The Battle for the Middle

The evolving landscape & value proposition of FoHFs and consultants

AN EXTRACT FROM A REPORT BY BARCLAYS PRIME SERVICES

As intermediaries between investors and hedge funds, funds of hedge funds (FoHFs) and investment consultants (ICs) play a critical role in the hedge fund ecosystem. By our estimation, they are the conduit through which over $1.5 trillion of assets flow from investors to hedge fund managers.1 Additionally, in their role as active spokespersons for the hedge fund industry, they educate and inform the investor community about hedge funds’ role in investment portfolios, making it easier than it has been, historically, for hedge fund managers to find a place in investors’ portfolios.

In the years following the financial crisis, the hedge fund industry and associated intermediaries have had to deal with significant disruption and change. Partly as a result, a lot has been said and written on how hedge fund intermediaries have been or will be impacted in the future, from the impending ‘demise’ of the FoHF model to the buzz around convergence of hedge fund intermediary models and the rise of customised solutions.

Methodology
To address the above questions, we tapped three sources to gather required information for analysis.

1. Survey of ~140 firms in Q2 2013, including:

  • 50 hedge fund investors;
  • 75 funds of hedge funds, representing one-third of total FoHF assets;
  • 14 investment consultants, representing two-thirds of total consultant hedge fund assets under advisory (AUA);
  • Interviews with a select group of survey participants for qualitative insights.

2. Barclays Capital Solutions ‘Meet the Consultant’ event series

  • Presentations by six of the top hedge fund consultants regarding their firms, hedge fund DD (due diligence) approach and practices between January and June 2013;
  • One-on-one conversations with several of the above-mentioned investment consultants.

3. External research and analysis

  • 30+ sources, including HFR, AiCIO, P&I, Preqin, financial filings, industry reports and news articles.

INDUSTRY SIZE AND MARKET STRUCTURE

Industry size
We begin by developing a high-level framework forthe hedge fund intermediary space and a rough estimate of the size of the hedge fund intermediation business. Hedge fund intermediation falls into two broad categories, advisory and discretionary2 services. As shown in Fig.1, we estimate that hedge fund intermediaries are the conduit for $1.5 trillion of hedge fund assets3, or two-thirds of the total industry.

Key takeaways:

  • ~$700 billion through FoHFs (~$600 billion discretionary and ~$100 billion advisory);
  • ~$830 billion through ICs (~$800 billion advisory and $30 billion discretionary);
  • ~$100 billion through both FoHFs and ICs (i.e., ICs recommending FoHFs);
  • ~$70 billion through outsourced CIOs.

It is interesting to note apparent evidence of convergence between the business models of FoHFs and ICs. Based on our estimates, FoHFs advise ~$100 billion hedge fund assets, and ICs manage (on a discretionary basis) ~$30 billion. The relative sizes of the two numbers also seem to suggest that FoHFs have had more success in winning advisory business than ICs have had in winning discretionary mandates.

Fig.2 shows the changes in AUA/AUM of hedge fund consultants and FoHFs over the past two years. In our sample, FoHF AUM decreased by 5%, likely as a result of a multitude of (interrelated) factors, such as (1) lacklustre net returns, (2) investors’ heightened scrutiny of fees, (3) the Madoff scandal, and (4) investors’ desire to take back control over their investment decisions. Most people would agree, however, that the continuing trend toward investors allocating directly to hedge fund managers has had significant impact on FoHFs’ business. It would be fair to say that the 5% reduction in FoHF assets, relatively small in light of the above challenges, actually points to FoHFs’ resilience and adaptability. Part of this resilience has been the result of the relative success larger FoHFs have had in riding out a perfect storm of adversity in recent years. As shown in Fig.2, there seems to be a strong negative correlation between FoHF firm size and percentage decline in AUM. Among FoHFs, the smallest firms (<$500 million) suffered the sharpest change in AUM relative to their asset base (-17% versus +5% for $5 billion+ FoHFs), suggesting that scale is becoming increasingly important for FoHF survival, a recurring theme throughout our study.

