Life Beyond the Founder

Succession planning for hedge funds

Originally published in the March 2017 issue

In 2017 hedge funds have effectively made the transition from investment niche for the super wealthy and risk-hungry endowment to becoming an established asset management model that is part of the investment mainstream. However, the nature of the business does not lend itself to deep existential thoughts on the future of the firm. Invariably hedge funds are founder-operated businesses. They are often opportunistic, possess deep skill-sets in one or more trading strategy or asset class, are increasingly systematic and quantitative, and usually have distinct cultures which allow them to take risks, think deeply about the market and recruit/reward those people built in their own image.

But after two decades the natural life-cycle of any business kicks in and thoughts turn towards the future and founder succession. Hedge funds face a unique set of challenges when it comes to succession planning since the reason they can raise capital and manage money in the first place is due to the skill and reputation of the founder(s) themselves.

In this article I will look at succession planning in its widest sense. Not just as a means by which a hedge fund lives beyond its founders but also more holistically; what a hedge fund might look like in the future beyond the specific set of strategies and operating model that the founders conceived initially.

The maturity of the industry over the past two decades, the rise of passive managers and the 2008 financial crisis have all meant that allocators have become more discerning (e.g. in terms of fees/performance), regulators have become more concerned about systemic risk in the market, and LPs have demanded more transparency into portfolio performance and risks.

Raising and keeping capital long-term: Moving from individual stars to a star team
As more allocators such as sovereign wealth funds, endowments and pension funds move to active oversight of their investments issues of corporate governance have started to impact all alternative asset management firms. And a key aspect of best practice in corporate governance is succession planning. With longer-term investment horizons than most typical hedge funds a traditional choice for these institutions has been private equity and real assets. If a hedge fund is looking to receive a capital allocation from a typical pension fund they should look at how these other asset management firms go about succession planning for the eventual retirement of their founders and principals.

One pertinent lesson is provided by TCW. Several years back TCW made a deliberate move away from individual “star managers” towards a model focusing more on investment teams. When he was there Jeff Gundlach managed 75% of the firm’s AUM; after he left investors pulled tens of billions in assets out of the firm. The painful lesson should not be lost on smaller hedge fund GPs looking at building an institution that outlives them. Increase the number of your alpha generators and the way that they are organized to manage money and this will help to mitigate key-man risk and improve the stability of your fund AUM longer term.

Phased transition planning: Years not months in the making
Investors, particularly institutional investors with long-term investing horizons e.g. based on matching pension liabilities, will need to be reassured that if a founder leaves that their replacement – or the investment team that replaces them – can still generate investment ideas and alpha without them. A transition plan which gradually shifts responsibilities to a non-founder, who themselves need to possess a proven track-record in their own right, will need to be the first step put in place.

Secondly, the founder(s) then needs to ensure they remain involved making joint day-to-day decisions and even stay on for a period after that to remain available to talk to investors while their successor manages the fund. Although an extreme example, Ray Dalio planned his transition out of day-to-day responsibilities at Bridgewater Associates over a decade. DE Shaw and Renaissance Technologies both had their iconic founders step down into advisory roles and eventually hand over all fund management duties to others for e.g. co-presidents or investment committees.  Although it may be easier for quantitative/algorithmic funds to do this since they are model-driven and not solely reliant on the investing brilliance of one or two portfolio managers, the phased model of succession planning can be equally successful for non-quant managers if implemented strategically with clear investor communication. Tom Steyer the founder of Farallon Capital Management stepped back successfully with minimal investor capital outflow; but this took place over 6 years from 2006 to 2012.

Talent: An internal and external challenge
Finding investment talent is vital to the succession planning in any hedge fund. Recruiting raw talent with the right skill-sets will become increasingly vital to finding and exploiting opportunities for alpha. The likes of Two Sigma and Point72 are already competing with Goldman Sachs and Facebook, Google and Amazon for the same set of skills in data analytics, modelling and AI/machine learning.

The sell-side used to be the primary supplier of both investment and research talent. But given how regulation in light of the 2008 financial crisis has eviscerated the proprietary trading models at investment banks, this source of talent has effectively dried up. Both larger and smaller hedge funds will have to source and build their own talent pools going forward.

Finding potential successors to the current founders/GPs will be the more immediate need however. Looking at other alternative asset management firms could again be a useful guide for hedge funds. Typically, private equity firms – particularly listed firms such as Carlyle and Blackstone – have built deep pools of investment talent internally that can pick up the reigns of the founders as well as looking outside their firms for talent.

