Over recent years industry-wide publications have focused on the plethora of changes hedge funds need to make in order to adapt to the ‘new normal’. Few managers today deny the need to adapt – many stall on the where and how.
In order to answer that question an understanding is required of the what. What needs to change, and why? Simply put, there are two important areas for change:
The operating environment has come to prominence due to permanently re-set investor due diligence standards and because of material regulatory change. WVP’s straightforward perspective here is described later in this paper.
The main emphasis of this article is preoccupied with the former – the running of the investment business. Critical adaptations are required but these have received less attention and less action by the hedge fund community. A beautifully simple quote from Daniel Broby, deputy CEO and CIO for public markets at Silk Invest, captures the point: “I had thought my priority was to run money, to deliver the best performance… but it’s really about running a business. If I’d known then what I know now, I would have been less focused on ‘Let’s have the best Sortino Ratio ever’ and much more focused on being a businessman.”1
With an ever-present and growing capital opportunity by pension funds and their advisors there is all to play for; if small to mid-sized managers understand how they need to adapt and if they are prepared to do what it takes, growth is achievable. We emphasise throughout this article our perspective regarding the necessary changes to the running of the investment business, and how to create the environment within which the firm will generate and sustain distribution results – i.e., growth.
Global investments into hedge funds and funds of hedge funds hit an all-time high in 2012 of $2.25 trillion.2 This growth in assets was set against the backdrop of persistent geopolitical and economic uncertainty, material regulatory upheaval and, finally, continuing intense scrutiny by the media of financial services firms and their conduct. Notably, and widely reported, the principal beneficiaries of industry AUM recovery and growth over the last five years have been the largest managers.
Institutional investors and their consultants – pension funds, insurance companies, endowments, sovereign wealth funds – continue to search for diversifying sources of alpha with their attention increasingly focused on the alternatives market. Analysis of the top 10 investment consultants reports an aggregate of nearly $550 billion in hedge fund assets under advisory across more than 2,500 institutional clients; and they acknowledge the industry is here to stay: ‘Some [investment consultants] are more cautious than others, but all recognise the continued role hedge funds have to play in a diversified portfolio’.3
Average allocations to hedge funds by institutional investors is currently around 10% (a five-fold increase over 2003 allocations) – this is expected to double by 2016. A specific dollar reference point: in 2012 Towers Watson’s clients allocated $12 billion to alternatives worldwide, a 70% increase from 2010, and although a large proportion of that growth has been to the benefit of the large funds, that exclusivity is reducing – note the comment from Towers Watson’s 2013 Global Alternatives Survey: ‘While the larger managers across all hedge fund strategies are generally perceived to be ‘safer’ from a business risk perspective, investors are also increasingly allocating in an informed manner to more modestly sized managers that have a proven record of alpha generation.’4
Our takeaway: there is a material opportunity to be realised by smaller and mid-sized managers if investment businesses are run and managed in a way that is aligned to their prospective clients’ objectives. The approach must reflect deeply that ‘it is all about the client’.
The running of the investment business
Daniel Broby’s comments, stated earlier, perfectly capture the necessary business approach that much of the industry has yet to grasp. The challenge set by every founder or team setting up a hedge fund firm is that it is a business – a business of product manufacture and distribution.
Success will only ever be measured in two dimensions: how well the product is manufactured and how effective the business is in distributing that product. Many firms in the industry almost exclusively focus on product manufacture – the investment piece and team. And yet if firm success is dependent upon distribution success, client satisfaction and client retention, why do firms invest less in the quality of their distribution?
Below, we present WVP’s opinion on four tenets which separate firms experiencing persistent drift and those with growing assets.
1. The nature of the business – product manufacture and distribution
The industry is no different to car or widget manufacture. Owners may not like this, but it is true. A critical difference is margin – the potential for extraordinary per capita total compensation if performance is good. The psychology here matters and it may explain why primacy is placed upon the investment process and people. A truth throughout business endures here – you may have the best product but if no-one wants to buy it then it is worth little to the investment firm.
Understanding that there must be an equal balance between the ‘product manufacture and distribution’ competencies is fundamental. Consequently, critical business behaviours are determined by the balance in quality between manufacture and distribution.
Our takeaway: position and distribute product to capture broad appetite within the market. The investment team is not immune from this in any way. The more awareness there is within the business and the greater the emphasis on behaviour and processes which support the distribution activity, the higher the likelihood that over time interest from prospects will translate into investments. It is all about giving the client what they want.
