The Hedge Fund of Tomorrow

Building an enduring firm

THE BANK OF NEW YORK MELLON and CASEY QUIRK

The following is an extract from the third collaboration between The Bank of New York Mellon and Casey Quirk, Thought Leadership Series, April 2009. This extract is taken from Chapter 4: Blueprint for the Enduring Firm.

Summary
Flaws in the standard hedge fund business model have triggered investor demands for better alignment. These flaws must be addressed in a comprehensive fashion; selective tinkering will not solve the alignment conundrum. Our prescription involves redesigning liquidity terms, fee structures, and investment team compensation in the context of investors’ long-term objectives, starting by harmonizing all three along a consistent time period not necessarily a calendar year. This means terms, fees and compensation will vary across managers and strategies, and therefore the industry will move away from a standard and static structure. It also means some old dogmas, such as the high-water mark feature, have outlived their usefulness and should be let go. The result will be the Enduring Firm, a hedge fund business that has a real chance of surviving multiple downturns and becoming a multi-generational firm.

Beyond alignments, our blueprint for the Enduring Firm marks a clear break with hedge funds’ cottage industry roots and is characterized by excellence and balance across four functional areas: business management, investments, distribution and operations; each with their own set of best practices. These common attributes are applicable to a wide range of business sizes and types, and we outline four models which the Enduring Firm can pursue: Single-Strategy Boutique, Multi- Capability Platform, Merchant Bank, and Converged Traditional-Alternative Manager. Our conclusion is that the Multi-Capability Platform model will see the greatest growth going forward. We also explore a fifth emerging model, the Alternatives Holding Company, which may facilitate growth and a form of ownership transition for Single-Strategy Boutiques.

Finally, funds of hedge funds are facing their own set of unique business challenges. As outlined in Chapter 3, investors still favor funds of hedge funds as a means for investing in hedge fund strategies. However, we believe this demand relies upon funds of hedge funds adapting their product and service capabilities to meet new investor demands.

Hedge Funds’ State of Misalignment
The recent crisis has revealed the extreme degree of instability inherent to the hedge fund business model, largely a function of poor alignments between three parties: investors, hedge fund firms, and firms’ investment teams. The legacy alignment structure has four big flaws:

  1. Business timing mismatch: A serious imbalance affecting all the alignment tools listed in the previous chart (liquidity terms, fees, performance measurement, performance payout, compensation structures) is the timing mismatch that has grown among them. For the majority of hedge fund strategies, there is little or no consistency within strategies for most of these tools. In times of stress, the result is, at best, investor surprise and frustration, and perhaps anger; at worst, a breakdown in a manager’s ability to remain a going concern, as survival comes to depend on locking assets against investors’ wishes.
  2. Destructive incentives: Much has been written about the asymmetry in hedge fund managers’ potential payout, and the high-water mark was one way to reduce this asymmetry. Unfortunately, rather than protecting the investors, the high-water mark has become a toxic incentive, setting the three stakeholders against one another and leading to a vicious cycle of destructive behaviors: excessive risk-taking in an attempt to make up losses, fund (or firm) closure, and investor redemption due to fears of the first two. Any investment with a performance-fee component can never have completely symmetrical payouts, but we believe there are better ways to mitigate the payout asymmetry than with a high-water mark.
  3. Rigid terms: A common standard for fee structures and liquidity terms made sense when the industry was smaller and concentrated in a few related trading strategies. As investment strategies and the investor base evolved, fee structures and terms should have evolved as well. There is at least one lingering rigidity that makes no sense regardless of strategy or investor base: the calendar-year orientation for most managers’ performance fees and liquidity. Even for liquid, short-term strategies, tying all of a manger’s investor base to a common calendar for redemption notices increases business instability. Likewise, cashing out the investment team every year, even for a short-term investment strategy, leads to volatile expenses and likely lowers team retention during a downturn, potentially putting the business at risk.
  4. Hedge fund compensation practices: For most hedge fund investment teams, measurement of personal performance and personal payout is not aligned to investors’ or firms’ longterm objectives, other than having personal assets invested in the fund. This may have been adequate when hedge fund firms were mostly single-fund and so the interests of the firm were closely tied to a fund and the investor base was primarily high-net-worth (so investors’ requirements and objectives may have matched those of the team). Neither is the case anymore. Additionally, the industry broadly does not provide investment teams with clear and transparent compensation drivers that give the team visibility and, therefore, reassurance as to how their compensation is derived.

