Learn the 12 essential clauses to review in an investment management agreement before you sign fees, discretion, and more.
I still remember signing my first investment management agreement. My manager was using words I didn’t know or even understand. It wasn’t until a few months later that I stumbled across a strange fee on my statement. Hours of research followed, before I finally understood what I’d gotten myself into.
Let me help you avoid the same pitfalls. By the end of this guide, you’ll know exactly what to look for when signing your investment management agreement and stay ahead of any Legal Update that could affect how these contracts are reviewed.
Quick Answer
And it is a legal document outlining the responsibilities of an investment manager and the expectations of the investor. It covers compensation, the scope of authority granted to the manager, and the circumstances surrounding termination. Read on to learn about the essential clauses and a checklist for reviewing this type of contract.
What Is An Investment Management Agreement?
An investment management agreement is a contract between you (the investor) and a professional money manager. It establishes the guidelines for how your assets will be invested, a description of the manager’s compensation, and the extent of the manager’s authority.
Think of it as giving someone the keys to your car – instead of telling them “don’t crash it,” you’re likely to write down parameters such as “no more than 10% in any one stock” or “only investment grade bonds.”
The details matter – and they’ll dictate whether you end up being pleasantly surprised or horribly disappointed with the final performance.
You could be a private investor or a large institution such as a pension fund – the principles are the same. You’re delegating decision-making power to another party, and this document serves to establish the parameters within which they can act.
Understanding Discretionary Vs. Non-Discretionary Authority
Discretion is a spectrum.
On one end is discretionary authority, meaning the manager can make decisions without consulting you first. On the other end is non-discretionary authority – the manager cannot make any decisions without your explicit permission.
Most fall somewhere in the middle, however, with the manager having discretion in day-to-day operations but requiring your consent before making any major decisions.
When I reviewed the agreement after discovering that mysterious fee on my account, I learned that I had signed over much broader discretion than I anticipated. Always read through the section describing the extent of discretion carefully – and twice.
12 Essential Clauses You Should Know For An IMA
If you’re going to sign an it, make sure you understand all of the following clauses:
1. Scope Of Authority
This clause establishes the limitations of the manager’s authority – trades, brokerage selection, voting of proxies, and corporate actions, among others. Watch out for vague language, which may be a red flag.
2. Investment Guidelines And Restrictions
This is arguably the most important section of the IMA, as it will dictate the parameters of your investment strategy. It should specify the permissible asset classes, any concentration limits, credit quality requirements, and leverage. It should also include any assets that are explicitly off-limits to your portfolio. Think of it as a description of your investment universe – the boundaries of your portfolio’s potential performance.
3. Fees And Expenses
Most managers charge a percentage of assets under management, with some additional fees for performance above a certain threshold. Ask yourself three questions: How is the fee calculated? When is the fee due? Who pays for the trading costs associated with buying and selling securities? This is where most investors get tripped up – I learned the hard way about the importance of understanding “crystallization” of performance fees.
4. Standard Of Care And Liability
This clause establishes the standard of performance expected of the manager, as well as their potential liability in the case of a dispute. It should state whether the manager has a fiduciary duty to you (the highest standard) or only an ordinary duty of care. This clause also covers indemnification and limitation of liability.
5. Reporting Obligations
This clause describes your reporting requirements – how often you should receive reports from the manager and what information they should include. Vague language here can make it much harder to stay on top of your investments.
6. Conflicts Of Interest
This is where you want to read carefully if you’re a public pension fund or any other type of institution – it should describe how conflicts of interest will be resolved in the case that your manager has other clients. How will they split winning trades between their different funds? Can they receive soft dollars (brokerage discounts) for research expenses?
7. Valuation
This applies mostly to private portfolios, but it’s still an important consideration for any investor. Determine who is responsible for valuing illiquid assets, and what methodology they will use. Make sure there aren’t any conflicts of interest if your manager is both selecting and valuing private investments.
8. Delegation And Sub-Advisers
Make sure the agreement specifies whether your manager can delegate any responsibilities to a third party.
9. Term, Termination, And Transition
Review this clause to understand the length of the agreement, the terms of termination (with or without cause), and the transition process. If you’re terminating the agreement, make sure you understand the implications for unwinding any illiquid positions.
