Four Imperatives for Hedge Funds

How hedge funds can gain strategic superiority

Originally published in the September 2008 issue

As assets under management (AUM) in hedge funds approach US$2 trillion globally, and as institutional demands and inflows increasingly drive the alternative investment market, industry leaders are facing an inflection point. It is no longer enough for top funds just to ride the wave of growth. Indeed, the maturing hedge fund industry is presenting new challenges, as well as opportunities, every day. There are multiple reasons why hedge fund managers need to act now to maintain or establish a leading position.

Many hedge funds are reaching new stages in their life cycles. Erstwhile start-up funds are hitting AUM thresholds that require additional infrastructure and more comprehensive management. Other funds are shifting from a single strategy to a multistrategy outlook, or diversifying their investor bases. Institutional investors are demanding transparency, enhanced returns, and highly evolved risk management practices.These are just some of the dynamics currently in play. Yet most leading funds face a common challenge: how to continue their growth trajectories and, ideally, break away from the pack. In order to meet this challenge, most players need to take action along four critical imperatives: strategic direction, distribution, operating model and organisational structure. We recommend the specific initiatives briefly outlined below.

Create a roadmap for long term strategic direction

To drive superior growth and reach their aspirations, hedge fund managers need to draw a long term strategic roadmap that defines their vision. They need to manage proactively amidst an ever-changing competitive landscape by clearly defining what they want their fund to be ‘when it grows up’, and how they plan to get it there. There are several key questions they need to ask themselves:

  • What is our competitive advantage in generating
  • Do we have an advantaged investment process that
    is reliable over time?
  • Who are our target clients and how can we align
    our offering to address their specific needs?
  • Should we go single or multi-strategy, and with
    what specific blueprint?
  • What is the end-game for our owners and
    principals? Should we go public, expand into
    adjacent business such as wealth management
    and private equity, or stay narrow and optimise
    investment returns?

The answers to these questions must be used to forge clear strategic goals that funds can then use to communicate their differentiated offering to prospective clients. Resources that enable the fund to pursue these goals must then be made available through annual planning and budgeting at both the organisation and fund levels.

Manage distribution effectively

It is critical to shift sales and distribution from being a relatively opportunistic process, as it is for many hedge funds, to being a focused and efficient function with clear targets. Rigorous analysis can identify the channels that will yield the greatest incremental revenue and that best fit the fund’s strategy. Once the channels have been selected, the sales force needs to be aligned against the targeted channels and customer segments. In addition, the fund’s executives should actively determine the sources of capital (eg. institutional investors, permanent capital) that can best help the fund reach its goals. Specific sales targets, along with tools to foster and track sales force productivity, will greatly facilitate effective management.

Optimise your operating model

Once the assets are in the door, it is essential to have an operating model that enables the fund to execute its strategic plan. As customer demands and regulatory dynamics evolve, hedge funds need to institutionalise their operating model (eg. technology demand management and prioritisation, metrics for business process and technology service delivery) while retaining both flexibility and an entrepreneurial culture. First, executives need to identify and address operational vulnerabilities, enhance business controls, and institutionalise risk management practices. For example, an optimal interface between the middle office, back office, and prime brokers must be developed as the fund matures. Similarly, business units can optimise costs by streamlining and standardising processes, and potentially by outsourcing specific functions. A successful operating model will enable the fund’s key people to focus on investment management and strategic priorities, as opposed to continuous crisis management.

Unlock your organisation’s capabilities

Finally, the fund’s top executives must prepare their enterprise to succeed in an environment that is constantly changing. Hedge funds need to transform key functions from being informal, decentralised groups of managers into being focused, coordinated teams that keep the fund’s strategy firmly centred in their sights. Clear role definitions, mandates, and decision rights must be created and then communicated broadly yet succinctly across the firm. Performance in each role should be gauged by metrics linked to service delivery and investment results. Incentives and compensation should be tied to overall attainment of the firm’s strategic objectives. In addition, difficult decisions need to be made concerning payout levels, equity stakes and non-compete clauses. Such a modus operandi will actually enhance, not hinder, the fund’s ability to acquire and retain top talent. Still, a process for the transfer of internal knowledge should be established in order to minimise disruption to the organisation when turnover in personnel does occur.

At this point in the market cycle, leading hedge funds have the opportunity to capitalise on their recent successes and advance their visions of gaining strategic and operating superiority. Players that fail to address the four imperatives highlighted above may find themselves under constant pressure to drive growth and to meet operating constraints. This will result in the loss of investor confidence and, ultimately, the loss of their best talent to more advantaged platforms.

Weighing the strategic question to cater to retail investors

Arguably, the next phase in the evolution of the hedge fund industry will be characterised by the emergence of retail investors. Many hedge funds are or will be weighing this growth opportunity. Our work with leading hedge funds has highlighted that moving into the retail market will necessitate a dramatic shift for hedge fund managers and they must carefully address several issues before they venture into the retail space.

Define the appropriate product offering

Products need to be adapted to retail investors’ demands, with potentially reduced lock-up periods, leverage and risk. Also investment strategies need to be scalable in a retail environment

Develop an effective distribution strategy

Managers need to decide whether to distribute on their own, or to find a partner with retail channels already in place, such as a mutual fund company or a wirehouse. Partners could distribute funds in a traditional form as a part of master trusts or wraps in exchange

Adjust the operating model and preserve the fund’s culture

Funds may have to form a new group, handle segregated compensation schemes, and consider implications for their own culture and talent retention.

Handle associated increase in regulation

Firms must consider how they will handle the additional regulation, transparency and disclosure that will inevitably come along with servicing retail investors while avoiding regulatory creep into traditional hedge fund markets. Ultimately, the decision to enter the retail market needs to be a calculated one. A manager needs to know exactly what the opportunity and cost is, given their unique organisational, operational and strategic capabilities and constraints.