The legacy alignment structure results in an unstable business and continued investor frustration. The current crisis provides an opportunity to fix these imbalances and establish the foundation for future growth.

The New Alignment Regime
Our objective in prescribing this new alignment model is to establish a framework that addresses the primary sources of hedge fund business instability, while maintaining the industry’s core DNA: rewarding success and earning fees from returns, not simply assets under management. As with any framework, this one should be flexible enough, allowing firms to adapt it to their specific business parameters.

We believe the alignment concepts apply to virtually all hedge fund and fund of hedge fund firms. However, if we were to apply this framework to each of the three categories of strategies we discussed in Chapter 3, then the strongest application is with liquid strategies (Market Directional Liquid and “Classic” Hedge Liquid), which together make up the vast majority of total hedge fund assets. For truly illiquid strategies, these concepts all apply but implementation would likely be more along the lines of the private equity and real estate alignment models.

Aligning Liquidity Terms With Investor Type and Strategy
Our starting principle is that liquidity terms should reflect underlying portfolio liquidity, investor liquidity requirements and investment horizon. For many hedge fund strategies, this is a seemingly impossible set of constraints, especially if they have a mixed client base with a wide spread in liquidity preferences.

Our solution is for managers to consider segregating their portfolios by both investment and investor type, and to vary liquidity terms for different client objectives. This could be implemented by introducing separate funds across the same strategy, each with distinct liquidity terms. This provides the manager with the flexibility to consider less liquid investments (if appropriate) and minimizes co-investor risk in the fund. Investors would have to accept that performance across liquidity classes could be meaningfully different.

Our second change to liquidity terms is to replace the whole superstructure of lock-ups, rolling liquidity subject to notice periods, and gates (all usually tied to the calendar year) with a simple idea: a rolling notice period. This would remove the instability that comes from having the fund’s capital base come up for renewal at a regular interval. Investors would not have to make the active decision to pass up on a redemption period; they can redeem any day and would get paid out after the notice period has passed. Combined with our first prescription, this removes the need for gates: investors can self-select the fund or share class with the appropriate liquidity (for example, 45-day, 90-day, 1-year, 3-year). The relevant portfolio is segregated to ensure liquidity actually exists, and the rolling notice period means that sudden surges in redemption requests are less likely.

Admittedly, these reforms would create operational complexities, but they would align manager and investor objectives. Even if the investment strategy is short-term and liquid, this segregated approach makes sense: multiple liquidity share classes increase the manager’s business stability and may be a critical feature to attracting institutional assets. Institutions we surveyed preferred to see less liquid fund terms due to perceived co-investor risk from mixing institutional assets with flightier high-net-worth or fund of hedge fund assets.

Separate Accounts?
Many investors and advisors increasingly view separate accounts, a fixture of traditional institutional asset management, as a potential “silver bullet” for the liquidity and transparency challenges with hedge funds. As with many silver bullets, we believe this one is only part of the solution, not the whole solution, and at any rate remains consistent with our new liquidity framework.

For very large investors, capable of investing $50 million or more in a single hedge fund, separate accounts might represent viable alternatives to investing in commingled funds. The underlying alignment issues (investment liquidity versus terms) and structure would be no different than a segregated share class as described above. However, there are real impediments to separate accounts becoming the standard across the board, especially for more esoteric or less liquid strategies (where it may be impossible to run a separate account pari passu to the commingled fund), and the benefits they accrue may be less relevant under our proposed liquidity and transparency regimes.

