Internal Costs

Cost management is a topic of the utmost importance to hedge fund managers of all sizes. As one fund manager interviewed by HFM Insights told us “we’re constantly reviewing it. We had a budget meeting last week – where can we cut costs? Everyone is looking at expenses.” In this section we will examine the internal costs firms can alter and how they might do so in order to streamline their businesses and maintain competitiveness.
September 2017

Report Overview

Where can managers save money?

If internal costs are the easiest to cut, they are also the hardest to swallow. The HFM Insights team chose to focus on four key internal costs – the firm’s location, staff, marketing, and travel and expenses – as well as a fifth way to improve margins internally – product fees.

1) Location

Office space is one of the largest costs facing any firm. With the majority of UK and US hedge fund managers located in high-end neighbourhoods of New York and London, price per square foot can be high. Yet with investor pressure to reduce fees and costs increasing elsewhere the question is, to splurge or not to splurge?

The big tech companies’ construction of ‘mega-offices’, including Google’s new $1bn London HQ and Apple’s $5bn “spaceship,” has been cited as a sign of hubris and costs getting out of hand. The hedge fund industry is by no means immune to this phenomenon, with a recent development in London’s Soho targeted at hedge fund clients featuring “champagne buttons” at desks, with employees able to order champagne, caviar and cocktails to their workstation.

The trend in recent years has been a move away from flashier districts and showy office blocks

Nevertheless, the trend in recent years has been a move away from flashier districts and showy office blocks. Research by Colliers International has highlighted the increasingly “footloose” nature of hedge funds; since the beginning of 2016 fund managers have rented approximately 230,000 sq. ft. of office space in Mayfair and St James’s, yet others have taken over 380,000 sq. ft. in different London locations. At the same time business rates in London have increased dramatically – one manager interviewed by HFM Insights experienced a more than 60% rise after the recent government revaluation – making an economical choice of location even more important.

Alternatives to Midtown and Mayfair

Anecdotally, as well, many managers are moving away from Mayfair or Midtown and setting up in areas such as Hudson Yards in New York and Victoria or Bloomsbury in London. This charge was led in the past by renegades such as David Harding’s Winton Capital Management or Ray Dalio’s Bridgewater Associates, who chose areas shunned by other managers as their base, but has been joined of late by a flurry of big names, including Pershing Square, Third Point and Point72. These firms have managed to achieve dramatic cost reductions in the process, with Pershing reportedly reducing its rental bill by 40%.

Figures provided by Colliers (Exhibit 2.1) show the differences in cost can be stark and certainly provide food for thought for any manager starting out or considering relocating. In London firms in the ‘hedge fund village’ of Mayfair and St. James’s paid an average of £118.00 ($152.00) per square foot at the end of the second quarter of 2017, compared to just £75.00 ($96.50) per square foot in Victoria. Meanwhile in New York City, firms in prime midtown locations paid on average $91.61 per sq. ft., compared to $80.52 in the newly popular Hudson Yards neighbourhood. Indeed, one manager interviewed by HFM Insights reported that the cost of office space in Midtown Manhattan is four times higher than what his firm pays at their Connecticut base.

Factors affecting choice of location vary widely and will inevitably include personal considerations. To quote one of the managers interviewed by HFM Insights “you cannot choose your office on the merit that it is half an hour closer to your kids’ school.” Key factors when choosing location include:

  • Cost
  • Functionality
  • Proximity to investors
  • Local regulation
  • Ability to attract talent
Do not go crazy, but do not skimp either –unless you are an established manager with an existing network, no one will want to visit you in the middle of nowhere

The ultimate consideration in any move must be what’s right for you at your current stage of business and in relation to your overall business model. Do not go crazy, but do not skimp either – unless you are an established manager with an existing network, no one will want to visit you in the middle of nowhere.
2) Staff

Another big-ticket item and one where, the axe often falls in times of crisis, is staffing. The average cost of employing a hedge fund analyst is $131k or $320k with bonus factored in, according to the HFM Compensation Survey 2016 (Exhibit 2.2). Meanwhile, several of the managers interviewed by HFM Insights asserted that staffing accounted for around two thirds of their operating costs.

As a consequence of the costs involved, reduction in headcount was the third largest area for cost reduction, behind renegotiation of service provider fees and switching service providers, among respondents to HFM Insights’ cost management survey. Of these respondents around one fifth had reduced headcount in the past 18 months as a means of improving margins, while a further 10% were considering doing so in the coming year and a half.

You pay more, but the calibre is higher. It’s more difficult to find hard workers in the UK. In the US it’s easier to run a hedge fund ‘machine’

Some of the reductions were drastic to say the least, with the COO of one US-based emerging manager reducing headcount by 40% from 25 to 15, cutting out an entire section of management. The reason? “You do not need heads of department at a start-up.”

Hiring and firing

Many of the managers interviewed by HFM Insights said that hiring in New York is more expensive than other locations from a total compensation perspective, but most seemed to accept this, with one manager saying rather than reducing employee numbers, his firm was moving jobs to New York from London. “You pay more, but the calibre is higher. It’s more difficult to find hard workers in the UK. In the US it’s easier to run a hedge fund ‘machine’.”

Staffing is a large, but sensitive cost centre. It is crucial for fund managers to remain ‘lean machines’ and position themselves for growth. Headcount should grow commensurately with the business, not ahead of it. Where possible look to the future – be innovative – with technological solutions that are being brought forward by service providers, including outsourced accounting and technology functions.