On the other hand, the average IC hedge fund AUA in our sample increased by 30% over the same period. ICs have benefted from two key trends since 2008: (1) public pensions, who are traditionally the most enthusiastic proponents and users of ICs, doubled their allocations to hedge funds, from an average ~4% in 2008 to ~8% in 20124, and (2) many investors, who are electing to allocate directly to hedge fund managers rather than investing through FoHFs, are preferring to do this with the help of ICs.5

Market structure
Although both belong in the hedge fund intermediary space, FoHFs and ICs have historically had distinct business models and, we believe, continue to have fairly different market structures/characteristics. In Fig.3, we compare the concentration ratios for hedge fund consultants and FoHFs against some well known industries. The four-firm concentration ratio (CR4) measures the cumulative market share of the top four firms in an industry as an indicator of industry concentration.

In general, highly concentrated industries tend to have high levels of (1) scale benefits, (2) barriers to entry, and (3) pricing power. Some examples of both types of industry concentrations:

  • High concentration: aerospace manufacturing (CR4 = 70%), investment banking and brokerage (CR4 = 66%), hedge fund consultants (CR4= 50%)
  • Low concentration: footwear manufacturing (CR4 = 7%), biotechnology (CR4 = 33%), FoHFs (CR4 = 17%)

Market structure, combined with an industry’s growth outlook, can reveal a great deal about the prospects of the players in the industry. Overall, it appears that FoHFs may be more challenged than consultants in the near term.

  • The market for hedge fund consultants is more concentrated but steady AUA growth provides some breathing space to the smaller players. The strategic priorities for the larger firms include gaining market share and growing their profit margins.
  • FoHFs face a more fragmented market structure, combined with declining assets (and margins). As larger funds scale up, the challenge for the rest is to retain assets and protect margins (in the face of fee pressures).

As FoHFs’ assets and margins have declined, their numbers have shrunk and will continue to shrink in the foreseeable future, given the difficult industry environment. Fig.4 displays the number of FoHFs and hedge funds in the past 10 years. The number of FoHFs grew faster than hedge funds up until 2007 (CAGR of 15% versus CAGR of 9% for hedge funds). After 2008, however, the growth trajectories decoupled. The number of hedge funds grew more slowly than before (3% CAGR), but the number of FoHFs actually declined (CAGR of -5%). We expect this consolidation of FoHFs to continue, with disproportionate impact on small and mid-sized FoHFs.

A key part of the consolidation trend has been recent M&A activity which also reflects disparate strategic motives and priorities of ICs and FoHFs. M&A transactions in the consultant space mostly revolve around the buyers’ desire to gain or maintain a competitive edge, e.g., combining complementary expertise, investor base. M&A activity involving FoHFs, on the other hand, is usually about scale, e.g., larger asset management firms buying smaller FoHFs at attractive multiples to get access to capabilities and talent.

FUNDS OF HEDGE FUNDS

It is a well known fact that the FoHF model has been under stress for some time, in part due to investors’ growing preference to invest directly in hedge funds. In response, FoHFs have adopted several changes to their business model to stay relevant. Fig.5 explores the two dimensions of products and investor segments along which FoHFs have evolved.

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  • Products – in an environment where investors’ demand for current FoHF products is fattening or declining, one option is to develop and market new products that cater to investors’ unarticulated or unmet needs.
  • Investor segments – a different option is to target untapped investor segments (e.g., retail) to supplement demand from existing client segments (e.g., pensions).

Based onthe above framework, FoHFs can choose to evolve along one or more of three alternative pathways: (1) improve existing products for existing investors, (2) develop and market new products to existing investors, and/or (3) market existing products to new investors. The statistics shown in the individual charts on the right side of Fig.5 refer to the percentage of surveyed FoHF respondents that have adopted each strategy in our sample over the past two years. Select highlights:

1. Improve existing offerings for existing investors.

  • Performance – 44% focused on improving net returns, usually by dialling up risk, making more concentrated bets.
  • Fees – 41% reduced fees.