Furthermore, separate accounts can bring a whole set of operational challenges and increased costs to both managers and investors, as well as unwanted fiduciary concerns or potential liabilities in excess of principal invested for certain investment strategies and structures. Investors should proceed with caution. Separate accounts will become far more common in the hedge fund world, but our forecast is that most investors will continue to use commingled funds.

Rethinking Fees
As with liquidity, our key assumptions around fees include our belief that fees should be tied to investor liquidity and investment horizon and should not be forced into a calendar year schedule automatically. While specific fee levels will vary by strategy and firm, and illiquid strategies in particular are likely to follow private equity-like structures where performance fees are paid concurrently with investor liquidity, the Enduring Firm fee structure has some common features:

Scaled management fee: A flat management fee that does not scale down with mandate size is a holdover from the “cottage industry” days, and has persisted until now due to the high demand for hedge fund strategies up to 2008. While management fees are a good source of business stability, investors have a strong preference and tolerance for performance fees, and the introduction of scaled management fees are one way managers can reward large investors without entirely surrendering management fee revenues.

Rolling and deferred performance fees: Performance fees will be more closely tied to investors’ realized returns and longer-term objectives. This means a performance fee measurement period that is not always a calendar year, or even necessarily 12 months, but is tied to liquidity terms and by implication, investment horizon. This also means the performance fee payout will likely transition away from a strict quarterly or annual basis, and towards a rolling basis incorporating a deferral.

As an example, the previous exhibit compares the revenues generated by the legacy performance fee structure with the performance fees generated by a revised, rolling structure. In both cases, assets, investment returns, and the performance fee level of 20% is maintained. The difference lies in how performance fees are calculated and paid. The proposed scheme has a monthly rolling performance fee timing and calculation of which varies according to investor liquidity. Our hypothetical example has 4 liquidity classes ranging from quarterly to 5 years. Total cumulative performance fees paid over the 10-year period is roughly equal across both schemes. The proposed fee structure has a smoother distribution of performance fee revenues, reducing variable revenue volatility by a third.

Although less straightforward than the legacy practice, this rolling fee approach provides a better alignment for investors, emphasizing consistent returns for the investor and stable revenues for the manager. Higher hurdles for higher performance fees: Most hedge fund managers have so far avoided a performance fee hurdle, arguing that the tactical decision to earn returns simply equivalent to cash was a choice that investors should reward in certain market conditions. This line of argument may have become harder to defend since 2008, when few managers made such a decision. In any case, managers may find that investors will likely accept a higher performance fee in exchange for a hurdle, even a cash hurdle. In our framework, the hurdle is not necessary for every strategy, but it is an optional tool to better align managers with investors. In particular, for market-directional strategies with a great deal of embedded beta, a hurdle makes sense.

High-water mark: As outlined earlier, the high-water mark feature is a source of bad incentives and destructive behavior. While the premise of the high-water mark, to keep investors from effectively paying for the same returns multiple times and act as a “risk break” on managers, is fair, it does not always work as intended. In the context of the new Enduring Firm alignment regime, the high-water mark provision should disappear.

Removing the high-water mark could create new benefits for investors. Restructuring performance fees as described above greatly reduces the “pay for performance twice” effect. Rolling performance fees should more closely align fees paid with returns booked, reducing overall fees until underperformance runs off, potentially years into the future (similar to a high-water mark). And the rolling performance fees reward consistent performance over the investment horizon, not simply a quick win before year-end, maintaining the high-water mark’s original objective of protecting investors with a risk break.

Other structures: We considered the idea of a claw-back or hold-back for performance fees as, in fact, a few hedge fund managers have implemented. In practice this is a cumbersome feature to implement, has unfavorable tax implications for managers, and frankly appears to be less effective than the framework we prescribe. Our primary motivation was to address business model stability. For the example used in the previous exhibit, cumulative performance fees earned over the 10-year period are roughly equal using the legacy or Enduring Firm fee structure; however, the new fee structure would have led to a more stable business, which is ultimately in the best interest of investors and managers.