At the same time headcount must be managed in a sustainable fashion. Cut too far too quickly and you may unintentionally create a stampede for the door, as staff ‘jump before they are pushed’. One consultant interviewed by HFM Insights suggested having a “bonus reserve” in order to pacify restive employees kept on after a period of reduction, while one COO emphasised the importance of continued openness and communication with staff, particularly about the need to run a profitable business.

3) Marketing

A study in March of 2017 by researchers at the University of Buffalo and the University of Oulu in Finland found that investors were more likely to allocate capital to hedge funds with names considered to have “gravitas” than those without. Little wonder then that firms are so keen to perfect their marketing to investors. How much is the right amount to spend on such activities or indeed does such a figure even exist? What solutions are on offer to keep costs in check and what are hedge funds doing in this space?

There was more disagreement than expected among participants in the survey over the acceptability of charging for travel

Unsurprisingly, marketing was seen as the least palatable cost to charge to the fund, rather than the manager, among respondents to HFM Insights’ quarterly survey with 95% of managers deeming it unacceptable.

With regard to marketing budgets, as one medium-sized London-based manager interviewed by HFM Insights put it “you can spend as much as you like; anything from zero to whatever you want.” The same manager had opted for a third-party solution which they claimed cost them £1,000 ($1,290) per month.
  Use of third-party marketers

Analysis conducted by HFM Insights of 350 managers registered with the SEC (Exhibit 2.3) indicated that the use of third party marketers was most widespread among medium-sized firms (classified by HFM Insights as $100m-$1bn), with 36% employing one or more third party marketer, presumably as they gear up for the push towards the billion-dollar mark. By comparison, use of cap intro grew with firm size, confirming the findings of HFM Insights’ Prime Broker Pressures report, which found that cap intro services provided to smaller managers were generally of poorer quality and delivered limited results in terms of generating new leads or attracting fund subscriptions.

Of respondents to HFM Insights’ poll only one manager had decreased their marketing budget over the past 18 months in response to cost pressures – further demonstrating the importance placed on marketing activities in a highly competitive market place.

Exhibit 2.4 Analyst note: HFM Insights conducted an analysis of third party marketers used by 350 hedge fund firms filing with the SEC.

One manager interviewed for the report felt strongly that is was better to keep marketing activities in-house as this allowed the firm to build up their own network of contacts, rather than relying on that of a third-party marketer. The only time this manager considered using third parties was upon entering new more “exotic” markets, where they may not understand the investor universe. This trend was further borne out by HFM Insights’ analysis of SEC filings as approximately one quarter of marketers used were based outside of the manager’s home country (Exhibit 2.4).

4) Expenses

A firm’s travel budget will vary widely depending on strategy, headcount and AUM. A billion-dollar club firm interviewed by HFM Insights spent $1m per annum, while another start-up hedge fund spent just $5,000. Every firm will require some business travel, whether it is fund managers visiting portfolio companies or marketing teams meeting with investors. Yet is it acceptable in these chastened times to fly first class or stay in a luxurious hotel on the company account?

Striking the right balance on travel

There was more disagreement than expected among participants in the survey over the acceptability of charging for travel related to new or existing business to the fund rather than the firm. 26% of respondents deemed the practice acceptable, with a further 9% unsure and the rest (65%) rejecting the notion according to HFM Insights’ survey results (Exhibit 3.5).

With downward pressure on fees a continued presence it seems unlikely that many managers will be able to carry on justifying expensing travel costs to the fund, particularly when this involves drumming up new business. One manager told HFM Insights he could recall only two instances where travel had been charged to the fund, both of which were under the most niche of circumstances.

Exhibit 2.5 Analyst note: Respondents were asked ‘In terms of investor fee pressure, is the worst behind us?’

5) Fees

The topic of fees has been chewed over many, many times in articles, reports and at conferences and briefings, but adjusting one’s fee structure remains the single greatest area of cost control for a hedge fund manager and one which over the past few years has attracted the most scrutiny from investors.

One of the most striking findings from HFM Insights’ survey responses was that although managers regarded their own firm as having further to go on reducing fees, they viewed their own efforts far more favourably than the industry as a whole (Exhibit 2.5). Just 11% of managers surveyed considered the worst to be behind us in terms of investor fee pressure on the industry, but more than a third (35%) were optimistic about their own firm’s situation.

Responding to fee pressure

Over half of respondents (53%) had reduced management and performance fees in response to investor fee pressure; making these the most popular responses to this particular challenge (Exhibit 2.6). Meanwhile, launching a new low-fee vehicle proved to be the least popular, with only a fifth of respondents having done so. As we shall see in the next chapter firms seemed more focused on launching new ‘classic’ hedge fund vehicles as a means of improving margins, presumably as each new vehicle brings them closer to their break-even AUM.

The key is to constantly re-evaluate where you are, communicate with investors and staff and examine the various options available

We see from the survey results that there is perhaps a level of overconfidence on the part of individual managers and more work needs to be done. According to HFM data the median fee structure for hedge funds remains the classic 2 and 20, the average, however, was lower at 1.52% and 18.58%. HFM Insights expects these figures to come down further over the next few years as managers recalibrate their fees to match investor expectations.
  In summary – constant re-evaluation

A hedge fund is a business like any other – for many emerging managers, particularly those who have come from a large institutional environment, with superb infrastructure behind them, the transition to a start-up environment can be daunting to navigate and can often lead to cost overruns and wastage. The key is to constantly re-evaluate where you are, communicate with investors and staff and examine the various options available, whether that be outsourcing, technology or when necessary, headcount reduction.

Nonetheless, many of the costs incurred in the day to day business of hedge funds are externalities, foisted upon fund managers by third parties and are often difficult to control, and it is these costs we shall examine in the next chapter.