In the results-driven investment world, it’s common for startup mutual fund managers – or those converting their private funds – to be centrally focused on breaking even. In fact, that’s often the first question investment managers ask their service providers when they sit down at their first strategy meeting: “When will I break even”? On one hand, it’s a logical question; managers want to know when their investment in operating mutual fund is going to pay dividends toward their own bottom line, and how quickly they can get there. And, there’s an expectation that the answer is as simple as a number. However, the first question that needs to be answered is: “What do you mean by break even”?
Break-even is not a simple function of net assets. It changes based on how investment managers obtain their assets, the investment objective of a particular fund, the expense ratio philosophy, and so on. There are numerous variables that investment managers need to contemplate to begin understanding what dollar amounts lead to break even. Before that, though, the manager and service provider need to draw the proper distinction between break even points. There is no default setting when it comes to breaking even, but the results tend to come in three stages:
Fund/Product Break Even: The fund is big enough to cover its own operating expenses, but the manager isn’t receiving any of its advisory fee. This is the quickest break-even point, but really only the first step toward a profitable business for an investment manager.
Advisory Fee Break Even: Another important milestone in the lifecycle of a fund, at this stage the fund is large enough for the manager to receive 100 percent of the advisory fee and cover all incurred operational expenses that can’t be charged to the fund.
True Break Even: Think of this as the summit of the mountain. True Break Even results when the manager is turning a bottom-line profit. The fund covers its own operating expenses, and the manager is covering all of its operating expenses including salaries for all employees devoted to the fund, including portfolio managers, compliance officers, research, sales and marketing personnel.
Critical Questions to Determine Break Even
Defining break-even is the first step in achieving it. However, it’s really only the beginning of the list of questions that managers need to answer to fully determine what amount belongs in the business plan. Below are some of those questions to consider about the path toward break even, and some tips to help managers achieve it.
Where Are the Initial Assets Coming From? Funds that are consolidating separately managed accounts, or taking assets from friends and family, have a distinct advantage and a quicker timeline toward fund break even.They don’t have to pay intermediaries in order to secure assets because they already have the assets. Startup managers who gain assets through a third party pay a percentage of those assets back to the platform, and thus need more total assets to get to the same net revenue as managers with their own assets. That makes a big difference toward break even.
What is Your Investment Objective? With the boom in mutual fund assets also comes a demand for more complex and unique strategies.There are trade-offs here, because different objectives lead to vastly different costs. Whether a fund is domestic or global, equity or fixed income, or low turnover versus high turnover all play into costs and profitability. More complex investment funds require more detailed valuations and reporting, leading to higher operational costs. For example, the costs associated with managing a U.S. domestic fixed income fund can be significantly higher than the cost of a domestic equity fund. It’s important not to overlook the impact of investment objectives on operational costs and ultimately the time required to get to break even.
What is the Fund’s Long-Term Business Plan? To optimize profitability and asset gathering, managers need to have a handle on the fund’s long-term business plan and feel confident that the fund’s pricing is appropriate.They have to know who they’re competing against and if they are giving up potential revenue. For instance, in the liquid alts space, management fees of 120 bps are common. If a manager is only charging 60 basis points, they’re giving up significant revenue. Vice versa, investment managers need to consider what fees are palatable to the market, as it is a competitive landscape and fees are typically a prime consideration of investors. It’s important to look at the overall pricing model and expense factor philosophy and make sure it aligns with where the fund is going long-term. Managers should also be sure the fee charged will cover the need to share revenue if they will need to be on distribution platforms.
Break Even Best Practices
Reaching just the first level of break even can seem like a daunting task for a new fund, even if managers have comprehensive answers to the previous questions. The good news is that some costs are avoidable for startups, because they are unnecessary for new funds – and even existing funds, in some cases. Managers might not be able to avoid these costs forever, especially if they have eyes for widespread distribution, but to decrease initial complexity, take heed of the following:
Steer Clear of Share Class Clutter – Startup managers don’t need to complicate things initially by launching multiple classes.In the critical first year of a fund when managers are still building assets and break even seems like a long way away, often the only share class that’s necessary is an institutional share class. For the many managers that initially target institutional investors, sticking to a single share class saves thousands of dollars in operating costs, at a time when assets are at a premium. Once the fund’s inaugural class reaches critical mass, then the manager can discuss adding other share classes, but even then, it may not be necessary. Avoid share class clutter to get to break even sooner.
Don’t Pay Where You Don’t Do Business – Frequently, managers check off all the boxes in their Blue Sky registration because they believe that it’s a necessary step in launching a fund. It’s not. Funds only need to register in states where they will have shareholders and paying for states with no shareholders is effectively wasting money.If the assets are highly concentrated in just a few states, this is a significant, avoidable cost.
Avoid Unnecessary Risks and Costs – Investment managers should explore multiple solutions for executing the fund’s strategy when possible to avoid taking on additional potential risk, and trading and custody costs. For instance, a manager looking to get international exposure could get that by owning ADRs or ETFs rather than directly owning individual stocks – which can be expensive and risky. Custody charges and daily pricing fees are steep and the fund becomes vulnerable to currency events if it holds foreign stocks. This higher risk also requires more compliance monitoring – another avoidable cost.
Sweat the Distribution Details — Have a well thought out distribution plan. Identify the target audience: think 1, 3, 5 years out and don’t overlook minor details in the distribution process that can cost major amounts of assets. For instance, some consultants have very specific screening parameters when recommending funds to investors. If a consultant is looking for funds with fees of less than one percent and a manager sets the fee at one percent, the fund will get screened out and potentially miss out on assets from that channel. Managers have to sweat the little distribution details, as well as, the broad distribution plans to gain traction and make the path to break even much smoother.
Split Fund Costs and Manager Costs Strategically – There’s little consensus among fund managers and service providers as to what distinguishes a fund cost from a manager cost, and the SEC hasn’t offered much guidance either. It’s not uncommon to see 10 fund groups calculate sub TA fees in 10 different ways. Managers need to look carefully at how costs are categorized, making sure to operate as effectively as possible within the confines of the law to pass along the appropriate costs to shareholders. To pass along a service fee to the shareholders, investment managers need to define exactly what the fee pays covers in order to remain as transparent as possible.
The path to break even – all three stages – is a complex mix of investing and pricing strategy. Investment managers looking to break into the mutual fund space need to have a track record of positive returns to attract shareholders, and also need to think about how to position the fund for future success. Thinking about these two concepts together will provide a holistic look at what break-even is and how managers can get there quickly. As we’ve shown, break even is more than just a number or simple calculation; it’s a goal that’s achieved through evaluating critical questions. Only then will the answer to “when will I break even,” be a number that managers can bank on.