2. The investment edge – S.I.S.
Marshall Wace founder, Paul Marshall, states: “A large part of the industry promises things it can no longer deliver. A lot of the industry is just one talented guy and a few analysts who last a few years but fail to develop a sustainable edge.”5
The importance of edge is underlined through three points:
To identify and articulate a firm’s investment edge – the bit they do differently from others, the bit they can substantiate and defend – is not an easy task. It takes lateral thinking and it requires everyone in the firm to understand that future success in asset gathering, at a price, will depend on the credibility of the investment edge.
Our takeaway: no investment process is wholly unique. There are many common attributes across investment processes and ways of thinking about investment problems which span firms. Yet, at a competitive price, if a firm is to deliver returns uncorrelated from the market and de-correlated from competitors, it must be able to build the firm around the piece of their process which is specific to their firm. That analysis must set the S.I.S. hurdle: Sustainable, Identifiable, Substantiated.
3. Distribution – the commercialisation challenge
It is not just about marketing. Marketing is one component. Amongst other things, effective distribution is realised when the business faithfully reflects the marketing material. Nor is it a case today of delivering performance and ‘the investors will come’.
Every business in the ‘product manufacture and distribution’ game needs to be able to substantiate claims they make in their marketing literature and in face-to-face meetings. Substantiation is both quantitative – through statistical analysis – and qualitative – through demonstration of processes, technology and planning (i.e., documentation and visual affirmation by prospects and their advisors).
Not only do these mechanistic due diligence attributes of the firm matter but also the ethos of the organisation, be it a 10 or 100-person business. We pose the question: does the purported story, belief system and firm direction pervade every member of staff? If not, what do the inconsistencies, which will naturally arise through the due diligence scrutiny phase, say to the prospective investor? These apparently minor details matter disproportionately. As Patrick O’Meara, founder of Profor Securities stated in 2010 (a statement still relevant today): ‘Your message must be consistently conveyed to investors. Years ago many investors would invest after speaking to a marketer, without an office visit, after a quick review of a one-pager – that game is over. Now most investors will meet at least five people at the hedge fund: the marketer, CEO, portfolio manager, risk manager and COO. These people must say the same thing… in many cases an inconsistent message is a deal-breaker for the investor.’6
Distribution has many facets. WVP would ask any hedge fund:
Much has been written by commentators on this subject. We highlight an apparently minor semantic regarding distribution, and suggest a change in emphasis, which may deliver disproportionate results.
The use of the phrase ‘Investor Relations’, still pre-eminent throughout the industry, may not be helpful. The risk comes from the tone of this phrase. It potentially creates a perception of remoteness from the investment firm. Clients care deeply about where they fit in the firm and the priority placed on them by the owners. How their needs are accommodated is of fundamental importance to them and does influence their investment decision-making.
‘Client Service’ – a small change in semantic – captures something wholly different, a tone of engagement, of alignment with the client and service to the clients’ needs. After all, if the business fails to present a framework to a prospect for how their needs will be appropriately met should they invest, it is highly unlikely that capital will be committed. As stated in a 2012 survey of the industry, ‘Much of the global hedge fund industry is in the midst of a metamorphosis into a fully institutionalised, mainstream player…. We need to fix the disconnect between investors and managers. We can do this through education and trust – and institutionalisation will help’.7
As described earlier, given the opportunity set, what processes and approach do hedge fund firms take to meeting (or exceeding) expectations regarding required investment consultant information and transparency during their assessment of the manager? How easy does the hedge fund make it for advisors to work with them? The more readily consultants are accommodated, evidenced by attitude and process, the easier it is to develop an effective relationship and achieve access to their advisory capital, other things being equal (i.e., investment performance, process etc.).
The tone that is set matters with these important asset gatekeepers. The critical internal analysis required: how ready is the hedge fund manager to service this increasingly important consultant-led distribution channel?
David Harmston, global head of clients at Albourne, states: ‘Albourne is witnessing a stark bifurcation of the industry into ‘New School’ and ‘Old School’. The latter have traditionally considered their opaqueness to be a badge of honour and this stance will necessitate an even greater premium in terms of return to be sustainable. ‘New School’ will be given longer to prove their value-add’.8
Our takeaway: only when a business delivers excellence in the investment process (product manufacture) and distribution will it succeed. It is in the investment team’s interest to fully support the distribution team in positioning and pitching of the product. Executing on distribution is a whole-firm exercise, and it always has been.
4. The mimicry trap – focus on your business and yours alone
Mimicry, as a strategy for business development, is a dangerous arena. Not entirely unsafe but certainly fraught with risk. The challenge for investors to find credible candidate managers is enormous. Whether small or large, investment firms must avoid mimicking their competitors, simply tail-gating approaches which have been apparently successful.