2. Market/develop new products to existing investors.

  • 46% focused on customised solutions; 15-25% focused on advisory services and niche strategies and emerging managers.

3. Target new investor types.

  • 15% focused on identifying/targeting new investor segments.

In the following sections, we will explore each of the above sub-topics in greater detail.

Performance
On the topic of FoHF performance, our analysis shows that while FoHFs have lagged hedge fund managers on net returns historically, the gap appears to have narrowed in recent years – a positive development for the industry.

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Fig.6 compares the one-year, three-year, and five-year annualised net return and standard deviation statistics for FoHFs and hedge fund managers. Select highlights:

FoHFs have lagged hedge fund managers on net returns historically.
– Lower annualised net returns on one, three and five-year basis.
– The additional layer of fees is probably a key factor.

The gap between FoHF and hedge fund annualised net returns, however, appears to have closed in recent years.
– From ~330bps (five-year) to ~210bps (three-year) to ~160bps (one-year).
– FoHF returns on a risk-adjusted basis have improved as well. The one-year average FoHF Sharpe Ratio has actually surpassed the average for hedge funds (not shown).

According to our analysis and the FoHFs we interviewed, potential explanations for these recent developments include (1) industry consolidation resulting in less successful FoHFs exiting the industry, thus improving the average returns of the group as a whole, (2) changes in FoHFs’ own investment approach aimed at delivering higher returns, e.g., dialling up risk, and making more concentrated bets, (3) FoHF fee reductions resulting in higher net returns, and (4) significantly lowered exposure to less liquid strategies post-2008 limited their participation in the market rally that ensued during 2009 and 2010 compared to the overall hedge fund industry.

Recent improvements in relative performance apart, FoHFs do appear to offer lower volatility and more diversification than hedge funds. Compared to hedge funds, FoHFs exhibit lower standard deviation of returns as well as lower correlation of returns with broad indices on a one, three and five-year basis (five-year correlation statistic shown on right chart of Fig.6).

Fees
On the topic of FoHF fees, we decided to address two key questions: (1) What is the average fee charged by FoHFs today, and (2) How much room is there for FoHFs fees to decline further? Fig.7 depicts the average fees charged on single investor vehicles by our survey respondents, broken out by FoHF size. On average, (across firm sizes) our respondents chargea management fee (MF) of ~80bps on AUM plus 5% of performance generated, a meaningful deviation from the traditional 1/10 structure (which is imposed by only ~10% of our respondents). Larger FoHFs appear to enjoy greater pricing power; the average fee structure for firms with $5 billion+ is ~80bps MF plus 5% PF versus ~60bps management fee plus 5% performance fee for FoHFs <$500 million.

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We noticed that the fee levels we obtained through our survey appear to be at the higher end of the anecdotal ranges we picked up in recent investor conversations. One potential explanation is that the figures in our survey represent the average fee that includes both recent fee structures as well as legacy fee structures, which tended to have been higher in general.

COMPARISON OF VALUE PROPOSITION

To provide context to the ensuing comparison of value propositions, we start by illustrating investors’ usage of hedge fund intermediaries in their portfolios, as depicted in Fig.8.

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Select highlights from the survey results:

  • Nearly 30% of our respondents allocate to FoHFs. Of those, nearly half allocate less than 20% of their overall hedge fund portfolio to FoHFs. FoHFs, therefore, represent a satellite allocation for these investors.
  • 40% use a consultant for their hedge fund portfolio. Of those, more than three-quarters use them only for operational due diligence (ODD) or as a ‘sounding board’ during the investment due diligence (IDD) process.
  • Approximately 70% of investors either do not use an intermediary or use them very modestly (highlighted in the left-hand blue oval), consistent with our earlier hypothesis that investors have been taking back control of the investment process since 2008.
  • Investors tend to use either FoHFs or consultants – it is relatively unusual (in 12% of the cases) that an investor uses both, suggesting the ‘battle for the middle’ is nearly a zero-sum game.
  • We also tested for the correlation between investors’ choice of FoHFs versus ICs as a function of (1) their hedge fund portfolio size, and (2) their number of investment professionals. Surprisingly, we did not find either variable to be a particularly strong predictor of IC or FoHF usage. Value is a balance between perceived costs and benefits. Our finding seems to suggest that investors do weigh both sides of the argument and that their decision is not purely economics-driven.

