The recent brouhaha between the San Diego Employees Retirement System and consultant Callan Associates reveals a fundamental challenge facing the investment consulting industry.  San Diego sued Callan in August, accusing them of improperly benefiting from supposedly arm’s-length relationships with third parties (namely various managers and a brokerage).  But is this alleged breach of trust really a surprise?  As a trusted consultant, Callan holds all the cards.  Yet investment managers, brokers, and even educational seminar companies are raking in the dough.

They’re not the only consultants who are frustrated.  The unfortunate reality is that someone set off a stink bomb in the investment consulting business and it seems that the major players are falling over themselves to get out of the room.

For example, Pensions & Investments recently reported on how private equity consultant Pathway Capital Management has “quietly jettisoned its consulting clients, moving full-time into the more lucrative investment management business.”

Watson Wyatt Not (necessarily) in the Consulting Business Anymore

In the same issue, P&I reports that Watson Wyatt is also running for the doors:

We’re not necessarily in the business of investment consulting anymore, said Roger Urwin, global head of investment consulting at Watson Wyatt Worldwide in London. We are part of the investment management business, and we provide investment consulting advice.

Translation: “We want a piece of the IM pie, but don’t want to alienate our traditional clients or tick-off the SEC”.

Whither Consulting?

Which leads us to the uncomfortable situation where no one is left to actually consult other than the managers themselves. Says P&I:

“This leaves institutional investors in a quandary. The pool of consulting firms that offer non-discretionary consulting services is getting smaller, pension fund executives say.”

But until consulting fees rise due to this impending shortage, talent will continue to flow to the more lucrative IM business.  Kevin Quirk, a partner at strategic consulting firm Casey, Quirk & Associates tells P&I:

“The typical revenue structure makes it difficult for consulting firms to compete, not just with one another, but with investment management firms that can pay these same professionals multiples of what they earn as a consultant…In many ways, this makes consulting a less than stable business.

A Quiet Revolution

The shift from non-discretionary advice to discretionary management to manager-of-manager platforms to funds-of-funds has been gradual and has featured many shades of gray.  According to P&I:

“Some consultants have entered the business of money management recently, creating fund-of-funds strategies or multimanager products that can be plugged directly into institutional investors’ portfolios. And some have gone from providing arm’s-length advice on manager searches and asset allocation to a more involved relationship where the consultant makes, rather than just suggests, investment decisions.”

“Watson Wyatt now provides an Advanced Investment Solutions that selects a manager for an institutional client and hires it directly, rather than handing clients a group of several managers to choose from during a search. The firm collects a normal consulting fee and a performance fee governed by the investment performance of the selected manager.”

More (asymmetrical) performance fees?  Where is Lisa Rapuano when you need her?

Pay-to-Play

The SEC may have inadvertently been the one to let off the aforementioned stink bomb when they came down hard on consultants for potential conflicts resulting from benefiting from the funds they recommend (“pay-to-play” explained).  Ironically, the SEC’s concerns over improper relations have been eclipsed by consultants who now just go ahead and provide the IM services themselves rather than create new business models that might surreptitiously benefit them.

Global Pensions pondered the liklihood of this potential conflict back in January 2006:

“With pension funds now able to receive investment advice through an increasing number of avenues, the big question is: what value will be put on impartial advice going forward? Will pension funds continue to recognise the merit in having an independent party assist and support them in their investment choices? Or will they instead opt to trust the advice of the suppliers of product, on the one hand reducing cost by eliminating a stage in the decision-making process, but on the other taking the risk that the advice they receive may not be the best option?”

The recent spat of consultants either adding IM services or dumping consulting altogether suggests that clients don’t mind as long as it is appropriately disclosed.

- Alpha Male

Post Script: D’oh! Only weeks after Pathway dropped its consulting service, San Diego announced that it wants into PE and needs some private equity consulting.