10. Confidentiality
While most IMAs are confidential, make sure you understand any exceptions, particularly if you’re a public pension fund.
11. Governing Law And Dispute Resolution
This clause describes the applicable law and the procedures for resolving disputes.
12. Regulatory And Compliance
This clause confirms that the manager is properly registered with relevant agencies (typically the SEC) and that they will comply with all applicable laws and regulations.
Why This Document Is So Important
As an investor, it serves as your steering wheel – even when you’re not driving. Vague guidelines open the door to unwanted risks, while poorly worded fee descriptions can erode your returns without you even realizing it. At the same time, this agreement creates a safety net for your manager – strict compliance with the terms will keep them from being held personally liable in the case of a dispute.
IMAs are also just one part of the puzzle – they intersect with securities laws, trust indentures, and even governing documents of the entity holding your investments. Always make sure that everything is consistent – or at least explainable.
Where Investors Usually Get Tripped Up
The guidelines schedule gets far too little attention, in my experience. Failing to establish a maximum concentration per asset class, or defining “investment grade” too loosely can be incredibly costly.
Discretion is rarely an either/or proposition. Always scan the document for any exceptions – the manager may have discretion in most cases, but not in specific instances such as derivatives trading.
Fees can quickly become complicated – while a simple management fee based on assets under management is easy enough to understand, performance fees, hurdle rates, and high-water marks require more analysis.
IMAs rarely exist in a vacuum – make sure the language in the main agreement is consistent with any custody agreements or side letters. Protection language in the main IMA may be completely negated by a separate side letter.
Finally, always understand the intricacies of portfolio unwind. Simply stating that the agreement can be terminated at any time is not sufficient if the portfolio contains illiquid assets.
Other Important Considerations
Some investors are concerned with key-person risk – if you’ve hired someone based on their specific skill set, what happens if they become unavailable? Make sure the agreement includes appropriate language regarding key-person risk.
Investment Management Agreement Vs. Investment Advisory Agreement
People often confuse it with investment advisory agreements – here’s a quick comparison of the two:
| Investment Management Agreement | Investment Advisory Agreement | |
| Authority | Often discretionary, manager has discretion to make decisions | Typically the client makes all decisions |
| Best for | Investors who want to be hands-off | Investors who want to be actively involved |
| Fee structure | Could include performance fees | Rarely include performance fees |
| Control level | Lower | Higher |
Quick Checklist
- Does the discretion clause contain any limitations?
- Are the investment guidelines specific enough?
- Is the fee calculation methodology clearly stated?
- Does the standard of care match your expectations?
- Are reporting requirements detailed enough?
- Is there a key-person clause if you’re hiring on an individual basis?
- Do the termination and transition provisions describe the process of unwinding the portfolio?
FAQ
Is An Investment Management Agreement A Legally Binding Contract?
Yes, once signed it becomes a legally binding contract that is enforceable according to the law specified in the agreement.
Who Typically Uses An Investment Management Agreement?
Individual investors, family offices, pension funds, endowments, and other institutions use IMAs when they want to delegate investment decisions to a professional money manager.
Can You Negotiate The Terms Of An Investment Management Agreement?
Yes, negotiation is typically possible – fees, discretion limitations, liability caps, and termination clauses are common areas of negotiation.
What’s The Difference Between Discretionary And Non-Discretionary Authority?
Discretionary authority means that the manager has the right to make investment decisions without seeking your approval first. Non-discretionary authority means that the manager can’t make any decisions without your explicit consent.
Key Taking
Looking back on my first time, I’m grateful that I hired a manager to begin with. I’m even more grateful that I eventually learned to understand the nuances of an IMA – particularly the importance of reviewing the guidelines schedule. If I could give one piece of advice to my past self, it would be this: it is much more than a formality – it’s the foundation upon which your entire investment strategy rests. Take it seriously, and review it as if your financial future depends on it – because it does.
Additional Resources:
- SEC Investment Adviser Public Disclosure (IAPD) :Search investment adviser firms and individuals, including registration information and regulatory disclosures.
- CFA Institute — Fiduciary Duty / Standards : Covers fiduciary duty, loyalty, prudence, and care in investment management.
- FINRA — Choosing an Investment Professional: FINRA’s investor resources for researching and selecting investment professionals.