The value comparison of fees
Fig.9 shows that, on average, FoHFs charge investors substantially more than consultants for both advisory and discretionary mandates.

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According to our respondents:

  • Approximately one-third of FoHFs offer free (ad hoc) advisory services for existing investors. Of those who do charge a separate fee, FoHFs on average charge ~40bps versus the ~20bps charged by consultants.
  • On the discretionary side, our FoHF respondents charge an effective ~100bps fee (based on an 80bps/5% fee structure6, assuming a 5% return) compared to ~40bps charged, on average, by consultants and 75bps charged by outsourced CIOs.

We have attributed an estimated average fee to each step in the investment process ‘value chain’, as shown in Fig.10.

By examining the fees charged for individual, stand-alone services or by pure-play firms, we decomposed hedge fund consultant, FoHF and OCIO fees into what is attributable to individual ‘value-added’ activities, as summarised below:

  • Advice on overall asset allocation: ~2 – 5bps;
  • Hedge fund due diligence: ~10bps (Ops DD ~2 – 5bps);
  • Sizing/portfolio construction: ~0 – 5bps;
  • Implementation of investment decisions: ~20 – 25bps;
  • Acting as a sounding board: ~2 – 5bps.

If the above estimates hold, the disparity between the actual and the estimated (theoretical) fee (by combining fees attributable to specific value chain steps) may be thought of as a ‘skill premium’ being charged by/paid to some players. A few interesting observations:

  • Hedge fund consulting appears to have become relatively commoditised; there is little difference between the hypothetical and the actual price being charged.
  • The implicit ‘skill premium’ being charged is ~30bps for outsourced CIOs and ~60bps for FoHFs.
  • While this is great for OCIOs and FoHFs in the near term, the flip side is that investors who do not see the benefit of paying a ‘skill premium’ are more likely to disintermediate these middlemen in favour of cheaper alternatives.

Drivers of FoHF fees
The million dollar question is, “What do investors get for paying FoHF fees?” Fig.11 depicts responses of surveyed investors regarding what they consider the most valuable FoHF services.

Access to niche strategies, closed funds, emerging talent and intellectual capital/expertise appear to be most highly valued. Most of these are unique benefits of FoHFs typically not obtainable through ICs or OCIOs, and likely paid for by the FoHF ‘skill premium’ we alluded to earlier. It is interesting to note that only 8% of investors considered customised portfolios a top FoHF value proposition, although customised accounts have been a major source of assets for FoHFs in recent years. Our takeaway from this is that as long as investors are getting access to the offerings they care most about, they value the ability of a FoHF to customise a portfolio for them.

However, by itself, the ability to offer a customised portfolio or solution has little appeal. Another key driver of FoHFs’ perceived higher value proposition and ability to charge higher fees is that their investment organisation is typically larger than that of ICs.

Fig.12 depicts the number of hedge fund-focused investment professionals (IPs) (on the y-axis) employed by FoHFs, ICs, and investors for different hedge fund portfolio sizes (shown on the x-axis).

The chart shows that, on average, FoHFs have a higher cost structure than ICs due to (1) a larger organisation size, and (2) higher average compensation levels. FoHFs employ, on average, at least two to three times the number of hedge fund-focused IPs than the number at ICs and investors, given the same level of hedge fund AUM/AUA. In theory, FoHFs’ larger investment organisation should translate into better research, and higher quality and level of returns over time, a justification for their higher fee structure.