Hedge Fund Compensation & Business Practices
The Enduring Firm employs a compensation framework for its investment teams that has strong alignment with investors’ long-term return objectives (and actual experience), as well as the firm’s long-term viability and growth. In addition, team members should feel the framework is clear, transparent and predictable, and not ad hoc.

While the specifics will vary by firm and strategy, the key components and attributes of compensation should follow a common template:

  • Performance fee-driven income should form the bulk of ongoing compensation; however, a majority of these payments should be deferred, into the firm’s products, as well as equity-like long-term incentives.
  • Over the long-run, the team’s upside should come from their stake in the business, including dividends and not just their fund investments.
  • Although it should not dominate pay, a discretionary component gives the framework flexibility and can be used to motivate behaviors beyond investment performance, such as cooperation with the distribution team.
  • Competitiveness must be maintained: investment teams’ compensation levels must remain competitive relative to comparable firms and strategies.
  • Firms should implement compensation reforms in stages over multiple years, careful to balance the competitive advantage of cash components with the longer-term incentives that ownership and equity-like interests would create.
  • Finally, the process to award pay within teams should be clear and transparent.

Retained Earnings: In tandem with rethinking compensation practices, hedge fund managers should also re-examine the standard industry practice of fully paying out all company profits on an annual basis. Introducing retained earnings provides managers with a capital cushion to maintain resource levels and investment talent during a downturn. Implementing retained earnings in a tax efficient manner will likely require substantial changes to managers’ corporate structures.

Implications
The new alignment regime promotes greater business stability by smoothing performance fee revenues and team payouts, eliminating destructive incentives like the high-water mark, empowering investors through better liquidity terms, aligning the business with investors’ long-term return objectives, promoting investment team retention, and supporting a long-term perspective. Few hedge fund businesses have been able to fully transform itself away from being a single-generation firm and into a multi-generational firm. The Enduring Firm alignment framework sets the stage for this transformation.

The Enduring Firm Checklist
Addressing the alignment conundrum is the industry’s critical challenge. Strong alignments are the foundation for the Enduring Firm and, therefore, represent a starting point. Once the alignments are in place, excellence and balance across 4 key functions must be developed.

A balanced organization is one where the 4 key business functions are able to work effectively together with appropriate resources, empowerment and latitude given to each function. Historically, hedge funds have generally been poorly balanced organizations, with the investments function dominating the business, distribution being relegated to an atrophied utility and no dedicated, separate senior business management setting the overall strategic vision and direction. By relying on senior investment professionals to drive these businesses “on the side,” most hedge funds had a short-term, reactive approach to distribution and no long-term business strategy. The industry’s tremendous growth through 2007 masked this imbalance, as strong investment performance, combined with some presence among buyers, was enough to drive flows.

In the current environment, and even more so going forward, we believe balanced organizations will have a strong competitive advantage over their out-of-balance peers by being more focused, nimble and effective across all 4 functions.

The Enduring Firm: Four Business Models
The Enduring Firm framework can be applied across the hedge fund manager universe. There are no size, product offering, or business scope constraints. However, we can identify 4 different types of hedge fund businesses which will prosper within the Enduring Firm framework. Each model has individual strengths and weaknesses, as well as unique critical success factors. While the Single-Strategy Boutique will continue to command a large share of assets, we forecast that the Multi-Capability Platform model will experience the highest growth going forward.
 

