This report sets out to understand how hedge fund firms are diversifying their businesses and the challenges they face in doing so. The benefits of diversification have been well-documented – a stabilised cashflow built on a range of investor types and behaviours – and HFM Insights expected to find a rich array of examples, increasing in number with firm AuM, and differences along geographical lines. These expectations proved well founded, with more European hedge fund managers diversifying into long-only products after launching Ucits products and more North American hedge fund managers diversifying into complex alternative asset classes.
An overview of the industry by business diversification was derived mainly from analysing the services and products of the firms listed in HFM’s ‘billion dollar club’ (BDC). HFM Insights sought to identify trends in investment strategy, asset class and product vehicle diversification, slicing the data by firm heritage, size and location. The results, combined with additional qualitative research, helped us make a distinction between ‘old’ and ‘new’ diversification – the former focused on multiple asset classes and strategies offered to a relatively narrow range of investors, the latter on a single core competency offered in multiple forms to multiple investor types.
Insights in the report’s second and third sections were gleaned from research interviews with hedge fund professionals, service providers and investors, and a proprietary survey of senior operations staff at hedge fund firms. Section two focuses on the challenges of launching a new product, exploring the costs of various vehicle types and the possible pitfalls of product structuring. Diversifying through a Ucits product based on an existing offshore investment strategy proved a pertinent example. The associated risks – investor confusion, brand damage and product cannibalisation – suggest most firms should avoid pari passu and create something with distinct strategy features and investor terms.
The final section explores the relationship between diversification and firm identity/ brand. Do firms have lines in the sand that prevent certain types of diversification because it might clash with firm identity? Yes, if not explicitly. This theme offered a chance to segue into key-man risk, with further analysis of the BDC rankings suggesting that half of industry assets are at firms with a single founder. Ultimately, we concluded that diversification remains a necessary endeavour, but that competition from traditional asset managers, risks in launching unusual products, and the pressure to brand, have seen hedge fund firms restrict exploration to within their niche. Managers are learning to do more in a smaller arena.
Few hedge fund firms can seriously consider ‘old school’ diversification
Business diversification in the hedge fund industry is not what it used to be. A handful of larger multi-strategy and quant shops offer a diverse range of asset classes, vehicles and investment strategies, but the outlook for this ‘old school’ style of diversification is bleak. Where hedge fund managers once moved between strategies and asset classes with ease, they now face a market crowded with talented competitors and picky investors. Today, a firm is more likely to stay within its core competency and instead diversify into new investor services – such as balance sheet and structuring solutions – and new investor segments.
Size matters when diversifying into other alternatives, but not long-only
Analysis of HFM’s ‘billion-dollar club’ rankings found that a similar proportion of large hedge fund firms ($5bn in hedge fund AuM or more), medium-sized hedge fund firms ($2-5bn in hedge fund AuM) and smaller hedge fund firms ($1-2bn in hedge fund AuM) offer hedge and long-only funds without other alternatives investments, but only the largest firms had diversified into other alternative investments. Evidently, the resources of a manager with $5bn in AuM make a difference with regards to complex asset classes, but firms with $1-5bn in AuM have similar opportunities for diversification.
Ucits is driving European firms into long-only as US managers look to alternatives
North American hedge fund firms in the ‘billion-dollar club’ offer investors access to a rich array of alternative assets classes, whereas in Europe, thanks largely to Ucits, hedge fund firms are far more likely to have diversified into long-only. Influential in this trend is North America’s rich history in private equity and alternative credit investing. But whereas complex asset classes, EU-AIFs and ‘40 Act hedge funds are more common among larger firms, at $1bn, size is no impediment to launching Ucits funds, with a similar number of smaller ‘billion-dollar club’ hedge fund firms offering Ucits when compared to larger and medium-sized firms.
Existing investors are managers top concern when diversifying into new products
Investors are wary of anything that might take a manager’s eye off the ball, including issues relating to a product launch they are not invested in, and managers know it. Senior operations professionals at hedge fund firms surveyed for this report said that their biggest fear when launching a new product type was that this might cause existing investors confusion or concern. A fund of hedge funds investor specialising in emerging managers that HFM Insights interviewed said they wouldn’t invest early in a new product outside a manager’s core competency, preferring to observe its progress from a distance.
Half of hedge fund industry AuM is affected by ‘single founder’ key-man risk
Key-man risk is rife in the hedge fund industry, with 70% of firms managing $1bn or more having just one founding principal remaining in an executive role. Combing the assets at these firms suggests more than $1.3trn is at firms heavily reliant on a single individual in an industry built on hard work, long hours and big egos (more than $1.6trn if including assets at sub-$1bn firms). While having one founder is no problem during the early stages of a firm’s lifecycle, key-man risk grows in line with firm AuM and founder age. More than 80% of hedge fund operations professionals surveyed said their firm would seriously consider shutting if their founder left.
Ucits is affording investors new access to ‘status symbol’ hedge fund managers
With so many offshore products from ‘brand-name’ hedge fund managers closed to new investment, some institutional investors are using Ucits as a means of getting into some very exclusive clubs. Investing with a blue-chip manager isn’t just about performance, it’s about getting access to the ideas of – and potentially meeting with – a star hedge fund manager, which even sophisticated investors prize. This helps explain why larger managers can still attract flows during periods of disappointing performance, and why quite so many Ucits funds from $5bn-plus hedge fund firms are at or above $100m in AuM (71%).
Fewer hedge funds are naming themselves after their founders than they used to
One straightforward action hedge fund founders have taken to reduce key-man risk in recent years is to avoid naming their firms after themselves. According to HFM Insights research, only 8% of ‘billion-dollar club’ hedge fund firms established in the last ten years were named for their founders, compared to nearly a third of the ‘billion-dollar club’ firms established prior to 1998. Combining the factors likely to increase key-man risk – including eponymous branding and remaining single founders aged 60 or older – this report presents rankings for hedge fund managers for whom succession planning is particularly relevant.
Two in three Ucits funds from sub-billion-dollar managers are below $100m AuM
Most Ucits hedge funds launched by traditional asset managers (62%) and $1bn-plus hedge fund managers (66%) are currently at or above the symbolic $100m AuM mark, while less than half of Ucits hedge funds launched by hedge fund firms generally are (46%). However, the disparity really starts to show when Ucits products launched by hedge fund firms outside the ‘billion-dollar club’ are isolated: within this group, about one-third of funds currently have $100m or more in AuM. The result is similar even for Ucits hedge funds from smaller hedge fund firms offered via distribution platforms. In short, size – still – matters.
Product diversification can change the way a firm thinks about its brand
Hedge fund firms with at least $5bn in AuM – the most heavily diversified group in the industry – 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, leaning on different attributes of their brand when pitching to different investor segments, and using the lessons learned when marketing new asset classes and products to new investors to strengthen the way they communicate generally.
The findings in this report were based on three primary sources: research interviews conducted in person and over the telephone, a proprietary online survey, and analysis of in-house and third-party data. Research was gathered between April and June 2017. In total, more than 50 firms contributed to our research. These were mainly hedge funds represented by operations staff, as well as service providers and investors.
In section one, most of the data derives from HFM Insights analysis of the firms in HFM’s ‘billion dollar club’ (BDC) rankings, AuM as of 1 January 2017. There were 434 BDC firms in total. However, most charts only used the information of the 360 BDC firms HFM Insights considered to have a ‘heritage’ in hedge fund management – firms that had made hedge fund products a key part of their launch offering – as opposed to traditional or alternative asset management.