External Manager

An External Manager is an independent firm or individual hired by a company or fund to oversee its investment portfolio and/or business operations. This is in contrast to a company run by its own internal team of executives and employees. Think of it as hiring a professional chef and their entire kitchen crew to run your restaurant, rather than hiring and managing the staff yourself. These outsourced experts are most commonly found managing investment vehicles like Hedge Funds, Mutual Funds, Private Equity Funds, and Investment Trusts. However, some publicly traded operating companies, particularly in specialized sectors like real estate or shipping, are also run by external managers. The relationship is governed by a Management Agreement, a crucial document that outlines the manager's duties, powers, and, most importantly, how they get paid.

On the surface, the logic is compelling. An external manager can bring specialized expertise, a pre-existing professional network, and economies of scale that a new or smaller entity might struggle to build from scratch. For investors, it offers a way to access a particular strategy or asset class—be it distressed debt or venture capital—without having to become an expert themselves. The core idea is to hire a “best-in-class” operator to handle the complex work of capital allocation. The fund or company provides the capital, and the manager provides the brainpower. This structure is the very foundation of the modern asset management industry.

This is where the fairytale often ends for the value investor. External managers don't work for free, and their fee structures can create a massive drag on your returns. Understanding these fees is non-negotiable.

The most common fee is the Management Fee, typically charged as an annual percentage of the total Assets Under Management (AUM). This could be anywhere from 0.5% to 2% (or more).

• The Problem: The manager gets paid this fee regardless of whether they make you money or lose it. This creates a powerful incentive for the manager to simply gather as many assets as possible to increase their guaranteed paycheck, rather than focusing on generating high returns. As Warren Buffett has pointed out, it's a “heads I win, tails I don't lose” scenario for the manager.

To better align interests, many managers also charge a Performance Fee (often called Carried Interest in private equity). This is a share of the profits the manager generates, famously structured as the “2 and 20” model: a 2% management fee plus 20% of the profits.

• The Nuances: To make this fairer, good agreements include a few safeguards:
  • Hurdle Rate: The manager only earns a performance fee on profits above a certain minimum return (e.g., 8% per year).
  • High-Water Mark: If the fund loses money, the manager cannot earn a performance fee until the fund's value surpasses its previous peak. This prevents managers from getting paid for simply recovering lost ground.

Even with these protections, the combination of high fees can be devastating to long-term compounding.

For a value investor, the default stance toward externally managed structures should be one of extreme skepticism. The core issue is the Principal-Agent Problem: the interests of the manager (the agent) are often fundamentally misaligned with the interests of the investors (the principals).

An external manager's primary product is the management company itself, which they want to grow. Your primary goal is the growth of your own capital. These are not the same thing. High fees, a focus on short-term performance to attract new assets, and a tendency to follow market fads (“style drift”) are all common symptoms of this misalignment. You are paying someone a fortune to manage your money, yet their business model may implicitly encourage them to act against your best interests.

Exceptional, investor-friendly external managers do exist, but they are rare. A value investor would look for managers who “eat their own cooking.” Key traits include:

• Significant Skin in the Game: The manager has a substantial portion of their own net worth invested alongside you.
• Fair Fee Structures: Low management fees and performance fees that reward long-term, absolute performance over a sensible benchmark.
• Owner's Mindset: The manager communicates candidly, admits mistakes, and behaves like a long-term business owner, not a fee-collecting asset gatherer.
• Independence: They have a disciplined process and are not afraid to hold cash or go against the herd when opportunities are scarce.

It's no accident that Berkshire Hathaway is structured as an operating company, not a fund. Warren Buffett and Charlie Munger work for the shareholders, not for a separate management company. There are no layers of fees siphoning off returns. For most ordinary investors who can't find (or access) one of the rare, truly aligned managers, Buffett's advice is clear: bypass the high-cost world of active management altogether and opt for a low-cost Index Fund. You may not beat the market, but you are guaranteed to capture the market's return with minimal cost, a result that will almost certainly outperform the vast majority of high-fee external managers over the long run.

An external manager is a hired gun for your capital. While they may possess great skill, they come at a very high cost that can severely damage your long-term wealth. Before entrusting your money to one, you must act like a detective: scrutinize the fee structure, verify the alignment of interests, and demand a long, proven track record of both integrity and performance. If you have any doubt, remember that a simple, low-cost passive investment is a far more reliable path to financial success.