In this article, London & Capital, an absolute returns investment house with USD1.6 billion in assets under management, summarises its perspective on future consolidation drivers in the global hedge fund industry, before outlining its own acquisition strategy.
Although concrete growth data is difficult to source – due largely to a history of light regulation of the industry – a credible estimate is thatthere were 610 hedge funds in existence in 1990, up from less than 70 in 1984. By the first quarter of 2005, aggregate numbers had surged to over 7,900. Total assets under management have grown from USD38.9 billion to over USD1 trillion over the same period.
Utilising these figures, we can estimate an increase in the average assets under management of each fund from USD63.8 million to USD127.3 million. In itself, this does not imply a need for consolidation. But this mean average measure is not indicative of segmental growth patterns. Indeed, although the largest funds have grown enormously in size, with the top ten operators accounting for a sizeable minority of overall industry assets (see table), growth has been unevenly distributed throughout the industry. Estimates show that as much as 45% of global hedge funds possess assets under management of less than USD25 million.
A further factor to bear in mind is the increasing cost of funding. In early August, the US Federal Reserve hiked the key Fed Funds rate by 25bps – the tenth straight increase of this magnitude – taking this benchmark cost of borrowing to 3.5%. In late August, futures markets were broadly anticipating a rate of 4% by year-end. Whilst the Fed's measured, incremental approach has been applauded, a continued increase in the cost of borrowing clearly implies increased risks for the less capital rich hedge funds – particularly those operating on a leveraged basis.
In this context, the ingredients are in place for the beginning of a consolidation in the industry. It stands to reason that operating conditions for many of the 3,500 or so sub-USD25 million hedge funds will become increasingly challenging, providing acquisition opportunities for more capital-rich investment institutions.
Rather than broken businesses, the type of acquisitions we typically look at are going concerns – the availability of which are likely to increase going forward. As one might expect, with this strategy our major challenge is integration. Therefore, the company acquisition process bears a striking resemblance to the personnel recruitment process. Without wanting to state the obvious, there is little value in negotiating a discounted price only to then lose revenue due to a non-alignment of core values. As a result, we break down the acquisition process into three key areas, or contracts: the commercial, environmental, and psychological.
To take the first and most obvious of these contracts, the commercial agreement is traditionally the one that the most time is devoted to. For both the buyer and the acquisition target, price is not only a paramount consideration, but also a difficult one to resolve – largely due to the personal financial interests at stake. We're sure that, somewhere out there, a psychologist has a word for the behavioural characteristic which identifies the ability to be dispassionate and objective with other people's money, but illogical and sensitive when it is your own.
In this respect, there is often a natural tendency for a seller to have a genuinely distorted view as to the true worth of his or her company. For those whose personality is driven enough to set up their own firm in the first place, their ambition is frequently accompanied by dreams of becoming the next Richard Branson or George Soros. Invariably, therefore, it takes time to conclude the commercial contract, and it takes the presentation of considerable evidence before the seller is able to fully appreciate his company's true market standing.
Beyond the initial buyout payment, we believe there then exists a powerful two-sided rationale to structure a deal so that the acquired party potentially receives additional financial rewards further down the line. As examples, long-term incentive plans and targeted exits are but two of the forms of commercial contract that are often preferred. Providing a supportive environment for the acquired party helps embed a co-operative and evenly incentivised integration process.
However, whilst the commercial contract is of crucial importance, we believe that there is often a tendency to place disproportionately heavy influence on this area, to the detriment of the other contracts. Indeed, in our experience the commercial contract is very rarely the main reason a deal is successful or not, as money, in the final analysis, is always negotiable. The stumbling blocks come with the second and third contracts – and this is where we believe our approach is more sophisticated than our peers.
With reference to the second contract – the environmental contract – there are a number of key questions we ask ourselves before proceeding. What is it like to work here? What are the people like? Who pushes which buttons and when?
All of our acquisition targets spend a certain period of time with us to ensure we have clearly communicated our visions and our values. Individuals meet all relevant personnel within our current set up, discussing company strategy in detail over an extended period of time; this goes for anyone with an influence on the integration process. Open, direct and honest conversations are always encouraged. We're not afraid or embarrassed to acknowledge and explain our weak points as well as our stronger areas; it is key to ensure that any acquired party joins us with open eyes and a clear idea of what the future will look like. As a result, this process actually precedes agreement on the commercial contract.
The third contract – the psychological contract – is the one which many firms tend to (mistakenly) place the least emphasis on. Frequently, this is at least partially due to the fact that it is a very difficult domain to confront on an emotional level. Like it or not, this is the 'ego contract.' Senior players at the acquisition target will have been used to having a very strong hand in shaping overall strategic direction. As entrepreneurs and market makers, these are the kind of people we seek out. But a dichotomy arises because the seniority of these players in a post-acquisition environment is inevitably diminished.
In this respect, we need to be sure that the acquisition outcome does not breed resentments and militate against the coherence of subsequent integration. We exercise great care in ensuring that key individuals are fully cognisant and content with the future roles that are marked out for them. In the final analysis, decisions need to be made for the good of the group and by definition only one individual can have overall responsibility for the ultimate outcome.
This is not to say, however, that we pursue an autocratic management style, or refuse to listen to alternative viewpoints. Far from it in fact. We like to give all or our executives as much freedom as possible and we have a light touch management style. Our boardroom is always characterised by good debate, opposing opinions and passionate proposals. But once a decision is made, the business generates value through its coherent and focused delivery skills.
In light of the above, what has been our practical acquisition experience to date? So far this calendar year, we have courted several hedge fund managers. If – as we expect – consolidation drivers start exerting a significant influence on the industry, further opportunities should open themselves up.
Thus far our focus has largely been on Europe, but we are also increasingly looking to source opportunities in the US. Earlier this year, we entered the American market by opening an SEC-registered office in Miami. This leaves us in a good position to search out opportunities among US hedge funds.
At present, we are nearing conclusion on two deals. We are in the process of taking a minority stake in an alternative asset manager that will broaden our customer offering, whilst at the same time keeping us within our range of core skills. The acquisition target has determined that our distribution value will enable them to achieve a swifter fulfillment of their objectives.
We are also at the final negotiation stage with an equity house. This deal will expand our skill-set and bring a whole raft of new options to our offering. The environments are well-matched and the commercial considerations are agreeable. Both sides are now working hard to ensure that the psychological contract is mutually acceptable, and that the acquired party has sufficient scope to continue driving its part of the organisation forward.
Those that fell away? Well, it is our conviction – and this has been endorsed by this process – that deals are driven by two things, money and motivation. The remarkable point is that money is always negotiable and none of the deals have failed to progress because of price. Instead, sticking points have centred on value differences, unbridgeable cultural gaps and divergent strategic objectives. Perhaps some would view us as being overly-preoccupied with these issues. We have certainly been spurned more frequently than we have rejected our targets. Ultimately, however, this is for all the right reasons. We are prepared to take the patient, long-term approach – the focus is very much on diligently seeking out fully compatible partners. It may even be that one such future partner is reading this very article…