Fewer launches, more liquidations
Industry data shows that more hedge funds liquidated in 2016 than in any year since 2008 – the most on record. Launches have also been on the wane. Between 2011 and 2014, more than 1,000 funds launched each year. In 2015, the number dipped below 1,000. Last year, fewer than 750 funds launched – the lowest total since 2008. In short, running a hedge fund business is not for the faint hearted. Getting off the ground is hard enough. Survival is harder still. The past three years have been a perfect storm of crowded trades, market turbulence, disappointed investors and squeezed margins.
Star manager success rate
Before looking at costs and cost saving techniques, we wanted to use this report’s first section to provide some further context to the environment in which new hedge fund founders find themselves. What can a firm do – or be – to best improve its odds of survival? Which types of start-up are ‘breaking even’ and able to consider cost saving techniques? Some of the most lauded new hedge fund founders have struggled to make the transition from star trader to star manager, and not for lack of talent. And yet, there are certain traits and attributes that appear to make it more likely for a new hedge fund to survive the initial headwinds and ‘break even’ on revenue and costs.
The Insights team tackled these questions by analysing the statuses of the first 100 hedge fund firms to feature in HFMWeek’s ’20 For’ series, an annual list of the 20 most exciting prospects among hedge fund start-ups. At the time of writing, six such lists have been compiled. Only the managers from the first five have been included in the analysis (the ‘20 for 2017’ article, published in October 2016, was discounted as constituents were deemed too new to be considered statistically significant). For each entrant, we looked at whether or not the firm was still in operation, and, if so, whether or not in August 2017 it had at least $1bn in AuM. From there, we looked at the background of the firm, concentrating on two key attributes: founder pedigree and investment strategy.
Success rate – by pedigree
Our findings suggest that founders coming from ‘brand name’ hedge fund firms (in this case, firms that at their peak had $5bn or more in AuM) were more likely to start a firm that has not only survived but gone on to pass $1bn in AuM (Exhibit 1.1). This group was also the most populous, accounting for 49 of the 100 (naturally, considering the pool was the industry’s most exciting prospects). Either way, the contrast with the 13 founders that plied their trade at smaller hedge fund managers is stark. This is not to suggest that founders with such backgrounds are not as talented as their more prominent peers, only that they face even greater obstacles in their route to success. It will likely be harder to raise capital and there will likely be less first-hand experience of how an industry leading business is run.
Hedge fund spin-outs from investment bank prop desks (the second most populous group with 20 examples) have enjoyed mixed success. A similar proportion of firms have passed $1bn in AuM (25%) as have liquidated (30%). Similarly, firms whose founders herald from the alternatives divisions of traditional asset managers tend to have survived (90%) although few have gone on to surpass the $1bn mark (20%). None of the ’20 For’ firms whose founders are from hedge fund allocators have liquidated. However, this was the least populous group (just 8 examples), and does included Emeth Partners, the equity spin out from Harvard Management, whose main fund has since been taken on by Clough Capital.
Success rate – by strategy
Exhibit 1.2 illustrates the fortunes of the 100 ’20 For’ managers when the data is sliced by investment strategy. Again, there was a topheavy category, with 42 firms running a predominately equities-themed fund. Despite the difficulties many equities managers have faced in differentiating themselves, the data suggests that firms with global macro funds had the highest rate of liquidation, 30%. However, firms from ’20 For’ founders running global macro and multi-strategy funds also fared particularly well, with 60% of both groups now managing more than $1bn. Chief among the global macro success stories is Rokos Capital, from former Brevan Howard partner Chris Rokos, demonstrating the potent mix of star power and under supplied strategy.
Comments and observations
The current statuses of ’20 For’ emerging managers, therefore, suggests that many start-up firms have struggled to build sustainable businesses if they both run non-equity hedge strategies and their founders were not at industry behemoths. As Exhibit 1.3 shows, almost half of the ’20 For’ liquidations are from this group (as are just 17% of ‘20 For’ firms now managing $1bn in AuM or more). Combining the results of this analysis with the results of a recent study from AIMA and Global Prime Partners (GPP) on ‘break even’ trends for emerging managers allows us to make several observations:
1) Non-equity strategies need more assets to break even…
Emerging managers with a founder who does not boast the ‘star power’ background of a tier one investment bank or hedge fund firm will always find it harder to raise assets than those who do. And their task is made doubly difficult if they’re running global macro, event driven or multi-strategy funds, all of which typically have a break even AuM close to or above $100m (Exhibit 1.4). The average equity long/short fund, meanwhile, requires just over $80m in AuM to break even. This also helps explain the high proportion of liquidations amongst non-equity funds from well-known ‘20 For’ managers.
