The Separation of Investments and Management

This paper suggests that the essence of these funds and their regulation lies not just in the nature of their investments, as is widely supposed, but also—and more importantly—in the nature of their organization.

Specifically, every enterprise that we commonly think of as an investment fund adopts a pattern of organization that I am calling the “separation of investments and management.” These enterprises place their securities, currency and other investment assets and liabilities into one entity (a “fund”) with one set of owners, and their managers, workers, office space and other operational assets and liabilities into a different entity (a “management company” or “adviser”) with a different set of owners. Investment enterprises also radically limit fund investors’ control. A typical hedge fund, for example, cannot fire and replace its management company or its employees—not even by unanimous vote of the fund’s board and equity holders.

I explain this pattern of organization and explore its costs and benefits. I argue, paradoxically, that the separation of investments and management benefits fund investors by limiting their control over managers and their exposure to managers’ profits and liabilities.

Limiting fund investors’ control rights and risk exposures is uniquely efficient in investment funds for three reasons: First, most fund investors have rights of exit that allow them to withdraw their assets from managers’ control. The strength of these rights varies from fund to fund, but in general these rights provide a powerful substitute for control. Control thus resides more efficiently in the hands of managers than in the hands of fund investors. Second, fund investors have uniquely strong desires for precision in the tailoring of risk. They desire exposure only to the risks of investment assets and not to the risks of management businesses. The separation of investments and management facilitates precision by limiting fund investors’ exposures to managers’ profits and liabilities. Third, fund managers can achieve economies of scope and scale by simultaneously or serially managing multiple funds. Simultaneous management creates both conflicts of interest and investment risks. For reasons that I explain, these problems can only be addressed by limiting fund investors’ control rights and exposures to managers’ profits and liabilities through the separation of investments and management.

This multi-faceted explanation may seem complicated, but the intuition behind it can be expressed simply: in terms of their rights and risks, fund investors look more like buyers of products or services than like investors in ordinary companies. The reasons why fund investors have no ownership or control over their management companies thus resemble the reasons why product buyers generally have no ownership or control over their manufacturers. For example, in much the same way that product buyers can exit by refusing to buy more products, fund investors can exit by withdrawing their money and refusing to pay managers’ fees. And in much the same way that product manufacturers simultaneously produce multiple products, fund managers simultaneously operate multiple funds.

This positive explanation for investment funds’ basic structure has extensive normative implications. Most important, it can illuminate the basic purposes of fund regulation. The purpose, it turns out, is not merely to address the unique problems created by securities investing, but also to address the unique problems created by the separation of investments and management. This pattern of organization creates an array of challenges not present in ordinary companies and the primary purpose of regulation is to address these challenges. Another implication is that we should change the way we define investment funds. In addition to looking at an enterprise’s assets, as law and scholarship currently do, we should also consider organization—namely, whether an enterprise separates investments and management. This would solve deep conceptual problems, such as how to distinguish private equity funds from conglomerates, whose assets are quite similar to private equity funds, but whose organization is radically different.

The full paper is available for download here.