Hedge Fund Manager Transactions

Why minorities stakes are in the majority

Originally published in the September 2008 issue

Despite considerable growth in recent years, the hedge fund industry remains fragmented, split between a small number of relatively large participants and many smaller players. Favourable economic conditions and investor demand for hedge fund returns have supported the growth and have provided opportunities for new firms to set up.

Although traditional corporate transactions involving acquisitions of hedge fund managers have been relatively rare, there has been a significant increase in activity in the past 12-18 months. Key features of these transactions include the purchase of minority stakes rather than full change of control and, rather than other hedge fund managers, the acquirers and/or investors have often been traditional investment managers and financial institutions (‘acquirers’).

This increase in activity has coincided with the credit crunch. Although recent market turmoil is a contributing factor, the underlying drivers are more broad-based.

What drives the buyer?

From a purely financial perspective, acquirers looking for income and capital returns on their outlay should not differentiate an investment in a hedge fund manager from any other investment.

Of course, acquirers will want to secure and enhance their direct financial returns, but they will also consider the broader benefits from their relationship with their investee companies. One key benefit of an investment in a hedge fund manager, for example, can be the ability to provide clients like pension funds and high net worth individuals with access to alternative investment products. This access to new product is one key driver supporting the growth in hedge fund manager transactions.

As the hedge fund industry has grown, the capacity of large financial institutions to manufacture alternative products has been eroded, particularly as more and more individuals and/or teams with strong track records and client loyalty follow the well-trodden path of leaving, either to set up their own business, or to join a hedge fund manager. The result? A successful investment approach is replicated in new funds often seeded by previous employers/clients.

Whereas historically the financial institutions may have invested in and built their own alternative investment capability, the tougher economic climate and associated cost focus within many institutions today, together with the increasing breadth and complexity of the alternative product range, can make a tie up with a specialist manager a more attractive option.

What about the sellers?

Many hedge fund managers have quickly established themselves as valuable private enterprises. Although a private company can provide a very attractive operating environment for individuals, the benefits of running a private business have to be weighed against the need to attract and retain talent, manage succession and secure value. For proprietors, the ability to confirm and monetise a proportion of the value created is naturally attractive. This means that ‘corporate development’ issues will always be on the agenda for the proprietors of a private hedge fund manager. For some managers, an IPO may be the way forward, but this is not the right answer for every enterprise.

In addition, distribution along with the desire to grow funds and to diversify the client base, are also key issues for hedge fund managers. Therefore, a link-up with an institution looking for access to a product can be attractive. This is particularly true if a manager has had performance issues in its funds that, with client redemptions, result in a loss of scale and ability to attract new talent. A close relationship with a financial institution might also provide access to the institution’s broader corporate capabilities. If the link-up can be cemented by an investment into the hedge fund manager, which deals with the issues described above, then so much the better. The manager can also profit from the softer benefits such as the enhancement to reputation that association with a large institution can bring.

What are the main characteristics of the investments?

A regular feature of recent transactions has, therefore, been the purchase of minority stakes in managers.

The benefits of a minority stake investment include: a degree of security, derived from the relative permanence of the investment, in the relationship between the two parties; the creation of a strong mutuality of interest in the success of the hedge fund manager; the ability of the hedge fund manager to maintain the independence, flexibility and culture which may have been important factors in its historical success. Where an acquirer has not taken control of a company, there will generally be no need for it to integrate the hedge fund manager and thereby require the adoption of all the acquirer’s corporate practices. The sale of a minority stake establishes a fair value for the hedge fund manager and also gives the owners the opportunity to crystallise some of the value in the business while at the same time enabling them to retain control. This is not to say that all recent hedge fund transactions have been minority stakes. In fact, there have been a number of transactions where controlling or majority stakes have been taken; IPOs in the sector also have been completed.

The key challenges of a hedge fund Investment

In summary, hedge funds are people businesses and financial interests in them are consequently sensitive to the behaviour and performance of the key people. Therefore, absolute clarity about each party’s objectives from the outset is fundamental to success.

As with any investment, a key issue for these transactions is the determination of value, which in times of market volatility can be difficult. The number of completed minority transactions in the recent past shows that deals are, in fact, being done. Valuations are generally not disclosed and the bespoke nature of the individual transactions, lack of underlying liquidity and often short history of financial performance can create a wide range of potential valuations. Potential acquirers may also need to be clear on what they will bring to the manager and how this feeds into the overall valuation.

In addition, the institutional investor needs to consider a variety of hard and soft factors when valuing the investment. Key amongst these will be: quality of historical returns and ability to replicate these returns; growth and capacity issues; client concentration risks; and a deep understanding of the ambitions and motivation of the proprietors and their ability to nurture and motivate other key individuals.

Exit options may also be important. Recent market conditions may have resulted in volatility in performance and managers will need to demonstrate that this is one-off in nature. Clearly, much of the value will be based on the premise that the owners and key staff of the hedge fund manager will continue to deliver investment performance and growth in assets under management. While ‘lock ins’, non-compete arrangements and deferred payments arecommon ways to secure the continued involvement of the owners, the approach has to be tailored to the circumstances of the particular business, hence the importance of a clear meeting of minds between the parties. This understanding also has to be capable of surviving changes in the roles of the people who strike the deal at the acquirer. Additional activities such as the creation of a strong, lasting relationship are ways that can help make the investment a success.

Ongoing challenges

Once an investment in a hedge fund manager has been made, the investor faces the challenge of managing its investment (which may be significant) so that it continues to deliver the required returns and increase in value. A critical element is the maintenance of the culture within the hedge fund manager, which has led to the historical success. This culture may be informal and reflect the attitude of the proprietors and key staff; an attitude which may be a reflection of the drive to leave the more procedural driven financial institutions in order to work in a less structured environment with a clearer link between performance and reward.

Acquirers, therefore, need to manage and resist the urge to ‘institutionalise’ the operations of the hedge fund manager, but, instead, focus on building strong business relationships with the proprietors and staff. The acquirer needs to tread a fine line between having sufficient understanding to protect its investment while at the same not interfering in the running of that business. The manager, of course, needs to deliver performance. This reinforces the need for absolute clarity at the outset as to the rights and responsibilities of the parties as to how the business will be managed.

In conclusion…

The current trend of corporate activity in the hedge fund world is for taking minority investments. This is not exclusive and majority investments are made. The fact that traditional acquisitions of hedge fund managers, firms led by people who have often chosen to leave a corporate environment to build their business, require a clear meeting of minds and great skill to execute, will probably make them relatively more infrequent. The next 12-18 months should make it clearer whether the minority approach generates value for the parties concerned. Clearly there are many investment opportunities and the market has entered an interesting phase where we should see much more transaction activity of one type or another over the next couple of years.