Ready for branding?
As seen in the previous chapter, senior operational staff are only too aware of the damage an ill-conceived product launch can have on a firm’s brand and reputation. Most hedge fund firms HFM Insights surveyed considered themselves ‘ready for branding’ i.e. ready to communicate their message to a wider audience (Exhibit 3.1), but the difficulty involved is evident in the almost 30% of respondents with at least $1bn in AuM that deemed themselves unready. Size is no protection against poor messaging, and branding is not to be taken lightly – especially now that competition has increased from traditional asset managers for whom it is second nature.
A key question HFM Insights wanted to address was as follows: Do hedge fund firms have a line in the sand that prevents certain types of diversification because it might clash with firm identity? Few interviewees admitted to it, but many seemingly operated within these constraints. Only the largest traditional asset managers and multi-strategy/platform hedge fund managers are diversifying beyond their core competencies, firms whose brand is defined by ‘old school’ diversification. Below that, most are staying within well-defined, strategy-specific boundaries.
But what does it mean for branding? Hunkering down on a core competency, communicating a clearly defined expertise, while also trying to maintain an element of flexibility ahead of unknowable commercial opportunities and industry events. Be the palm tree, as one US-based COO suggested. Easier said than done. Differentiating oneself as a hedge fund manager is harder than ever, and what was once the obvious solution, tying the firm’s identity to an individual, has been complicated by expectations that a business is less reliant on its founders.
Of course, key-man risk is itself nothing new. More than 80% of senior operational staff that HFM Insights surveyed said the departure of their firm’s founder could prompt the closure of their hedge fund management firm (Exhibit 3.2) – about one-third suggest their firm would close automatically. But the industry’s issues run deeper than perhaps expected.
Single founder firms
HFM Insights’ analysis of ‘billion dollar club’ (BDC) managers with a heritage in hedge funds (referred to hereafter as ‘hedge fund managers’) shows that 70% (251) of such firms have one remaining founder in an executive role (Exhibit 3.3). Combing the hedge fund assets at these firms suggests that $1.34trn is being managed by firms heavily reliant on a single individual (67% of BDC hedge fund manager hedge fund AuM). If similar calculations are applied to include hedge fund managers with under $1bn in hedge fund AuM, total assets at single-founder firms would surpass half of all industry assets ($2.9trn at the start of 2017, according to HFM Data).6
Having one founder is not necessarily a problem. During the early stages of a hedge fund firm’s life-cycle it can ensure that decisions are made quickly, the direction of travel is clear, and the investor pitch has an engaging story at its heart. Indeed, worrying about key-man risk is moot until there is a viable business to put at risk. But as a manager grows, so, too, will the need to consider key-man risk, brand, and product diversification, as well as the extent to which the three interact.
One way to address these issues is through mergers and acquisitions. Bolt-on additions to a firm can provide greater product diversification and overhaul a firm’s image, while large-scale mergers can bring in new blood and help to reduce key-man risk. A recent example of this came with the merger of Standard Life with Aberdeen Asset Management. Aberdeen, well-known for its focus on emerging markets and fund of hedge funds has been able to diversify its product offering and also, after a long series of difficult quarters, enhance its brand image through the merger.
Brand from all angles
The very largest managers – those with at least $5bn in AuM – discuss ‘brand’ regularly, exploring how their message is being received by key demographics. Investors, internal staff, the media, and ‘the street’ may all have a different perspective on a hedge fund firm’s brand and should be approached accordingly. The savviest firms will go further. Does their brand mean something different to investors in the US compared to investors in the UK? A professional at one BDC hedge fund manager HFM Insights interviewed said his firm leans more on the star power of its founder when pitching to investors in his home country than it would elsewhere.
At the same time, it pays to be conscious of where investor segments overlap. A senior operations professional at one London-based BDC hedge fund manager HFM Insights interviewed said that diversifying into long-only had helped the team think differently about the way they communicate with the firm’s institutional hedge fund clients. The firemen and policemen sitting on the boards of US pension funds will digest brand in much the same way that retail clients will, for example. Once at operational efficiency, managers may benefit from fresh perspectives on brand and communication simply by undertaking thought exercises on product diversification.
Sophisticated investors will monitor key-man risk regularly, requesting an update on succession planning at least every six months and/or when a significant event that affects a key individual takes place. The COO of one fund of hedge funds manager HFM Insights interviewed said he was wary of smaller firms in this respect as the founder would likely be both the CEO and PM and have fewer staff surrounding them. That said, he also noted that smaller firms benefit from less turnover in senior staff as the key individual or individuals likely have their wealth tied up in the enterprise.
Naturally, the risk associated with a key individual also increases as they age. HFM Insights analysis of the BDC data suggests that more than $300bn in hedge fund AuM is managed by BDC hedge fund firms with one remaining founder aged 60 or older (Exhibit 3.4). This applies to more than 40 firms, including 13 firms with at least $5bn in hedge fund AuM.
The spike in AuM in the 65-69 age bracket is due to Bridgewater Associates founder Ray Dalio, whose efforts to find a suitable successor at his $160bn industry leader ($122bn in hedge fund AuM, according to the latest BDC rankings) highlights the challenges facing even the largest hedge fund managers.
