Repeating Mistakes of the Past

Are hedge fund businesses repeating mistakes of the past?

Originally published in the May 2007 issue

Attracting and retaining strong investment talent is the key determinant of success within the asset management industry; loss of or lack of fund management talent are always precursors to the decline of investment management businesses.

As hedge fund businesses mature and 'institutionalise', are they capable of maintaining their allure to talented individuals? Second and third generation employees are increasingly demanding a larger impact on the business, and are increasingly leaving to set up their own firms. Are hedge funds going to repeat the mistakes of traditional asset managers and lose their leadership positions? If equity has not been consistently passed down the business, and corporate cultures have become corrupted by size, inflexibility or under-management, it is entirely possible that hedge funds are in the process of repeating the mistakes traditional managers have been suffering from for the last decade.

During the 1980s and 1990's mega banks dominated the asset management industry but this has not followed through into the hedge fund business. Indeed those traditional managers which have had any success at all have built their hedge fund business quite separately from their traditional business – there is barely one example of the two successfully coexisting in an integrated fashion. The structure of the industry would be very different today if houses like Merrill Lynch/Mercury, Barings or Jardine Fleming had been able to retain the talent that has gone on to flourish so strongly elsewhere. It seems almost inconceivable that such an occurrence could have come to pass. Despite their undoubted distribution capabilities and access to bank capital, talent continues to drift away from traditional houses and seldom, if ever, returns.

There are strong reasons for boutiques attracting talent. It is simply a better model for a professional services firm. In most professional firms it is people and culture, not process, structure or planning which are the keys to success. Talented investors are generally sceptical of business managers and dislike being managed – they demand a stake in the firm's governance and still tend to thrive in loose, flexible structures where initiative matters. Equally they appreciate the transparency that simple partnerships can create – they weed out mediocrity and passive participants who drain bonus pools without contributing to success.

One size does not fit all

A successful asset management business needs a long term outlook and low staff turnover. With the notable exception of a number of US non-public traditional asset managers (which happen to be run as virtual partnerships) these conditions simply don't exist in traditional asset managers, nor is it likely that they will be satisfied any time soon. Most traditional houses are unwilling to compensate portfolio managers on a formulaic basis for fear of bursting open their pay structure and creating greater disquiet amongst employees: many pay lip service to 'best practice' but this is seldom evident in the numbers.

Second, investment professionals recognise the shareholder value that they are creating: not least manifested through high cash flows. Equity participation may well exist in big firms but generally in a very watered down form: it is highly unlikely that the endeavours of one portfolio manager would be sufficient to have an impact on either the share price or their personal wealth.

Partially as a result of this, the firms tend to lack a culture which is supportive and aspires to be genuinely excellent; the very ingredients that provide a fulfilling and enjoyable working environment. As firms grow, inevitably the need for policies and procedures expands, but generally one size does not fit all. Some of these flaws (but not all) are increasingly becoming evident within the hedge fund industry.

It is interesting to consider to what extent broadly-based equity participation is a key determinant of success. As yet there is insufficient academic analysis within the industry to be categorical, but anecdotal evidence suggests that an increasing number of firms are being forced to share equity more broadly to stave off departures and firms which have remained unwilling to share the spoils have seen weak morale and higher staff turnover. In several years it is likely that there will be good evidence that firms with a broad partnership culture and equity participation were able to sustain their competitive position for longer than those that did not.

Portfolio manager or business manager?

One difficult issue pervades the industry – reconciling a portfolio manager's innate desire for a stake in the firm's governance to their key purpose – creating value for their clients. There are many examples of firms where the balance is wrong and the founder (often a talented portfolio manager) becomes a business manager in all but name and fund performance suffers.

It is implausible to believe that an individual spending say 50% of his time managing a fund can be competitive with an equally talented person spending 100% of their time investing. Clients deserve more given the level of fees they are charged. Those firms that are successful will separate out the genuinely strategic issues (where key stakeholders need to be involved) from the operational (which should be fully delegated).

Governance structures need to evolve to reflect this. A Chief Operating Officer is unlikely to have a sufficient mandate to run all aspects of the business on a day to day basis. There is a real danger that hedge fund firms are under-managed (with the corresponding risks) or worse still, badly managed by somebody whose real skill is running money.

Private equity firms have now started to become more pervasive in asset management, although it is interesting how little impact they have had over recent years: particularly given the cash flow dynamics of the business. They are now buying into existing firms more readily. Will governance structures survive sufficiently to keep talented individuals, and will the inevitable exit make clients reticent of committing long term funds in advance of such a major event? The jury is out.

The brain drain

Traditional firms have failed in the hedge fund world for predictable reasons. It is unlikely that their success will change as the impediments to their being competitive are real and pervasive. It is inevitable that talented individuals will continue to drift away, attracted by focus, flexibility and potential rewards of success in boutiques.

However, it is also probable that the industry will continue to see fragmentation as larger hedge fund firms fail to foster the very environment which made them successful and attractive in the first place. An unwillingness to share equity participation, an ego-centric governance structure still overly focused on the original founders and a deteriorating cultural environment, will force people to move on. Talented individuals have an innate desire to share in governance at some level. It is unlikely that generous profit shares will be sufficient to keep them as firms get larger and more impersonal – after all this is the very environment that many proprietary traders left in the first place.

Key to sustaining the culture

Achieving a transfer of value to the second or even third generation is not easy but there are precedents. Ironically it is in this traditional world that the best example can be found – Capital Group is amongst the oldest firms in our industry and amongst the most stable.

Their intensive focus on sustaining culture and their genuine belief that employees should participate in the ownership structure of the business are a beacon for any firm: long term investment performance and staff turnover have been an example to us all.