In this post we write about and quantify the opportunity cost of not optimizing the speed at which the accounting package is due investment managers. Obtain the benefits of the time value of money from a faster receipt of these deliverables at the end of the month or quarter.
There is a scene in the western A Fistful of Dollars where the new stranger in town passes a coffin maker, telling him to get three coffins ready. This stranger, famously played by Clint Eastwood in his film debut, is on his way to confront a group of men who belong to one of the town’s presiding gangs. The coffin maker beams with excitement as he anticipates about what’s to go down next.
Owners and managers use scaling techniques in their businesses to capture economic opportunities in a market. This effort proves to be successful when each additional sale or dollar earned is done with the same resources prior to the effort to make that additional dollar. In tech firms, managers scale with software-as-a-service (SaaS). At auto original equipment manufacturers, managers scale with production lines. At fund management businesses, the general partner scales with capital deployment across investment platforms using financial leverage. Business managers scale operations as much as they can until marginal costs begin to meet or exceed marginal revenues. At that stage, returns approach zero or become negative as competition drives profits down.
When a company gets to this point, there are array of choices ahead for managers who are looking to grow and improve efficiency.
Moving into another industry carries additional and often unknown risks. Capital expansions can require additional investment with possible dilution to owners. Acquisitions can be fraught with asymmetric information and cultural differences. For investment companies, a hedge fund manager may close a fund to investors because the levered strategy is at capacity. A commodity trading advisor (CTA) may have a growth constraint because there are regulatory limits on position size in an intra commodity spread strategy. Either of these managers may need to hire a new team or develop an algorithm or run a new portfolio. Both managers realize greater costs in the form of wages, hardware purchases, or additional office space overhead.
Make Working Capital Work
This is where vendor relationships can help with extracting value from your operation. Working capital, current assets minus current liabilities on a balance sheet, is used to finance the daily operations. Operators monetize short term assets to cover short term liabilities. They use that capital to run a business without the need to initiate a capital call in a general partnership or request an equity infusion at a startup. Short term obligations include vendor payments to Bloomberg for a terminal, to Thomson Reuters for news flow, to Moody’s for credit risk data, to Trading Technologies for an execution platform, to the building owner for rent and to an underwriter for directors’ and officers’ insurance.
At externally managed funds, operators charge investors for some vendor payments directly. For those expenses charged to the management company, there are two primary sources of revenue that cover them: management fees and incentive fees. These accrue over a quarter and are paid out to the manager in a following month. For managers there are vendor payments due in in this ensuing month.
For internally managed funds, for management company expenses and for managers who pay themselves compensation out of fee receivables, every decline in receivable days counts. Getting paid faster four times a year over a period of ten years can add up. For example, at a general partner, fees are paid-in from the fund when the net asset value (NAV) package is completed by the fund administrator. A managing member gets paid after this task has been completed. This accounting work on a fund at the end of a quarter determines if profitability levels have been met and exceeded by the manager. The NAV of the fund determines how much a member is to be paid. The speed at which this package is delivered determines when the manager gets paid. Here’s why that also matters:
A Tale of Two Funds
Two funds (Fund A, Fund B) hire two different fund administrators. Fund A has US$100 million in assets under management (AUM) and has been in business since 2010. Fund B also has US$100 million in AUM and just opened the doors. Fund A has grown from US$10 million and is supported by a fund administrator that delivers the accounting package on the 15th of the month following each quarter. Fund B is funded with US$100 million and uses a fund administrator that prepares the accounting package by the 5th of the month at the of each quarter. Assuming fund economics are the same (performance, cost structure, prime brokers, operating systems etc.) with the only difference being the fund admins, how much of a difference do those 40 days a year over 10 years make? How much does faster working capital have on a manager’s payout in present value terms over that time period?
Fund A may be comfortable with their current fund admin. Paying for brand value is “worth it”. They carry the perception that brand premium justifies their higher expense. Fund A may even be more comfortable with the working capital delay over a working capital improvement over those next 10 years.
How Much is this Really Going to Cost?
However, there are real costs to those 400 days. Managers make personal investments, close real estate deals, reinvest in their businesses to make and initiate capital calls. At an 8% discount rate, assuming a market return, and $25,000 reinvested every quarter over the next 10 years, that 400-day working capital improvement for Fund B is over US$150,000 in present value terms. That 89 basis-point per year improvement in the interim return is 3-4 years of college tuition for a child. The return on invested capital (ROIC) for managers plowing money back into their own fund or into their own general partnership is likely much higher than the market return of 8%. The working capital improvement in present value terms goes up even higher than the US$150,000 in these cases.
If the investment amount goes up over time, assuming the fund grows organically or inorganically, the opportunity cost of not getting paid faster only increases.
Exhibit 1 – Cumulative Value of Cash Flow Improvement over Standard 15 Day Accounting Package – Hypothetical
A same day accounting package is the bar to reach. For active managers with complex financial instruments or unique legal structures, 0-day accounting packages are not feasible. With security settlements, bond income accruals, subscription processing and accounting checks and balances, 3-5 days delivery times should be the target. We have graphed 0 days and a 10-day improvement over 15 days (5 days completion).
Exhibit 2 – Present Value of Cash Flow Improvement over Standard 15 Day Accounting Package – Hypothetical
Clint Eastwood’s character was a boon for local businesses in A Fistful of Dollars. This new entrant generates additional value for the town’s inhabitants. He accomplishes this by transferring power from the two gangs running the town back to the hoteliers, tavern owners and coffin makers. Eastwood’s character, upon “meeting” one of the gangs for the first time, drew his pistol and does what faster gunslingers in westerns do best. On his way back to his quarters, Eastwood says “my mistake, 4 coffins.” The coffin maker, again, emits a joyous expression as the new man in town has delivered a 33% increase in expected sales.
Now only if Eastwood could help the coffin maker expedite payment from the deceased.