  1. Single-Strategy Boutique: In many ways the standard hedge fund, the Single-Strategy Boutique is built around a core investment capability. The critical success factors for the Single- Strategy Boutique are strong investment returns and concentrated focus, in particular around distribution strategy and resources. This model benefits from simplicity: being easier to manage and providing a straightforward story for potential investors. However, the model’s growth potential is limited as it likely suffers from investment capacity constraints, and it will increasingly struggle to attract attention from the major institutional and high-net-worth intermediaries. Organizational balance is hard to achieve and maintain in these investment-dominated businesses. As a business, constrained growth will cap any potential economies of scale, and this model will also be susceptible to revenue volatility (even with the Enduring Firm fee and liquidity structures in place).
  2. Multi-Capability Platform: The Multi-Capability Platform represents the hedge fund version of the typical multi-product traditional firm. It also differs from legacy Multi-Strategy firms by unbundling strategies and teams into more distinct product offerings. This model is based on a series of distinct investment capabilities which leverage a common business infrastructure, brand and distribution. Its critical success factors are highly effective business management and strong alignments across investment capabilities. The Multi-Capability Platform model has high growth potential and benefits from being scalable, maintaining a diversified revenue-stream, attracting more attention from institutional and high-net-worth intermediaries, and realizing better support and attention from operating and trading counterparties. The primary challenges are creeping business-management complexity, difficult distribution decisions (either too focused or too dispersed), and the risk of a “star” team or personality rising to disrupt organizational stability.
  3. Merchant Bank: This model represents the “heirs to Wall Street” firms with capabilities across a range of disciplines beyond asset management, such as M&A advisory, origination, or market making, coupled with core capabilities in alternative asset management. Its primary success factor, therefore, is the strong collaboration, synergies and alignment across the firm’s breadth of services. This is a less common model, but benefits from the perception of a unique investment “edge” and highly diversified revenue streams. On the other hand, this model is the most complex to manage and has high potential for conflicts of interest.
  4. Converged Traditional-Alternatives Manager: This is a franchise that transcends the traditional-alternatives divide, with strong, integrated investment capabilities powering both traditional and hedge fund strategies, under a common business infrastructure, brand and distribution. Its critical success factors are effective integration of the alternatives and traditional businesses, with strong and deep alignments. The model has the greatest scale potential and likely benefits from a legacy market presence, brand, infrastructure, and diversified revenue streams.


However, the converged model is very difficult to execute: effective investment integration is a major challenge, including eliminating likely conflicts, as is the development of a single distribution infrastructure.

As of 2008, no single business model dominated total hedge fund assets, but the largest share was held by Single-Strategy, followed closely by legacy Multi-Strategy. Our forecast is that by 2013 legacy Multi-Strategy will lose substantial share to Multi-Capability Platform firms. Multi- Capability Platforms are more scalable than Multi-Strategy firms, have a stronger investment proposition to buyers and are more conducive to organizational balance and alignments. In fact, our model shows a large portion of 2008’s legacy Multi-Strategy managers converting back into Single-Strategy Boutiques or making the leap to become Multi-Capability Platforms.

A Distinct Fifth Model:The Alternatives Holding Company
A final business model that is not an Enduring Firm per se, but will likely play a growing role in the hedge fund industry, is that of the Alternatives Holding Company. In general this can take 2 forms: either a seeding-oriented model where an important long-term objective is eventual affiliate maturation and independence or a model built around investing in managers at scale and creating a diversified mix of affiliates, without the elements of seeding that resemble venture capital investing. Historically, financial holding companies concentrated on hedge funds almost exclusively focused on seeding, but this has changed in recent years.

In this model, the holding company parent will have limited operational interaction with affiliates, without any major attempt to integrate business or distribution functions. Specific to hedge funds, the holding company should be open (and perhaps prefer) minority stakes. For many managers, but especially Single-Strategy Boutiques, selling a stake to an Alternatives Financial Holding Company can be an effective step towards ensuring long-term internal alignments are strong, while facilitating an inter-generational transfer of ownership and management.

Funds of Hedge Funds Evolve
The fund of hedge fund industry is facing its own set of challenges, all of them closely related to the problems hedge fund managers need to address. As with our overall projections, our fund of hedge fund projections are predicated on the assumption that there will be a class of funds of hedge funds that are themselves able to evolve into Enduring Firms, a list which will likely include both legacy leaders as well as newer groups.

