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So, you’re disappointed with your fund’s invest-ment manager and are considering replacing it. How do you solicit, select and contract with the right investment management?

This article will discuss the key issues to consider in preparing a request for proposal (RFP) for new investment management, including options for soliciting proposals and interviewing prospective managers, and what terms and conditions trustees should demand when con-tracting with new investment management.

The selection of investment managers is a fiduciary duty—an exercise of discretion over the management and admin-istration of plan assets. A fiduciary must elicit information necessary to assess the provider’s qualifications, quality of services and reasonableness of fees. Fiduciaries should fol-low these guidelines.

Soliciting ProposalsA carefully drafted RFP will provide trustees with the

information they need to evaluate investment managers on an apples-to-apples basis rather than sifting through moun-tains of marketing materials and presentations. The RFP also

serves as documentation of the evaluation process, a very important concern if you are later challenged as to the “pru-dence” of your selection.

First, you need to decide whom you are going to target—the entire investment community, just those managers that are top performing in an asset class or just managers who live in your state or suit some other criteria? If you are targeting a limited number of preselected managers—and assuming your governing law allows you do that—you can direct your RFP to these managers alone and don’t have to seek respons-es from a larger group.

Your fiduciary duty is to secure the services of the best managers at a reasonable cost that will best serve your unique needs. Assuming you choose to throw your net as wide as possible, most funds elect to place a small ad for just one weekly issue in Pensions and Investments Magazine or some other industry magazine of record, which will result in wide dissemination of your RFP.

If your fund uses general investment consultants, you can ask them to forward your RFP to managers whom they might recommend. You can also advertise the RFP in a na-tional publication like the Wall Street Journal, or even local

Key Issues in Securing Investment Managersby | Marc R. Lieberman and Kathryn M. Magli

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Hiring a new investment manager is an important decision well worth trustees’ considerable effort—from sending RFPs to writing the contract.

Key Issues in Securing Investment Managers

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papers of statewide publication, if local managers are of in-terest. And if you have the ability, you should post your RFP on your Web page. The entire objective of the exercise is to attract the best managers, and not the Three Stooges.

Crafting the RFPNow that you’ve decided whom to target and how, you

need to craft an RFP that tells prospective managers who you are, what you do and how you expect to do it. Until manag-ers know that, they won’t know if they can fulfill your needs.

If you’re a Tart-Hartley fund, make that clear. If you’re a gov-ernmental plan or 529 fund, make that clear. Some managers may be precluded from representing governmental plans due to Freedom of Information Act concerns. You also need to identify the precise type of management you seek, so you don’t waste your time evaluating managers that don’t have the experience or expertise to address your particular investment needs.

Thus, a general solicitation for “investment management services” won’t be productive. State precisely what you want, as specifically as possible: “Active large capitalization discre-tionary equity investment management” is far better than “equity manager.” The more tailored your inquiry, the better

your responses will be, and the more productive you will be in evaluating the responses.

That brings us to the next important aspect of your RFP: What key qualities are you seeking in your manager? Do you value return over preservation of capital, or vice versa? Are fees a primary consideration? Is a clean litigation history impor-tant? Must the manager have a top-quartile record for a speci-fied period? Must the manager be registered as an investment advisor, and have its own money at risk with you? These and all other qualities in a manager you hold dear need to be specified; by doing so, you will be inviting each manager to address how it meets and/or exceeds those qualities and conditions.

Another key component of your RFP is identification of the legal, political and/or economic constraints governing your operation. Are you precluded from investing in cer-tain countries or foreign securities in general? Are you pre-cluded from contracting with an entity unless it warrants it complies with all U.S. immigration laws? Are you prohibited from indemnifying a manager for certain of your liabilities? Are placement fees or political contributions to your trustees

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prohibited? Must all managers be ap-proved by a third party, such as a state treasurer for governmental plans? Do you have peculiar limitations on your ability to delegate discretionary author-ity to managers, such that all trades by a manager must first be approved by a board of trustees?

Other key considerations might be: Do you have budget constraints that will prevent the manager from being timely paid? Must you disclose all com-munications with a manager under public records laws? Are you precluded from engaging in derivative, swap or certain loan obligations, or are there particular limits on those transactions? The bottom line is that if you have un-usual constraints on your operations as they affect the manager’s authority and ability to perform, you need to identify your peculiar constraints up-front, so those managers unwilling to abide by such constraints can bow out early.