1. Private firms reflect their founder’s ambitions. Every founder has strong personal reasons determining the rationale for the firm’s direction. As a hedge fund business, observing and mimicking the results of particular decisions ‘seen across a competitor’s fence’ will by no means provide the necessary clarity as to why those decisions have been made in the long run. To simply mimic what you do not deeply understand carries with it substantial risk – to reputation but also, critically, the risk of moving beyond the firm’s core competency. Investors pay for competency and expertise – stay within this sphere and build the business to realise the owner’s ambitions.
2. Investor due diligence attempts to ascertain why decisions have been made. Again, investors only wish to be exposed to businesses where their interests are aligned with the manager’s. A strategy of mimicry may result in the perception, through the prospect’s due diligence process, that business development and decision-making does not closely reflect the owner’s personal objectives. The prospect will likely conclude that mimicry reduces predictability of the manager when faced with future business challenges. Remember, investors do not like the unpredictable – they wish to gain deep comfort that expectations between manager and client are clear, understood and predictable.
3. Look-alike firms will struggle to truly differentiate and therefore will struggle to justify fees. The greater the number of similar firms, the greater the perception of homogeneity and the greater the market’s pressure on fee income. A generic firm results in generic or commoditised fees.
Our takeaway: we agree with Ross Ellis, vice-president of SEI, when commenting on differentiation: “Based on what we heard from institutional investors and fund managers, it is time for the industry to make an evolutionary leap in proving its worth to a hungry yet hesitant investor base”.9
The operating environment – a comment
It is what it is. That may not read as a helpful statement. Yet it is meant to empower the investment firm. Don’t fight it – the rules of the game have changed regarding investor due diligence requirements, regulation and public scrutiny. Adaptation to this environment is critical – irrespective of whether the manager believes the new burden of regulation is warranted, fair or not. It is what it is – be pragmatic. There are many third-party firms that can guide each investment business on how to adapt their operating environment – compliance, legal, technology. Investment firms would be well advised to outsource the ‘delta’ in moving from the historic regime to the current status quo. As Michael Green, CEO international of American Century Investments, states: ‘You have to understand what you’re good at and outsource those things you’re not. It’syour only chance to stay in business’.10
Our takeaway: do what it takes to pass due diligence; outsource to survive. Asset-gathering will only be successful if the operating environment meets or exceeds due diligence requirements. We do not believe the operating environment is the source of competitive edge or differentiation. It is binary – you either pass or fail. If you pass, then points (1) to (4), as described above, come into play. If you fail, the working capital fuse will keep on burning.
Whilst investment performance is of material importance, the effective running of the investment business continues to be absolutely essential and yet is still underestimated by owners. It requires that basic understanding of the core business problem – how can products be successfully manufactured and distributed in scale? How can competencies be most effectively commercialised?
With a material opportunity ahead as presented by the consultant-led capital pools, we believe there is all to play for for those firms with defensible returns and for those who master the four critical tenets of:
• The nature of the business – manufacture and distribution;
• Distribution – the commercialisation challenge;
• The mimicry trap – focusing on your business alone; and
• The investment edge – sustainable, identifiable and substantiated.
With 873 fund closures in 201211 alone the question endures on how to grow, how to develop investor confidence in your hedge fund capabilities and how to increase the chances of surviving more than the industry average of three years. A well run business aligned with clients and built on a clear understanding and explanation of its investment edge will, perhaps, just realise that chance.
Jonathan Willis is a Founding Partner and Director of Willis Venture Partners. WVP is a specialist business development firm, working with hedge fund managers of all sizes, with significant experience inside investment businesses.
1. SEI, “Six Ways Hedge Funds Need to Adapt Now”, March 2013.
2. Hedge Fund Research Inc., Press Release, 14 March 2013.
3. HFM Week, “Investment Consultant Top 10”, April 2013.
4. Towers Watson, Global Alternatives Survey 2013.
5. Investing: ‘Hedges on the edge’, Sam Jones, Financial Times, 30 August 2012.
6. FINalternatives, ‘Hedge Fund Marketing: 10 Steps to Gaining More Clients’, 14 May 2010.
7. KPMG, ‘The evolution of an industry’, 2012
8. HFM Week, ‘Investment Consultant Top 10’, April 2013.
9. SEI, ‘6th Annual Global Survey’, March 2013.
11. Hedge Fund Research Inc., Press Release, 14 March 2013.