Alternative M&A

RAVI ANAND, HEAD OF CORPORATE FINANCE, DEXION CAPITAL

The talk of consolidation, initial public offerings, mergers and acquisitions, not to mention other transactions in the alternative asset management industry has been discussed for some time. It is clear that there is a substantial pipeline of possible deals that are being considered and which may be executed later this year and into 2012. To put things into context there are thousands of hedge fund and fund of hedge funds firms scattered across the globe. As with many industries, a few of the firms command the lion’s share of the sector – the largest 5% of hedge fund firms represent more than 60% of assets under management and 9% of FoHF firms control more than a third of that market’s total assets. In both cases, the result is that there are a large number of firms which one could argue are subscale and could draw benefit from corporate activity.

Though hedge fund industry assets are over $2 trillion, the sector is still a relative minnow compared to the global asset management industry. Despite its relatively small size, there is nonetheless a great deal of continuing talk of the need to access alpha/hedge fund skills and the benefits of uncorrelated returns. The crisis of 2008 saw hedge fund assets plummet and a number of managers consider whether they had a viable future. As a result of this, there was a significant rise in the number of M&A focused conversations among a wide variety of asset managers during 2009 and early 2010. Some of these conversations resulted in transactions, but a good number did not.

So, what transactions transpired from these discussions andwhere do we see M&A activity in alternatives going?

Completed M&A activity
As seen, the level of M&A activity in the alternative asset management industry has increased significantly, albeit from a low level. Since the beginning of 2010 there have been 57 transactions which have an alternative fund management aspect to them. We have identified three key (but definitely not sole) drivers to the alternative M&A transactions which have taken place:

• Distribution – transactions where a party seeks to extend its product range, distribution reach and/or acquire investment skills;

• Distress – a rather emotive description of transactions that result from an entity needing to satisfy financial requirements, a parent/shareholder wishing to exit because of sub scale or lack of strategic fit, the recognition that the status quo is not viable or a group seeking to achieve critical mass; and

• Financial – where a private equity or other strategic investor takes a stake in an entity to either buy out or retire some founders’ capital.

dexiontable1

Table 1 summarises the M&A activity since 2010 where there has been some element of alternative AUM by the above categories and the sub sectors of the alternative market (excluding real estate, fund administration and asset-backed securities or ABS-related deals).

Unsurprisingly the level of distress related transactions has been highest amongst FOHFs. It is also worth noting that FoHF also had the largest degree of intra-industry transactions, i.e. consolidation-related.

Interestingly, we have also seen some merging of alternative skills, with private equity houses (largely those that have floated) extending their product range. Examples of this include Fortress moving into credit with Logan Circle, Apollo tying up with Lighthouse to enter the fund of hedge funds space and Carlyle broadening its interests by taking stakes in Claren Road and Emerging Sovereign Group.

Man Group was the most active group in the single manager sector. It acquired GLG Partners for $1.5 billion. Man also bought out the remainder of credit specialist Ore Hill that it didn’t own and also sold its stake in Bluecrest Capital back to management.
IPOs were largely limited to large private equity players as they sought to prepare for succession changes in management.

Valuation
Given the nature of transactions across the alternatives space and the idiosyncrasies of ownership, management/performance fees and client concentration, valuation comparisons are virtually meaningless.
Transactions involving scale businesses such as RBC/Blue Bay, Henderson/Gartmore and Man/GLG fell within the boundaries of market precedent for transaction valuations but are unable to provide any standard for smaller transactions where, typically, there is limited cash exchange and more deferred consideration.

The FoHF space is illustrative of how valuation metrics have changed. The heady days of selling at 3-5% of AUM/5-7x EBIT (earnings before interest and tax) have been replaced by pure earn out deals on retained AUM and a share in future profitability. Of course financial buyers, e.g. AMF, AMG or Goldman Sachs (through the Petershill fund), do provide some benchmark but such private deals have limited disclosure.

Impediments to alternative M&A
There are a number of issues which are particular to alternative asset managers which can make transactions more difficult to effect:

• Alternative asset managers are very personal businesses – the founders are frequently the CIO or CEO and have often left larger financial institutions because they value independence. These ‘ego’ factors can result in difficult negotiations, high expectations on valuation and very valid concerns regarding the extent of key man risk;

• A large proportion of owner/manager firms are not necessarily seeking to create equity value but are more focused on cash flow generation through strong performance and performance-related fees;

• As a relatively young industry there have been limited succession and re-incentivisation issues to deal with;

• The bonus-based culture of a traditional asset manager has been hard to implement in a high performance fee generative and lean alternative business; and

• Historic expansion has been largely driven by team moves and recruitment, rather than the need to acquire other firms to grow and evolve.

As result of these factors, regardless of the macro investment industry factors that should logically drive M&A, a large part of the alternatives industry will not participate in any form of corporate activity. Our very approximate estimation is that only 25-35% of the alternative industry either has the desire to consider, or would potentially be attractive enough to a third party to undertake, a transaction.

What does the future hold?
We have seen the alternative investment world become more transparent and accountable and consequently firms have to be more institutionalised, providing a full service to investors, whilst continuing to generate uncorrelated (alpha) returns relative to traditional markets. This can create a dichotomy – between maintaining the boutique’s signature investment style and being sufficiently bureaucratic to attract institutional allocations. We believe that to be successful, firms will have to change their business models and this will give prominence to business managers and distribution professionals alongside high profile investment professionals. These factors will also partly drive M&A transactions alongside a maturing industry that will need to deal with generational change from the founding partners to new partners. There is also the matter of adjustment in how hedge funds are distributed. This will see FoHFs become more advisory than discretionary managers as traditional asset managers continue to face pressure to acquire alternative investment skills.

We anticipate transactions taking place in the following areas:

• Diversified asset managers – will continue to develop alternative offerings and will find a way to both acquire, recruit and incentivise talent. The search for superior growth and profitability will make boutique alternative firms with specialised niches and/or superior track records of particular interest for partial or full ownership;

• Single manager hedge funds already at scale – see above and below;

• Single managers sub scale – some of these businesses will come together and merge into larger single managers or form alliances or joint ventures to institutionalise, extend their distribution reach and have a greater ability to launch new products; and

• Funds of hedge funds – will continue to consolidate finding new partners/entrants amongst traditional institutions, consultants and wealth managers that need the skills of FoHF managers to allocate to hedge funds within their multi-asset portfolios.

Generally we also expect to see cross-border activity increasing as firms will localise distribution and enter new investment markets to provide product to their home market. We think publicly quoted markets will be a long-term growth opportunity but only for large diversified groups that can undertake the disclosure and corporate governance requirements.

Recent history has shown that the alternative investment industry is capable of evolving at a much greater pace than the rest of the asset management industry. Alternative managers have embraced the changing distribution landscape and are dealing with staff retention and recruitment requirements. Coming from a boutique non-bureaucratic background the individuals tend to meet challenges head on. It is this entrepreneurial and animal spirit that drives a successful industry and will result in an increase in M&A transactions.