Other key factors: How often do you need cash, and will the contract that is the subject of your RFP require the man-ager to maintain certain cash reserves to enable you to meet your cash needs? Will the manager be allowed to borrow money, hedge risk or incur leverage that threatens to erode your principal or even increase your potential liability be-yond your allocated commitment? The degree to which you will tolerate lever-age is very relevant to who is best suited to manage your money.

One of the most important criteria to be specified in your RFP is the bench-mark against which a manager’s perfor-mance will be judged. Will you consider only managers that have been in the top quartile of managers exceeding a par-ticular benchmark? And once the man-ager is retained, will you consider tying

performance to a benchmark, rewarding the manager when it exceeds the bench-mark and punishing it when it doesn’t? Or will you instead pay the manager an annual fee based upon assets under management (which is a far more subtle method of rewarding return), or will you only pay the manager a set fee for managing your assets, regardless of per-formance? All this needs to be discussed in the RFP, and by engaging in the exer-cise, you’ll find you can better determine precisely the kind of manager you want.

Post-Madoff, the sort of auditing standards your fund is going to insist upon are quite relevant. Must the man-ager’s operations undergo independent audit, and if so, when and by whom? Will you insist upon audits conducted by a Big Four accounting firm, or will a regional outfit or even a local audi-tor do? Will you insist on reviewing the manager’s annual audit papers and to have access to its auditors? In light of the Madoff fiasco, independent evaluation of your manager’s operations is critically important.

Also relevant is whether you want the manager to attend and make reports at your meetings and if so, how often? Must the person reporting to you always be the portfolio manager, or can he or she be an underling or even a “relationship manager” who doesn’t really know much about the composition of the portfolio. Will you pay the manager for appear-ances, or do you expect those appear-ances to be rolled into the fee package? What precisely do you want the manager to report on? Will you also look to advice from the manager on investment trends?

You also need to inquire, up-front, whether anyone associated with the manager has any relationship with anyone in your fund. If placement fees

are paid, who is getting them and how much? Will the manager warrant that no one affiliated with your fund is get-ting any compensation from the man-ager other than as referenced in the written agreement with the manager?

And in connection with its man-agement, will the manager do business with affiliates at rates in excess of mar-ket or, perhaps, engage affiliates whose services are not reasonably required? Will any income realized by the man-ager from managing your money (oth-er than the management fee) be offset against the management fees?

We think it’s important to tell pro-spective managers, in the RFP, who will be evaluating them so that they can tai-lor their responses accordingly. Will staff make the initial cuts, in consultation with a select group of trustees? Will a com-mittee of the trustees make the initial cut? You should also consider advising whether the manager will be expected to host site visits. You might also consider including in your RFP a list of your se-curities holdings and your allocations for each asset class. This will give each man-ager an opportunity to advise how such allocations might be improved.

The RFP also needs to describe the process that will be used to evaluate a manager. Will all applications be evalu-ated by a committee, which, in turn, will recommend a limited number of managers for interview or site visits? Will the pool of eligible candidates then be whittled down to an even smaller number that will be interviewed by the entire board, which will then select the winning manager or managers, subject to negotiation of a contract and the performance of due diligence? Might supplemental responses be required?

Finally, the RFP should establish

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deadlines for submission of responses—deadlines you should stick to. You also need to identify who on your fund is au-thorized to answer questions from respondents, so your entire staff or board are not peppered with inquiries. Make it clear that all inquiries should be directed to the designated person only, and that your fund ultimately is free to select any or none of the respondents. Also make it clear that mere selection will not obligate the fund to enter into a contract with the selected manager.

Interviewing Prospective ManagersOnce you have gathered and evaluated the RFPs, the sec-

ond step of the selection process is interviewing managers. How many candidates should you interview? Of course, it de-pends on how many viable candidates you have. If you have four strong candidates out of a response of ten, interview all four. If all ten of the responses have piqued your interest, con-sider conducting telephone interviews to weed the field to the top three or four.

The interview process is your opportunity to ask the tough questions and to evaluate the responses. It’s a little like putting someone on the “hot seat” to drill down to how the investment managers view themselves and their services. Your questions at the interview should be designed to get a better understanding of the investment managers’ philosophies as well as to identify any inconsistencies from the RFP. Some key questions are:

• Who is your competition? What makes you better than them? Requiring a manager to describe its rival will best reveal who that manager really is.

• Are your staff members incentivized to take risks with our money they would otherwise not take with theirs? A manager not investing its money in similar strategies makes you question whether it is putting its money where its mouth is.

• How is your investment style consistent with our goals? A manager that has actually researched who you are and what you are seeking may be a superior candidate to achieve your aims.

