We asked people about how they viewed the future of the industry: is it a bend in the road or is it a crossroads? Of those interviewed, 27% argued that this was just a bend in the road – another cycle not fundamentally different to them as business managers from other cycles – and their existing business management tools would be sufficient for dealing with the current situation. Some 38% said that it was a sharp bend – a severe shock but not a point of redefinition for the industry – while 35% of interviewees said that it was a crossroads. Several were concerned that the investment management industry as a whole was deeply discredited. Others felt that the hiatus presented an opportunity for firms to re-examine their business models and that fewer but stronger firms would emerge. In this article we examine the implications of the recent events on firms themselves – what changes are approaching and how should firms gear themselves up to respond to that change effectively.
Implications for operations
The classic way to represent an organisation is as a pyramid, with the CEO on top supported by the board, the managers and then the workers. Gene Bellinger observed that in most organisations the classic pyramid model could be better represented tipped on its side, illustrating how the most senior roles create direction and impetus to move the firm forward (see Fig.1). However, many investment management firms can more accurately be modelled as a cupcake, with the cherry representing the CEO sitting on top of a thick layer of icing. When tipped on its side and asked to move forward, this shape has far poorer aerodynamic qualities (see Fig.2).
For stand-alone hedge fund firms, the multi-boutique model has been popular. However the new risk which has become evident for a highly-empowered multi-boutique model is that when one strategy goes wrong, it endangers the rest of the firm – the possibility of potential contagion from one strategy to the firm, and hence to even the best-performing strategies, was not fully appreciated before the crisis.
Now that we have seen the ability of a few products to bring down a big brand, this begs the question of whether we will be moving away from the “cupcake” model of investment business power, where the investment managers have a high degree of control over the running of the firm. Has the flying cupcake been smashed by the tennis racquet of the financial crisis? Or, less picturesquely, has the importance of operational quality translated into a new level of dialogue between the investment staff and the rest of the firm? The regulators are certainly already imposing more stringent operational risk control requirements. The sight of Keydata going bankrupt due to an operational tax error has re-emphasised that operational risk, unlike investment risk, is charged directly to a company’s bottom line and can destroy the firm. Companies are now much more focused on identifying and managing the bear traps of areas which bring excessive risk, and this means that it is becoming less acceptable for investment staff to refuse to connect with the rest of the firm. Separately, managed accounts are forecast to rise in popularity for hedge fund clients, primarily to prevent the contamination of performance from other investors’ cash flows, but they can also give a client much greater control over operational and counterparty risk. They are not particularly popular with managers who see that they can bring huge increases in complexity, especially when the account drifts away from the main fund.
Poor operations are definitely a deal-loser at the moment while excellent operations may be becoming a deal-winner. However, one by-product of an increased focus on operational risk management is that operational complexity is set to rise. Some of the new requirements – to manage liquidity and counterparty risk, to give far greater evidence of the investment process, and to develop fair value pricing methods which do not only rely on the last traded exchange prices – put great strains on the underlying IT and data management platform. This has to be balanced against the fact that there are still immense pressures within firms to control the cost of operations – this new mood does not permit the operations teams to spend freely to meet the new requirements. The outsourcers must be major beneficiaries of this situation, even though many firms will openly admit that their outsourcing arrangement has not turned out to be the effortless solution that they had persuaded themselves they were going to get. There will also be increased costs from regulation. The investment industry lobbied successfully over the last 30 years for light-touch regulation and for self-regulation. The light-touch era is definitely over and the challenge now is to try and prevent over-compensation. Even if market sentiment does recover quickly, the shock to the regulators has been severe and it will take a very long time indeed to return to a lighter regulatory mindset. The Alternative Investment Fund Managers (AIFM) regulation being rushed through in Europe is designed to crack down on hedge funds, but is already threatening to spill over into Undertakings for Collective Investment in Transferable Securities (UCITS) vehicles. The problem with pushing new regulation through quickly is the threat of unintended consequences. The AIFM consultation process is felt to have been perfunctory and the cost-benefit analysis that Europe committed to doing on new regulation is nowhere to be seen.Regulation will also focus on wider areas of the fund management business. The scope of regulation is reaching out beyond the way that collective vehicles are managed, to include the way that firms themselves are managed, and the way that they manage their outsource service providers.
On a more positive note, one piece of regulation with unintended good consequences has been open-ended investment companies (OEICs) which have been enthusiastically adopted by the Pacific institutional markets as bringing an assurance of operational competence. The European hedge fund industry is also aware of this and many firms are making plans to create OEIC versions of their existing, more lightly-regulated products. The benefit of more regulation, properly managed, could be a reduction in the due diligence pressure currently being felt. Clients who have remained very unconvinced by the concept of a voluntary code of conduct can take more comfort in a regulated and policed set of rules.
