a better price” or “We manage other mandates for them” or “They’ve been with us since way back when” or “They get a non-profit, government, education, prompt-pay discount, etc.”  Also, if newer personnel from the investment manager become involved in negotiating fees, they may have simply made an error in giving a lower fee to another client. The investment manager may have ‘lost control’ of its pricing matrices over time.

 What really matters is not the rationale or the reason, but rather, what the MFN clause says.  Contractually, it does not matter how the investment manager views the fee.  What matters is how the MFN clause holds up to examination.
 
Practical ways to manage and monitor MFN:
  1. Hire an independent compliance audit firm to perform the examination of the MFN clause and determine whether there is an overcharge.
  2. Require that future MFN clauses contain a provision for audit and require that the investment manager pay for the audit if an overcharge is found. (This alone can strengthen voluntary compliance.)
 
Red flags to look for:
  1. The investment management agreement (IMA) containing the MFN provision is outdated, indicating that market conditions, e.g., competition, technology, have changed. These typically change the fee structure for newer customers.
  2. The MFN language is broad or vague.
  3. A significant new investor was added recently; this, combined with changes in the manager’s relationship management team, can be a red flag.
  4. No one has ever checked on the MFN provision.

Based on the results of the audit, open a discussion with the investment manager and ask for a refund of the overcharges. Then, consider negotiation and possibly settlement. Depending upon the reason for the overcharge you may then decide to modify, restructure, or terminate the agreement. 
 
You should not be too concerned when asking for a refund of overcharges. Remember, it’s the members’ money…you really don’t have an option to leave the money on the table.  Consider that the investment manager has also likely benefited from the MFN provision by gaining additional volume, longer term agreements, and avoiding delays in the negotiation with new customers due to pricing matters.
Copyright 2017 Steven M. Harding. All rights reserved.

About the Author
Steve Harding has been helping pension funds and investment boards manage risk for more than twenty-five years.