• Who has fired you within the past three years and why? Managers that are frequently fired, whether be-cause of performance or otherwise, are red flags.

Manager InvestigationAt the end of the interview process, but before you start

talking contracts, it is extremely important that trustees per-

form their due diligence on the investment manager they have selected. It is incumbent upon trustees to confirm the man-ager’s credentials, including licensing, education, litigation history and the like. In searches we’ve conducted over the past several years, we discovered:

• One manager was affiliated with a foreign terrorist group.

• Another was on Interpol’s most-wanted list.• Others lacked the college degrees they said they had

earned.• Other managers had been besieged by fraud lawsuits

and bankruptcies.Can you, in this day and age, rely solely on your general

investment advisor to “check out” your potential managers, and not conduct an independent investigation? Your general investment advisor probably does not investigate the litiga-tion history, educational background, criminal history, licens-ing credentials and corporate filings of potential managers. Instead, the advisor’s “investigations” are typically limited to on-site visits and interpersonal relations with the manager and knowledge of the manager’s industry performance.

Thus, trustees must conduct an independent investigation of the manager if their general investment advisor has not performed a thorough one for them. In addition, it is critical to check references, including obtaining at least one refer-ence from former clients. And of course, it would be prudent to require the investment manager to provide you with con-firmation that it is insured and perhaps, bonded.

NegotiationAfter refining the best prospects down to two or three can-

didates, request a copy of each manager’s proposed investment

takeaways >>•  A good RFP will tell prospective managers the type of fund—with

its legal, economic and political restraints—and the kind of man-agement the fund is seeking.

•  Through questions at the interview, get a better understanding of managers’ philosophies.

•  Confirm a manager’s credentials, including licensing, education and litigation history.

•  In negotiating a contract, be aware of new service provider fee disclosure rules, terms to avoid and terms to include.

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management agreement and scrutinize its terms. Can you live with its provisions? You need to determine how flexible the manager is to modifying its terms to suit your needs. Remem-ber, the marketing/client relations guys for a manager have nev-er spoken to the manager’s lawyers. Get as many concessions as possible during the interview process, well before you approve that manager at the board level. Concessions made during the interview cannot be cut back by the manager’s lawyers.

If it’s your practice to approve an investment manager generally before you negotiate terms, make sure approval is subject to successful negotiation of terms. The best practice is to approve only a transaction that has already been fully ne-gotiated to your satisfaction.

Service Provider Fee DisclosuresAs part of contract negotiations, plan fiduciaries need to be

mindful of the new service provider fee disclosure rules. In-vestment managers responsible for investments held as part of a retirement plan subject to the Employee Retirement Income

Security Act of 1974 (ERISA) may have an additional responsi-bility to disclose service and fee information to plan fiduciaries.

Effective January 1, 2012, certain retirement plan service providers, including investment managers, must provide plan fiduciaries with a list of services provided and the com-pensation that the investment manager reasonably expects to receive, the source of any indirect compensation and any fees associated with plan investments. These disclosures must be provided prior to any new contract, amendment or renewal, and any time disclosed information changes.

The requirement to disclose certain fees and compensa-tion by service providers to plan fiduciaries establishes a high standard for plan fiduciaries in meeting their ERISA fidu-ciary duties. Plan fiduciaries have the responsibility to ensure that payment for necessary services does not exceed reason-able compensation. Fiduciaries must request and review the required disclosures in order to satisfy the prohibited trans-action exemption requirements set forth under ERISA Sec-tion 408(b)(2). Failure to comply with the new disclosure requirements may result in a prohibited transaction, which is considered a breach of fiduciary duty. In addition, prohibited transactions are subject to excise taxes under Section 4975 of the Internal Revenue Code of 1986.

Terms to AvoidAssuming you’ve chosen your manager, what terms

should you avoid? Eight key terms to avoid are: 1. Provisions delaying your right to terminate the man-

ager, or requiring some sort of cause to do so. Re-quiring more than 30 days’ notice is trouble. Your right to pull the plug is your ultimate safety mechanism.

2. Provisions exposing you to excess liability. Will you be on the hook for more than your investment, whether due to the manager’s use of leverage, deriva-tives or indemnity exposure?

3. Refusal to provide notice of liability events. You must insist that the manager report when it’s sued for fraud or securities violations, under serious regulatory scrutiny, or when its auditors or key staff (lawyers, compliance officers, etc.) leave. To do otherwise might result in you being the last man standing on the life raft.