Investor value perception
As we have demonstrated in Fig.10, consultants and FoHFs overlap on two value chain activities: hedge fund manager DD and portfolio construction. In order to better understand how investors evaluate FoHFs and ICs on these two activities that they both perform, we asked investors to rate their consultants and FoHFs on a scale of 1 to 5 (5 being the best) along four dimensions: (1) breadth of hedge fund manager coverage, (2) quality of hedge fund manager due diligence, (3) rigour of portfolio/risk analysis, and (4) sophistication of IT/portfolio and risk tools. Select highlights:

• On an absolute basis, both FoHFs and ICs received above-average scores (3 or higher), suggesting that most investors are generally satisfed with their services. However, in relative terms, ICs outranked FoHFs on all four dimensions.

• Manager due diligence – ICs ranked slightly higher than FoHFs on both breadth of coverage (3.8 versus 3.6) and quality of coverage (4.2 versus 4.1).
– Two factors might have helped ICs’ ratings: (1) ICs’ manager coverage is cumulative (reports stored in a database) and FoHFs’ coverage universe is static (number of managers in the portfolio at a given time), and (2) ICs typically document their views in detailed reports whereas FoHFs do not.

• Portfolio construction – ICs again scored higher on both rigour of portfolio analysis (4.1 versus 3.4) and sophistication of IT tools (3.8 versus 3.5).
– One reason may be that ICs tend to be more transparent with clients about their tools/processes than FoHFs. Additionally, FoHF ratings may also be hurt by the greater dispersion in the quality of FoHFs versus ICs.

Another point to keep in mind in interpreting this data is that manager due diligence and portfolio construction together represent a combined hypothetical value of ~15bps to investors. Assuming both FoHF and IC fees are fair, these two activities represent the bulk of hedge fund consultants’ value proposition, i.e., 75% of IC fees, but only 15% of FoHF fees. This would lead to the conclusion that these activities represent the ‘bread and butter’ of the average hedge fund consultant offering, but only a small portion (at least theoretically) of FoHFs’ value proposition to investors.

Nonetheless, a key lesson for FoHFs from this analysis is as follows: being more transparent about ideas/systems/processes may help improve investors’ perception of the value provided by FoHFs, especially when returns are elusive. Better communication of the ‘means’ being employed may be more critical when the ‘end’ in the form of higher returns is not attainable.

LOOKING AHEAD

In Fig.13, we show our estimate of the revenue pool for IC and FoHFs at the end of 2012 along with our projections for 20147, based on the analysis of the data we obtained through our survey.

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Select highlights:

• We expect the hedge fund consultant fee pool to increase by ~15% from 2012 to 2014.
– Led by strong growth in hedge fund AUA (15%) driven by institutional investors (primary users of ICs) continuing to bypass FoHFs and going into hedge funds directly with help from ICs.

• On the other hand, we expect the FoHF fee pool to decline by ~10% over the same period.
– FoHFs face a declining asset base (-5%) and more fee pressure than ICs (~5%).

• However, the FoHF fee pool is three to four times the size of the IC fee pool. As a result, the combined revenue pool is expected to decline ~5%.
– The downward trend of the intermediary fee pool is a symptom of investors’ increased control of the investment process – manifested by their disintermediation of FoHFs, and their increased usage of ICs as sounding boards (rather than fully relying on them).

Fig.14 summarises our expectations for key groups for the next 18–24 months:

• Despite our expectation that the overall FoHF revenue pool will to continue to shrink, select FoHFs will likely emerge stronger.
– We expect large FoHFs to be in a unique position given their scale, deep and broad expertise in alternatives, and ability to provide a ‘one-stop shop’ solutions platform.
– Small (and some mid-sized) FoHFs will continue to be challenged in a shrinking industry. They may need to consider all options to retain/grow assets including M&A options or re-positioning themselves as OCIOs.

• ICs will continue to enjoy a growing fee pool. Major players are expected to grow their AUA, though we expect to see firms pursuing divergent business strategies.
– Albourne can continue to gain market share via their flat pricing model and enter other segments in the alternatives industry (e.g., private equity, real estate).
– Other top hedge fund ICs can continue to gain AUA but will find it difficult to expand margins in a resource-intensive business due to Albourne’s flat pricing model. They may need to push harder to get into higher-margin businesses (i.e., win discretionary mandates) although this strategy has challenges of its own.
– Generalist consultants have an advantage in pursuing a scale strategy given their large client base on the long-only side. Their challenge is to prove they can compete with the specialist ICs on the breadth and quality of coverage of the hedge fund universe.