The duration of private equity deals tends to mean that people need to stick around longer than in hedge funds to see their investments come to fruition. With a bonus model linked directly to annual portfolio performance most hedge fund talent tends to be more transitory.

But lessons can still be learnt. Firstly, build a team from within and from without; internal talent will know positions and exposures more intimately but outsiders can bring in valuable operating experience in terms of the overall investment platform, as well as trading expertise in new asset classes/strategies. Secondly introduce some form of contingent compensation plan that provides an incentive for employees to stay with the firm and maximize value creation over the longer-term. Trading talent still need annual bonuses linked to portfolio performance, but including a contingent component would address issues of sustainability and talent retention.

Operating platform: Big data meet big brother
From an operating platform standpoint succession planning is all about building a lasting platform that can scale and support the investment function as it grows – either in volume or in complexity. The platform will also need to address ongoing operational risks and meet investor/regulatory demands for transparency and reporting.

The advent of AI and machine learning provides intriguing possibilities in terms of a range of activities be they investment related, compliance or post trade that could be radically shaken up. In the not too distant future a handbook like Ray Dalio’s “Principles” (an employee manual of 210 lessons) could be codified into some form of AI which connects to security systems, computer networks, email and portfolio management systems to monitor compliance, track employee behavior and even guide investment decision making. Although he recently left, Ray Dalio’s decision to hire former Apple executive Jon Rubenstein to put into place systems to support his “vision” may have had elements of this “big data meets big brother” future scenario. Dalio himself credits his “Principles” with improving decision-making at Bridgewater and even leading to the creation of their current investment process. This digitized approach to succession planning may be unrealistic for many funds and “radical transparency” is certainly not suitable for every organizational culture but cherry-picking elements of this approach, for e.g. heuristic algorithms to codify part of the investment process, could be highly beneficial to smaller managers.

The more mainstream cloud computing paradigm does offer more widely accepted benefits; zero local infrastructure, reduced personnel costs and an “always on, always updated, always available” computing model. Hedge fund technology firms such as the one I co-founded – Indus Valley Partners – have built such cloud platforms to support smaller hedge fund managers with $50-100m AUM across their investment life-cycle. The ability to look into exposures at any time with the latest data, or perform a quarterly filing automatically or send an investor a detailed performance report has never required less overhead in terms of cost or planning for the future.

“The vision thing”
What do hedge fund founders want? Many are driven individuals who want to focus on trading and maximizing alpha for themselves and their investors. That’s it. No board of directors to answer to, no risk-approval to be sought beyond their own. For these founders there is no desire for their fund to live beyond their own personal desire to manage money. Increasing regulatory hassle and investor oversight may mean a future as a family office but certainly planning their succession may hold little relevance to them.

However, others may see a future beyond this, maybe as a listed company with access to permanent capital to offer long-term performance for pension funds and endowments and mutual funds (e.g. Man Group). Or as an asset manager generating alpha by allocating between multiple fund strategies and managers (e.g. Bridgewater Associates). Or as a market maker/liquidity provider that plans to become an integral part of the market micro-structure (e.g. Citadel). Or even as new type of bank providing risk-intermediation services or direct lending (e.g. Apollo Global Management).

Of course, if succession planning feels like too much hard work and the economics of morphing into a family office along the lines of Soros Fund Management or Point72 Asset Management seems unattractive, there may be scope to sell the management company. Highbridge Capital Management was bought by JP Morgan in 2010. All the founders remained for the immediate post-sale period but their paths varied after that; one founder Henry Swieca left and the other Glenn Dubin stayed on at the bank.

In whatever future the hedge fund founder seems him or herself in, the one constant is that the status-quo will not be tenable. Hedge funds may be formed in the image of their founders but they cannot continue in that image ad-infinitum. Successful succession planning in its widest sense will distinguish those players who will remain from those who will – either voluntarily or involuntarily – decide to step out of the game and seek pastures and pastimes anew.

Six hedge fund succession management strategies
1. Implement a phased succession plan – following the current strategy
2. Implement a phased succession plan – build a multi-manager model
3. Evolve into a new type of financial institution under a board of directors with a formal succession plan in place
4. Become a family office
5. Sell the management company
6. Wind-down the fund/return investor capital