The fund of hedge fund specific challenges fall into 2 groups:

Liquidity: As with hedge funds themselves, liquidity bedevils the fund of hedge fund industry. There is a short-term tactical element to this problem: the majority of 2008 redemptions occurred at the fund of hedge fund level, putting severe strain on these businesses, triggering gates and suspended redemptions. The underlying problem remains the same as that which plagues hedge funds: the commingling of a wide swathe of underlying strategies holding wildly divergent liquidity profiles together with a mixed investor base with different liquidity requirements.

Application & value-add: As investors and advisors move away from looking at hedge funds as a single amorphous allocation, and start to use hedge fund strategies within their allocations to equity, fixed income or illiquid assets, fund of hedge fund offerings will need to reflect this new reality. Furthermore, the growth of specialist consultants whose services overlap with some fund of hedge fund functions introduces new questions among investors about precisely how they should use funds of hedge funds.

The solution to the underlying liquidity challenge is to fully align liquidity terms with investment liquidity and investor requirements, similar to the Enduring Firm hedge fund. This means segregating investors by liquidity requirements into distinct funds or share classes and maintaining that alignment down through the underlying hedge fund managers. By definition, this means that illiquid strategies will have no role in liquid fund of hedge fund portfolios.

The bigger evolutionary leap is around funds of hedge funds’ application and value-add to investors. This will require 2 major changes in perspective. The first centers on a strong validation of funds of hedge funds’ value proposition, which will vary substantially by firm and could include one or more of the following: manager sourcing, access and research, due diligence and monitoring, strategy allocation, portfolio construction and management. Secondly, funds of hedge funds must clearly articulate how to best package this value proposition.

What is certain is that the classic funds of hedge funds offering a broadly diversified commingled portfolio with a diverse array of managers representing the hedge fund strategy universe will lose share to another, more focused packaging set that builds on investors’ changing perceptions regarding hedge funds.

As with hedge funds, there are some common best practices that characterize the next-generation funds of hedge funds.

Conclusion
The hedge fund industry’s recovery and future prosperity depend on correcting the poor longterm alignment that exists between investors, firms and investment teams. Future alignment structures will match investor liquidity needs, portfolio liquidity, investment horizon, performance measurement and payout periods. Liquidity terms will vary by firm and strategy but will be a direct function of the investor base and the strategy’s liquidity characteristics. In many cases, a rolling notice period will supersede the cumbersome legacy liquidity terms of lock-ups and gates. The high-water mark feature will fade and firms will measure performance fees on a continual rolling basis. Multi-Capability Platforms will thrive, while Single-Strategy boutiques will maintain market share.

Funds of hedge funds will consolidate their role as chief hedge fund investors, but to do so, most will need to overhaul liquidity practices, change product and service offerings and re-affirm their core value proposition to investors.

PARTING THOUGHTS: THE NEW ACTIVE MANAGEMENT
We remain optimistic on hedge funds’ future, perhaps because of, and not in spite of, the crisis and turmoil. The industry’s current trials will, no doubt, result in a dramatic reconfiguration of the hedge fund and fund of hedge fund landscape, a wrenching process which will hurt competent managers and damage otherwise good
businesses.

However, this process also represents a unique opportunity for this industry to finally mature, shedding many practices, standards and anachronisms that ultimately hold back hedge funds and their managers. This includes an operating model that no longer works, poor transparency practices, an anti-regulation mindset, outdated terms, and poorly aligned fees and compensation schemes. In sum, a business model designed to maximize short-term volatility.

Ultimately, hedge funds have the opportunity to be at the forefront of asset management, and vie for control of a far greater asset pool than the $2.6 trillion we estimate. This is the really big prize for hedge funds: if they can get the alignment and business balance right and become fully-fledged asset management companies, this industry will redefine the products and services that characterize “active asset management.”

Hard copies of the full 52 page report are available on request from The Bank of New York Mellon by emailing AIS_Europe@bnymellon.com