Institutional investors employ a rigorous due diligence process, especially for emerging managers, new products and novel strategies. This due diligence process often creates challenges in accessing top managers with funds that are oversubscribed and/or closed quickly.
The Master Custody Account (MCA) is a new investment structure designed to improve governance, alignment of interests and subsequent performance of a portfolio. The MCA creates a platform where asset allocators can quickly invest in single manager funds, products and strategies. Within this structure, fees and expenses are negotiated at the top platform level on an aggregate asset under management basis.
The MCA structure originated at San Bernardino County Employees’ Retirement Association (SBCERA) in 2008. It was implemented by former SBCERA Chief Investment Officer, Tim Barrett, who is now the CIO at Texas Tech University. The concept came to fruition for two main reasons: the financial downturn of 2008, and the investment team’s frustration in not being able to move fast enough on good credit strategies, which could have mitigated losses. Standard statutory restrictions and policies made the investment diligence process slower than optimal for capturing the best opportunities, and standard structures restricted the return contribution of a manager’s best ideas. This structure allowed institutional investors to invest alongside and/or through a manager with reduced conflict of interests.
“We already manage a diverse portfolio and the MCA allows us to optimize exposure, both short and long, given the ever-changing opportunity set.”
-Mike Nichols, Senior Investment Officer, TTU
It took about three and a half years to design the structure. And by the summer of 2012, TTU's Board approved execution. Their first MCA closed just months after, in December 2012. Since then, public investors such as Texas Tech University System (TTU) endowment have utilized this structure to great effect. “They provide the ultimate flexibility to put the manager’s best ideas in a separate account and still help the manager,” says Barrett. He recommends investors to start with one MCA, run it for a year, and monitor its progress in order to show captured fee savings for the board.
One of the MCA’s primary advantages is to align interest and concentrate co-investments on a manager’s best ideas. “We already manage a diverse portfolio and the MCA allows us to optimize exposure, both short and long, given the ever-changing opportunity set,” says Mike Nichols, senior investment officer at TTU. For example, when looking at most venture managers, about 10 percent of the positions generate 90 percent of the returns in the fund. As a limited partner, you do not necessarily want exposure to all of the positions, but rather only the top ones. An MCA allows asset allocators to react quickly to new strategies and top products, as legal terms built into the agreement allow for quick allocation.
"TTU’s MCA investment program has been successful at significantly improving our returns beyond what would be possible solely by allocating externally to commingled vehicles," says Dan Parker, deputy chief investment officer at TTU. "MCAs have also improved the quality of our dialogue and relationships with managers, as well as improving the alignment of interests.”
"A bespoke investment structure that is going to revolutionize the way investments are going to be made in the coming decades."
-Harvard Law School
The MCA structure creates multiple advantages for limited partners. Besides allowing quickness to react, there are holistic fee structures that account for commingled funds and co-investments. Thus, the MCA structure is able to capture rebates or receive fee netting at the top level. For instance, if a hedge fund that an endowment invested in was up but their co-investments were down, the endowment would be able to capture rebates by netting against each other. This structure also holds reduced contracting time and costs for both the manager and asset allocator, as it creates standardized terms that can be applied across a co-investment sub-portfolio.
When the MCA structure was created, people were skeptical and never thought that it’d become widespread. What was born out of one investment program has been sought after by the Blackstones, Carlyles and Apollos. To illustrate the rising popularity, an MCA article published in the Journal of Custody and Security Operations generated over 14,000 download requests. “A bespoke investment structure that is going to revolutionize the way investments are going to be made in the coming decades,” is how Harvard Law School describes it.
However, MCAs may not be suited for every organization. While the MCA is very flexible, it is generally built for a governing structure where the board is comfortable granting authority to the investment staff to make these decisions. A way to structure this is to let staff allocate a certain percentage of assets, whether that’d be 1 percent, 5 percent, or however much the board is comfortable with. There are also staffing implications since MCAs are also most likely to be successfully implemented by investment teams with experience in direct investing as well as allocating. The MCA structure does require additional reporting requirements on the back end for both managers and staff. So institutions have to find a way to capture all of the data and show value to the board. However, there are plenty of administrators and tools that can capture performance and metrics.
Although this structure is not going to be appropriate for every asset type or allocator, it has proven to be viable for various sized institutions. It is here to stay as an industry-transforming structure that is poised to change how institutions manage and invest capital.