Dalio has been instrumental in building, if not the best, then certainly the most visible example of a distinctive ‘culture’ within the hedge fund industry. But his success here has not extended to success in reducing key-man risk. Bridgewater has endured some very public issues during Dalio’s attempts to hand over the reins. He remains highly visible today, a regular panellist at events and an active blogger – chiefly to ensure Bridgewater’s online footprint is dominated by palpable content, one suspects. Reports suggest Dalio is building a machine to ‘think like him’ so that decisions can be made in his absence. Make of that what you will. Either way, it speaks volumes about his brand.
Reducing key-man risk
1) Through management style
When a firm has just one remaining founder, management style has an even bigger impact on key-man risk and succession planning. Below are three loose camps into which the management styles of hedge fund founding principals and CEOs fit:
i) The Controller – A founder who surrounds themselves with junior staffers they can mould to their way of thinking.
Pros: The firm maintains a consistent sense of direction and style that, during times of plenty, helps shape a strong brand and reputation. Decisions can be made quickly, and new ventures – such as product diversification – implemented nimbly.
Cons: Brand is very much tied to the founding principal, increasing key-man risk. Junior ideas will be less readily considered, and poor ones from the top implemented unchallenged. Succession planning also becomes difficult, with the principal less willing to cede control. Staff turnover is likely high.
ii) The Competitor – A founder that surrounds themselves with experienced staffers and fosters a competitive environment in which decisions and ideas are challenged.
Pros: The firm has several strong personalities offering a range of ideas. Mistakes are more likely to be caught and individuals held to account. With new solutions coming from a range of sources, the firm’s brand appears robust and yet flexible, its strengths not concentrated in one individual.
Cons: An expensive solution early on in a firm’s lifecycle. Also, with the wrong mix of individuals, the firm could be pulled in several different directions at once. Internal power struggles are also more likely, creating potential issues for succession planning.
iii) The Mentor – A founder who chooses a single successor early on and encourages them to offer new ideas albeit within an established framework.
Pros: A strong sense of direction is maintained, while offering the strongest possible indication that the firm is considering its future. Investors will see a forward-thinking firm with at least two strong individuals at the helm.
Cons: The successor becomes a form of internal key-man risk. If they feel the transition of power is taking too long, they could leave for another firm or start their own. The founder then risks the sense of stability they have fostered as well as the years spent in careful tutorage and planning.
2) Through investment style
As noted earlier, diversification into related new asset classes can have secondary benefits for brand and communication. Diversification into related new strategies also reduces key-man risk. Teams sat on the biggest multi-strategy platforms – Citadel, Brummer & Partners, Millennium Management – develop their own cultures and brand, in part to demonstrate a sense of independence to investors and service providers, but also to build some flexibility into the parent’s brand. The chances today that even a mid-sized hedge fund manager joins this elite group are small (emerging enterprise Decura Investment Management came closer than most before coming unstuck in 2015). A more attainable direction lies in diversification by trading style.
i) Low risk – systematic strategies
In many ways, systematic investment managers are best suited to combat key-man risk. After all, their USP is an algorithm, not an individual. The ongoing success of Man Group’s AHL program can in part attest to that. London-based Winton Capital Management is an example of the flexibility quant firms boast. Monikered for the middle name of its founder, David Winton Harding (the ‘H’ in AHL), Winton Capital has successfully rebranded itself as a ‘Science Company’, one that just happens to operate in the investment management industry. For Winton, diversification into new and unusual technological ventures – including recently established incubators for cyber security and machine learning start-ups – is not only harmonious to its brand but expected by the marketplace. Its reliance on Harding for brand power lessens with each new endeavour. Not everyone can be Winton, of course, which is partly the point. But all quant products have a robust USP.
ii) High risk – discretionary l/s equity
At the other end of the risk spectrum, discretionary long/short equity managers face the strongest headwinds from the star-man storm. Theirs is perhaps the easiest story to tell, but certainly the hardest to differentiate. For obvious reasons, discretionary long/short equity managers are particularly reliant on their PMs for their reputation and brand. John Horseman, founder of London-based Horseman Capital, learned the price, literally, of his brand power, when, following an announcement in 2009 that he would end day-to-day management of two Horseman funds, investors redeemed $2.5bn. Even the firm’s European Select Fund, managed by different PMs, was affected. It is likely that a significant portion of the withdrawals were from institutional investors obliged to redeem following the departure of a designated ‘key man’. Either way, the risk is clear. There is only so much a discretionary manager can do with regards key-man risk – a robust succession plan is a good start.
3) Through non-eponymous branding
Regardless of core competency, there is one thing every founder can do to reduce the perception of key-man risk – avoid eponymous branding. And a trend is evident, with fewer founders naming their firms after themselves than they used to, according to HFM Insights research (Exhibit 3.5). Among BDC hedge fund managers, only 8% of firms established in the last ten years were named for their founders, compared to 11% of the firms established during the ten years before that, and 31% of the firms established prior to 1998. Even accounting for the dubious suggestion that older firms were more likely to survive and reach $1bn in AuM if eponymously named, the difference is significant.
High risk firms
Combining the factors likely to increase key-man risk, HFM Insights has created two rankings of BDC hedge fund managers for whom succession planning is particularly relevant (Exhibit 3.6). First, a list of firms where there is one remaining founder aged 60 or older in an executive position, and second, a list of even more vulnerable firms that, in addition, have branded eponymously, and rely on a discretionary core competency.