Conclusions

• Hedge fund intermediaries are getting squeezed by both investors and managers.
– Hedge fund Investors – have been taking back control of the investment process since 2008; this has been manifested through (1) the disintermediation of FoHFs, and (2) increasing usage of ICs as a ‘sounding board’.
– Hedge fund managers – hedge fund industry is maturing, characterised by slower growth (net inflows grown at ~3% post-2008 versus 11% pre-2008). These effects are being transmitted to the intermediaries (e.g., muted returns, smaller inflows).

• We expect the overall fee pool for hedge fund intermediaries to decline by 5% (or $300 million) to $6.5 billion by 2014, although FoHFs are expected to face more imminent stress than consultants.
– The hedge fund consultant business is highly concentrated with steady AUA growth. Main priorities for top players include competing for market share and protecting margins. We expect the fee pool for consultants to increase 15% by 2014, fuelled by strong growth in AUA.
– FoHFs have a fragmented market structure with ‘disrupted’ growth. For many, the challenge is to retain assets in order to survive. We estimate the fee pool for FoHFs to decrease by 10% by 2014, driven both by declines in fees and in the asset base.

Three things consultants should consider going forward:

  1. Don’t stress – ‘rising tide lifts all boats’. The current environment presents an opportunity for the industry. Consultants should make sure to allocate appropriate resources to new business development.
  2. Be prepared to deal with the risk of commoditisation and fee pressure – some are better suited to pursue a scale strategy while others are better off trying to break into higher margin businesses (e.g., discretionary mandates).
  3. Winning discretionary mandates sounds easier than it is – breaking in requires significant resources: advisory businesses historically operate on a low-cost structure; to break into a higher-margin business will require firms to commit to a higher-cost structure.

Three things FoHFs should consider going forward:

  1. Get scale – a key competitive advantage obtainable through asset raising or M&A. It is the prerequisite for delivering #2 and #3 below.
  2. Cut fees – currently FoHFs still charge a ~40-60bps premium compared to consultants and outsourced CIOs. While many investors appear to find FoHF services valuable, the relatively high fees are a major stumbling block for others.
  3. Play offense – FoHFs have been under stress for some time and many have become reactive. In recent years, a majority has emphasised customised solutions as a new value proposition. Our survey shows that investors value FoHFs most for their ability to provide access to premier/closed funds, investment ideas, product innovation, and new talent. FoHFs should play to their strengths and focus on the truly differentiated value propositions that cannot be delivered by consultants.

To obtain a copy of the full report from Barclays, please contact Jon Laycock at jon.laycock@barclays.com

Notes

  1. Strategic Consulting 2013 Hedge Fund intermediary market sizing model.
  2. Put simply, in an advisory arrangement, the intermediary party makes recommendations (usually pertaining to asset allocation, policy statement, and manager selection/rebalancing) and the investor approves them. In a discretionary arrangement, the intermediary has the authority to directly implement investment decisions and the investor monitors the result.
  3. Does not include assets intermediated through private banks and multi-family offices. Sources consulted include: HFR, Preqin, Strategic Consulting survey results, Casey Quirk, and P&I.
  4. “It Takes Three to Tango”, Strategic Consulting Hedge Fund Intelligence, 2010; “Till Performance Do Us Part”, Strategic Consulting Hedge Fund Intelligence, 2012.
  5. “Mind the Gap”, Strategic Consulting Hedge Fund Intelligence, 2012.
  6. The average fee structure for our FoHF respondents’ single client vehicles.
  7. 2012 figures estimated by taking the product of average fees of our surveyed respondents and the AUM / AUA size estimates from Figure 2. We applied a 20% haircut to the resulting figure to arrive at the final figure. The rationale for applying the haircut is that, according to our respondents, ~10 – 30% of an average firm’s AUM / AUA produce zero or significantly lower fees than average.