Rising internal costs may cause firms to try to increase revenues by taking on more assets to manage – often to the detriment of performance. This works directly against the feeling interviewees had that managers need a greater focus on delivering performance and becoming more client-centric. One big advantage that hedge fund firms have is that their industry metrics have tended to focus on performance rather than assets under management. Interviewees for the report were concerned that during the boom years of 2002-07 investment firms, especially long-only managers, became focused on gathering assets rather than managing them. There was agreement that firms need to be more thoughtful when designing new products… at least until the next boom years return, cynics would reply. Greater use of product and strategy caps and a clearer understanding of the corporate goals were some of the solutions put forward. Many hedge fund firms have been able to stick to their original performance-centric ideals and will find this less of a challenge.
When we are examining the balance between icing and sponge, should we be considering the greater threat that the world has lost its sweet tooth – to rescue the metaphor, will people no longer want to pay investment managers to manage their money?
The assumption for clients – all clients – is that if they are unsophisticated they want fully-bundled products. As they get more sophisticated, they move towards assembling their own portfolio out of a range of individual products which are run by investment managers. But the products they can use to do this may be changing. The good news for hedge fund managers is that alpha products are still seen as a key part of the new landscape; the challenge here is for beta-plus managers who face the threat of trackers and exchange-traded funds on one side, and a resurgence of private client advisory stockbroking on the other. The bad news is that when it comes to fees, the 2+20 and – especially for fund of hedge funds – 3+30 models have been shown to consume too much of the potential gain, and the fee model will definitely be coming under pressure.
The combination of the need for greater internal competence, rising costs, and squeeze on fees, leads us on to the questions of size and consolidation. Who can be a fund manager, are the small hedge fund firms going to struggle to survive, and if so, what will they need to do? It certainly appears that the Madoff affair has prompted a new question for RFPs: Do you have more than six employees and how many of them are related? This, together with the requirements listed above, means that it is becoming increasingly difficult for the really small boutiques to attract money, and the barriers to entry for new startups are getting prohibitively high. Another result of recent events is that fund managers will need more capital than before – to meet formal capital adequacy requirements, but also to give investors confidence in the stability of the firm. This implies that managers can benefit from being owned by firms with a strong capital base, but it is not clear that many of those firms really want to own an asset manager.
What does the market look like for firms seeking to find a new parent? There are certainly many firms on the market – but there are even more individual teams offering themselves. The challenge for a multi-strategy firm is how to convince the potential owner that the assets will transition, and how you can convince them not to acquire a number of individual teams which will avoid the emotional baggage of doing a corporate integration and will certainly be a lot cheaper. Integrations are difficult and draining to do – the large integrations that Blackrock and Aberdeen are managing to do are the exceptions, rather than the rule. All this means that the ideal target parent would probably be a boutique “agglomerator” in the BNP Paribas/BoNY Mellon style – but there aren’t many of those to choose from.
Looking at the other choices, having a large bank as a parent brings its own problems – and the recent spate of sell-offs demonstrates that banks currently don’t appear to want to own asset managers. Having a life company or other major client as a parent can bring stability, distribution, and a welcome reminder about client-centricity. Within custodian banks, asset management has worked well, especially for the very stable beta-related products. Private equity ownership can work well, but in the end it is by definition an interim state. Firms that are private equity owned will still need to have a further destination in mind.
Many of the hedge fund firms we talked to said they had completely ruled out the idea of going for a public listing. This is understandable – received wisdom states that being listed is very difficult to manage as the obsession with quarterly targets does not sit well with the longer-term management of an investment firm. However some long-only firms that we talked to felt that they had found the key to making it work, which is to manage the shareholders very carefully. Having done that, the shareholder base can be an excellent source of funding.
The ideal combination appears to be becoming a listed firm while involving a bank or life company as a significant major shareholder. Having some large shareholders brings stability and an implied brand guarantee, having a free float of stock allows staff participation and, with careful management, the shareholder base can act as an excellent source of additional capital when necessary. However different ownership models require different management styles. Public shareholders, partners and large banking/client parents respond well to different types of management, so a management team should be very clear about the changes that they would need to make to themselves before considering a change in parent.
So, to return to our original crossroads analogy, while the clients have been left standing in the central reservation surrounded by fast moving traffic, the firms have found that the road has changed from a reliable tarmac surface to a loose and bumpy gravel surface, requiring a whole new set of driving techniques and a much stronger vehicle. Firms have found themselves having to consider a wide range of internal and external challenges while still having to respond to a very concerned client base. The age of the purist investment-driven boutique has passed, and the future requires firms to have a far broader balance of skills and a greater focus on business management rather than purely investment management. An improvement? That’s up to you to decide.