Succession planning, and how to build a long-term, sustainable business, isn’t just a concern for hedge funds and their investors, but for any type of investment manager. This can be seen in the current lively discussion taking place about the fate of Berkshire Hathaway once Warren Buffet steps down. The hedge fund industry, however, seems to be particularly famous for its star traders, those legendary titans and unique individuals who somehow manage to defy the odds time and time again by consistently outperforming their peers and benchmarks. In the process these individuals rise to almost mythical status, and, in doing so, they prove that investing is as much an art as it is a science.
Often investors will refer to these individuals as having a “unique feel for the markets”, a “special intuition” or ability to “see relationships that others seem unable to imagine”, and a view of the world which may be remarkably different from anybody else’s. Arguably, it may be these different world views that lead to consistent, uncorrelated and outsized returns. Even though exceptions clearly exist, it is exceedingly rare that these feats are achieved by funds that are run by a committee.
The consensus among investors is that a decision taken by such a committee will likely represent the lowest common denominator of ideas generated by the people sitting around the table – those least controversial and, often, therefore, average and run of the mill. For many allocators, investing in a hedge fund is therefore very much about backing these star portfolio managers, but they often do so with a degree of apprehension. To make matters worse, the traits that seem to be making some traders so successful are seemingly hard to replicate. Therefore, for many investors, the idea of those individuals handing over the baton successfully to the next generation is viewed with considerable concern.
Being invested with a star manager is all well and good for as long as there is no change at the helm, but what happens once the key person decides to retire or leaves for some other reason? Key man risk is a major consideration for many investors, and while the industry wouldn’t be what it is today without these star traders, it is also something that needs to be managed very carefully – hence the inclusion of key man clauses in many offering documents. This is an area that warrants some consideration before picking a manager, in order to avoid unpleasant surprises at a later stage – as few things are more frustrating than finding out that one of your top-performing managers is handing back capital because of the departure of its star trader.
Being able to deal with this risk rather than shying away from it by avoiding the issue of succession planning, and ruling out some of the top-performing funds in the industry as a consequence, is a key component of any successful hedge fund selection process. It is also an area in which investors can exert a certain amount of influence by pushing for a clear succession plan to be in place, or to work with a manager to create one. The alternative – and this is in many ways, sadly, the rule rather than the exception – is that a fund has to close its doors with the departure of its star trader.
We have seen many firms over the years try to make the transition from one generation to the next, only to be faced with deteriorating performance and redemptions. The bar is set very high, and the probability is stacked against most managers, as outstanding talent is, by definition, not easily found. Finding individuals that share the same world view, culture and way of doing things can be very challenging. Managers regularly tell us that instead of bringing on a more experienced trader or portfolio manager with preconceived notions of how the world works and how things should be done, they feel it is easier to try to train somebody who may have little experience but raw talent in their own way of doing things. We know many managers that now have specific programmes in place for this sole purpose.
Conversely, there are many examples that come to mind where the addition of an external star trader to an existing fund was made with much fanfare, only for investors to then find out a couple years later that this previously successful new trader has not been able to adapt to a change in culture, with the result that expected returns failed to materialise. Often this then culminates in the departure of the previous star trader, causing significant disruption and a loss of confidence by investors.
The worst situations that we have seen are where firms that were used to taking their directions from one individual are trying to re-invent themselves into firms run by committee. More often than not this is the antithesis of the existing culture, and leads not only to lacklustre performance, but also staff defections, to be followed or preceded by investor defections.
Succession planning can only work if it is part of a firm’s culture and it is embraced as an essential part of the business’s long-term strategy. This means a multi-year commitment – ideally five to 10 years – of engraining a unique culture, way of doing things, and specific world view into the next generation of traders and portfolio managers. It should therefore become clear early on in a conversation with a manager whether serious consideration has been given to the issue of succession planning, and whether there is a real institutional commitment to this. The most promising firms are those where from an early stage a number of talented people are being groomed to take over the reins, and where considerable effort is put into their development. This often includes shadowing the main trader for extended periods of time and creating very specific incentives to keep these individuals motivated for multi-year periods.
Rather than being seen as an expense, this process is regarded as a necessary investment in the future of the firm, and we are most encouraged when managers tell us that they strongly see this as a fiduciary obligation to their investors and are acutely aware of key man risk, its ramifications, and the need for this to be properly managed.
It is important to empower the next generation of managers early on, to provide them with sufficient capital and time to build their own independent and credible track records, and to allow them to interact with investors frequently. Many managers have great programmes in place that allow potential successors to either start their own products or run significant parts of existing portfolios, with very clear P&L attribution and clearly documented decision-making processes that allow investors to really understand the rationale employed, and how returns have been generated. This builds confidence on both sides. Ultimately, the strongest argument for any investor to stay with a manager will be to see a long-term, audited track record of outperformance by the next generation.