Playing Chicken with Investors

Investors would be excused if they'd never heard of the Chicken Little Growth Fund. With an unheralded manager, an unproven hyperaggressive strategy, and a short track record, the fund stood out from the crowd only by its gimmicky name. In short, it seemed that if ever there was a fund destined for mediocrity followed by eternal obscurity, it was Chicken Little Growth Fund.

Not surprisingly, Chicken Little Growth Fund's board recently announced that it was liquidating the fund following a 16-month run. But not before the fund had taken shareholders on a wild ride. In short, when the fund's manager reneged on a promise to cover certain operating expenses of the fund, the fund's board played a game of brinkmanship that, for a time, put shareholders on the hook for the disputed payments.

Though highly unusual, the incident shines a light on the increasingly common practice of investment manager back-office outsourcing, a recurring theme in our analysis of fund administrators like the  Bisys Group  and  DST Systems  as well as global custodians like  Investors Financial Services . In Chicken Little Growth Fund's case, the manager had entirely outsourced the fund's back-office operations to a third-party provider. As part of the arrangement, the provider even appointed a board to oversee the fund's affairs. In effect, the manager outsourced fund governance, an arrangement that raises a host of questions given the potential conflicts of interest involved. Those conflicts appeared in sharp relief amid the Chicken Little fund's recent travails, nearly costing the fund's investors dearly in the process.

More generally, investors considering funds that are party to these types of arrangements--which are likely to grow more commonplace over time, especially with startup funds--should pay special heed to factors such as the manager's background, the prudence of the fund's strategy, and the reasonableness of the fund's expenses.

In this piece, we follow the Chicken Little fund story's unlikely arc and examine the complications that can arise when an asset manager outsources fund governance to a third party. In addition, we provide some parting thoughts on the trend toward outsourcing in the asset management business, whether it's likely to endure, and, if so, what it might mean to investors.

Long Story Short
On December 1, 2006, without warning, Chicken Little Growth Fund's board announced that it was reducing the fund's net asset value by $0.32 per share, which translated to a roughly 2% hit at the previous day's close. The board also ceased offering new shares of the fund. Then, roughly two weeks later, the board reversed its earlier decision, restored the fund's NAV, and reopened it for business anew.

What happened? In short, the fund's manager, Daedalus Capital, stopped paying its bills. The fund's board responded by assuming that shareholders would assume those debts and hiked the fund's expense ratio accordingly, explaining the $0.32 per-share NAV reduction. Then, when Daedalus made good on the payments it owed, the board directed the proceeds to the fund, thereby restoring the fund's NAV.

So, no harm, no foul, right?

A Curious Decision
Not quite, as the fund's board shouldn't have threatened shareholders with the $0.32 per-share NAV reduction in the first place. In a nutshell, that reduction would have had investors assuming debts that weren't their responsibility.

To understand why, consider that the fund's board and Daedalus had contractually agreed to cap the fund's expense ratio at 3% through July 31, 2007. In other words, if the expense ratio totaled 5%, shareholders would incur 3% and Daedalus would absorb the remaining 2%, and so forth. Because the Chicken Little fund's actual expense ratio in its first fiscal year was a staggering 35%, Daedalus was on the hook for all but 3% of the fund's 35% expense ratio.

Based on SEC filings, it appears that Daedalus held up its end of the deal from the fund's September 2005 inception through July 2006: The firm paid more than $128,000 during that period in order to prevent the fund's expense ratio from exceeding the agreed-upon 3% cap. But when Daedalus stopped picking up its share of the tab, the fund's board turned to shareholders to make up the shortfall, explaining the $0.32 per-share NAV reduction. In shifting the costs in this manner, the board essentially disregarded the expense cap, as the fund's expense ratio shot up to 10%.

The board's action was significant, as it had originally imposed the 3% expense limit after expressing concern regarding Daedalus' high management fee. That is, the board seemed to be keenly aware of the need to cap expenses for shareholders' sake and that awareness informed its negotiations with Daedalus. Yet, when Daedalus was unable to honor the terms of its pact with the fund, the board didn't seem to have any qualms about having shareholders foot the bill. In effect, the board seemed to be willing to violate the very principle it had insisted upon in hiring Daedalus--not to charge shareholders more than 3% per annum.

In sum, it appears that the board was prepared to let fund shareholders shoulder Daedalus' debts, even though fundholders had been given no prior indication that was a possibility. What's more, the board retained Daedalus as the fund's advisor despite that firm's failure to honor the terms of the management contract it had inked with the fund.

The independent chairman of the Unified Series Trust, Stephen Little, declined to comment on questions specifically relating to the Chicken Little fund and the board's handling of the matters described.

Fund Board or Repo Man?
Inexplicable as the board's actions might seem, a closer look at its composition offers some possible clues into why the board might have taken this step. For instance, at the time this episode was playing out, one of the board's trustees had financial ties to the fund's administrator and distributor, Unified Fund Services. And while the other three trustees were technically independent, they were handpicked by Unified to oversee the 40-plus funds that are among those the company does business with. In other words, Unified has significant representation--directly or indirectly--on the fund's board.