4. Lack of key man clauses. The success of nearly every organization is attributable to just a few players. Ensure that if that is the case, those persons are dedicated to

Marc R. Lieberman is chair of public pensions/alternative invest-ments at Kutak Rock LLP, based in Scottsdale, Arizona. A certified specialist in real estate law, he

directs a team of lawyers across the country dedicated to negotiating alternative investments for pension systems and other institutional investors. Lieberman is a graduate of Indiana University and received his law degree from DePaul University. He can be contacted at Marc.Lieberman@KutakRock.com.

Kathryn M. Magli is a partner in the Omaha, Nebraska office of Kutak Rock LLP, where she focuses her practice on employee benefits, including health and welfare plans,

qualified and nonqualified retirement plans, governmental plans and executive compensa-tion matters. Magli graduated from Edgewood College in Madison, Wisconsin, and received her J.D. degree from Creighton University School of Law. She can be contacted at Kathryn.Magli@KutakRock.com.

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your account and their departure will trigger an imme-diate right to notice and termination.

5. Overly limiting confidentiality restrictions. Govern-mental plans usually have Freedom of Information Act (FOIA) obligations. DO NOT allow your manager to encumber you with confidentiality restrictions that vio-late your FOIA obligations.

6. Overly broad powers of attorney. While the manager must have power to conduct your investment business within the scope of its mandate, that power should be strictly limited to such mandate and terminate on the manager’s bankruptcy and/or the account’s termination.

7. Overbroad indemnities. The manager must not be fully indemnified for its actions, regardless of severity. There must be recourse against the manager for its “willful” or “intentional” misconduct, recklessness and/or breach of the investment management agreement. Efforts to limit the manager’s liability to situations where it subjectively believed it was acting in good faith should be resisted.

8. Exclusivity. Allowing a manager to be the fund’s exclusive provider in an asset class severely limits the fund’s options, with respect to both flexibility of achieving its investment aims and bargaining power to achieve better economics.

Preferred TermsAs far as preferred terms, we like to see these, at a minimum:• Local venue. Many managers will insist on disputes be-

ing litigated in their state of operation (typically New York or Delaware). Insist that all litigation between the manager and the fund occur in your preferred venue, and that the law of such venue will control resolution of all claims involving the fund’s interests.

• Contingent fee, incentive payment. The manager should warrant it has not entered into any contingent fee or similar arrangement with anyone associated with the fund concerning the performance by the manager of services for the fund. The manager should also warrant that neither the manager nor its affiliates (nor, to the manager’s knowledge, persons employed by or serving as trustees of the fund, whether directly or indirectly through affiliates) will receive any incen-tive or special payments associated with or resulting from the manager’s contract with the fund, except as otherwise expressly referenced in the management agreement.

• U.S. Corrupt Practices Act/U.K. Bribery Act. The manager should warrant that it will not make any pay-ment to anyone that is, to the manager’s knowledge, in violation of the U.S. Foreign Corrupt Practices Act, as amended, or the U.K. Bribery Act of 2010, as amended, and further, that the manager has taken reasonable mea-sures to prevent a violation of those laws by its person-nel and agents. These warranties are critical to protect your fund’s investment.

• Anti-money laundering laws. The manager should warrant that it is subject to and is in compliance with U.S. anti-money laundering laws and that, in order to fa-cilitate compliance with such laws, it has implemented a written anti-money laundering prevention program rea-sonably designed to comply with U.S. anti-money laun-dering requirements.

• Representations. The manager should make a number of representations, including that all of its representa-tions to you are true, that nothing in the investment management agreement will result in breach of its obli-gations or licensing (or violate the law), and that the in-vestment manager is in compliance with the law and all of its contractual and governmental obligations. The manager should also avow that there is no legal action, suit or arbitration or other legal, administrative or gov-ernmental investigation, proceeding or inquiry pending or, to the knowledge of the manager, threatened against it or its assets that might reasonably be expected to have a material adverse effect on the manager; that no gov-ernmental approvals are required to enable the manager to operate in accordance with the investment manage-ment agreement’s terms; and there has been no litiga-tion or threat of litigation or governmental investigation resulting in a finding or admission that the manager or its affiliates were guilty of fraud, willful misconduct, breach of fiduciary duty or violation of the securities acts.

ConclusionSelecting and retaining new investment management is

no picnic. Retain counsel experienced with preparing invest-ment management agreements, and listen to your counsel’s advice. Don’t be so wedded to the manager that you cannot walk away, for at the end of the day, you’ll be married to that manager—at least for a while.