Why would Unified seemingly hold such sway over the fund's board? Unified is what's known in fund-industry parlance as a "turnkey" service provider. In that capacity, it provides soup-to-nuts middle- and back-office services, including fund administration, fund accounting, transfer agency, and distribution. One solution that has proved increasingly popular to independent startup funds is the "third-party series trust." A third-party series trust is a legal trust that houses the funds of multiple, unaffiliated advisors that, lacking the requisite back-office expertise and unable to rationalize the up-front costs associated with launching a fund, find it more economical to pool resources. In so doing, these advisors are able to share the costs of fund compliance and board oversight by outsourcing these functions to the turnkey provider. The simplicity and cost-effectiveness of back-office outsourcing and the series trust is, in essence, what brought Daedalus to Unified.

It's worth noting that Unified shepherded the Chicken Little Growth Fund through the initial startup and registration phase and performed essentially all back-office functions. The costs associated with these back-office tasks are subject to the aforementioned expense limitation agreement that the fund established with Daedalus. In other words, Daedalus owed the disputed payments not to just any vendor, but to the service provider that has potentially significant influence on the fund's board--Unified Fund Services. (Technically speaking, Daedalus owed these amounts to the fund which, in turn, owed them to Unified.)

These circumstances cast the dispute--and the board's resolution of the matter--in a different light. Given the board's ties to Unified and Unified's understandable desire to be paid in full for the services it rendered to the fund, the board was arguably thrust into playing the role of creditors' committee. (Though filings never specified what types of fees had gone unpaid, it's also worth noting that a portion of the unpaid fees could have included directors' pay.)

Against that backdrop, the board's decision to retain Daedalus and shift the burden for these disputed amounts onto fund shareholders looks more questionable. For instance, one possible interpretation is that the board used the threat of an onerous expense hike (and eventual liquidation of the fund) in order to gain leverage over Daedalus and force payment. Another is that the board opted to retain Daedalus because, at worst, the tactic of threatening investors with an expense hike would induce payment in full--either from fund shareholders or a chastened Daedalus--while still holding out the potential for Unified to service the fund in the future, should it survive. By contrast, had the board summarily fired Daedalus, it would have instantly thrown the fund's future into doubt, as Unified would have lost the right to use the fund's name (the fund was licensing it from Daedalus) and shareholders might have headed for the exits amid any ensuing personnel and strategy change.

For its part, Unified contends that the situation--an advisor reneging on a promise to cover an expense waiver--was virtually unprecedented. Thus, the board's action was simply meant to bring the dispute to shareholders' attention while the board continued to grapple with the issue and devise a solution. Unified also disputes the notion that the board's decision to retain Daedalus was part of any Machiavellian ploy to force payment--be it from the manager or shareholders.

The Advisor Blinks
Alas, Daedalus was first to blink: On Dec. 14, 2006, the fund's board announced that Daedalus had reimbursed the fund for all unpaid expenses through Nov. 30, 2006. Further, it announced that the fund's NAV had been recalculated as of Dec. 1 to give effect to the payment. As such, fund shareholders suffered no dilution. (In addition, though not noted in the announcement, the board reopened the fund only on the condition that Daedalus agree to pay several months' worth of expense reimbursements into escrow.)

However, in its announcement, the board noted that there was no guarantee that Daedalus would be able to make the required payments in the future. In the event of nonpayment, the board warned that fund shareholders would again be on the hook.

In the end, it didn't matter: On Jan. 16, 2007, the board announced that it was liquidating the fund. The tipping point apparently came when Daedalus again fell behind on its payments. Fortunately, the proceeds that Daedalus had deposited in escrow were sufficient to settle up any unfunded expense reimbursements, thereby averting the need to dun shareholders' accounts. Thus, according to Unified, shareholders will not incur any costs beyond the fund's 3% expense ratio when the fund's holdings are liquidated.

A Troubling Pattern
Fortunately, the Chicken Little Growth Fund is minuscule, with less than $1 million in assets. Thus, when viewed within the broader context of the multitrillion dollar mutual fund industry, the fund's troubles barely register a blip. (It's worth noting that this isn't Unified's first brush with controversy; in 2006, the firm paid a $125,000 civil penalty in settling SEC charges that it had misstated the books of a money market fund, incorrectly calculated the NAV of a bond fund, and failed to submit required financial filings on time.)

But this isn't the first incident of its kind. In June 2006, for instance, a tiny offering by the name of the Rational Investor Fund was liquidated under strikingly similar circumstances. To wit, the fund's advisor indicated that it could no longer afford to reimburse the fund for various administrative expenses pursuant to an expense limitation agreement. In addition, the fund was part of a series trust and overseen by a board with extensive ties to Gemini Fund Services and affiliates, which served as the fund's transfer agent, accountant, administrator, and distributor. Finally, the fund's board levied a $1.50 per-share charge on shareholders to compensate for what a filing described as "the fund's current obligations and estimated closing costs excluding any possible reimbursement that may subsequently be paid by the Advisor."

As it turned out, shareholders didn't suffer any harm. The advisor subsequently came up with the proceeds needed to cover the reimbursement. Thus, the fund made a $1.50 per-share disbursement to each shareholder, essentially negating the earlier charge.

Click here to read the second part of the story.