2) As do most spin outs from investment bank prop desks
Of the five ’20 For’ prop desk spin-outs that have liquidated, all were focused on investment strategies other than equity hedge. Notable examples include: Edoma Partners, the event driven offering from the former head of Goldman’s prop desk, Pierre-Henri Flamand; and Avantium Investment Management, a 2011 spin out of Deutsche Bank’s emerging markets macro team. However, prop desk spin outs in general are less likely to run long/short equity funds: only 15% of ’20 For’ start-ups with investment banking pedigree did so compared to almost 50% of all other ’20 For’ firms.
3) Talent was not the missing ingredient for prop desk failures…
Did higher break even points contribute to the failure of some prop desk spin outs? It certainly wasn’t a lack of trading skill or star power. Industry commentators were quick to use the failures from the initial wave of Volcker Rule spin-outs as examples of prop desk traders building overengineered, costly and inflexible business infrastructures in the mould they were used to. Either way, launching products with bigger teams and more complex strategies than the typical hedge fund start-up clearly made getting to break even that much harder for many investment banking veterans.
4) But non-equity ‘brand name’ hedge fund talent is in short supply
Despite their higher break even points, several ’20 For’ global macro, event driven and multistrategy start-ups have gone on to become some of the biggest new firms in the industry. What they have in common is star power pedigree. More than 40% of ’20 For’ firms now managing $1bn in AuM or more are from founders with a strong hedge fund pedigree running non-equity focused strategies. One conclusion is that high quality ‘non-equity’ hedge funds are in short supply, and those with founders from brand-name hedge fund managers are well placed to hoover up investor interest.
5) Fixed income hedge fund managers are first to turn a profit…
Fixed income has one of the best survival rates – and one of the better success rates for hitting $1bn in AuM – among the ’20 For’ emerging managers, and the AIMA/GPP data offers a partial explanation as to why. The strategy has the lowest break even AuM among the strategies listed, $77m, and is also producing the biggest profit for its managers (Exhibit 1.5), with a difference of 77bp between the group’s average management fee (1.43%) and average operating cost (0.66%). In short, fixed income funds are profitable sooner and earn more when charging industry standard fees.
6) Although multi-strategy managers could afford to charge bigger fees
Despite having close to the highest operating costs among all major hedge fund strategies, they also have the second lowest average management fee (Exhibit 1.5). There is only a 13bps difference between the two and, in addition, the AIMA/GPP data suggests that the strategy has the third highest break even AuM at just under $100m. Could multi-strategy hedge fund managers afford to charge more for their services? Perhaps. Although HFM’s analysis of its ‘20 For’ firms also suggests that new multistrategy managers have been particularly successful in building their AuM.
As is clear, impressive AuM, track record and resources, are, in themselves, no guarantee of survival. Nor is reputation. If hedge fund liquidations last year were at their highest level since 2008, it is also significant that the recent cull has included several well-known firms hit hard by unexpected market movements. Last year saw the shuttering of, among others, 28- year industry stalwart Perry Capital and London-based equities shop Nevsky Capital. This year has seen the closure of former Citigroup oil trader Andy Hall’s Astenbeck Capital Management and, perhaps most notably, Goldman Sachs luminary Eric Mindich’s Eton Park Capital. All four firms were multi-billion-dollar money managers at their peaks.
Eton Park is also noteworthy insomuch that the firm still had a reported $7bn in AuM at the time of its closure. In his letter to investors explaining his decision, Mindich said his team had been “unwilling to compromise on the business model and investment program in which you invested or the way in which we have pursued it”. Lofty expectations are a double-edge sword, of course, but more damaging is the limited room for manoeuvre the current environment affords. Building a firm with a top tier infrastructure is hard enough. Building a firm with a top tier infrastructure that can remain profitable during the full spectrum of market stresses is hugely challenging.
Luck, judgement and resources
In many ways, new hedge fund managers have an advantage over industry veterans. Launching today means a founder can build a firm designed to deal with contemporary challenges from day one, rather than spend the considerable time and resources needed to get an older infrastructure up to speed (this issue will be covered across our upcoming ‘Technology’ reports in Q4 2017). Of course, this benefit is afforded every generation of start-ups. But, without wishing to sound naïve, one might argue that contemporary expectations and the pace of change are such that business owners today are attuned to the importance of futureproofing like never before. As a result, building a hedge fund in 2018 will require a lot of forward thinking, a fair amount of luck, and no small amount of resources.
Through HFM Insights research and proprietary HFM data, Exhibit 1.6 provides a flavour of the resources managers of varying size will need to run a sustainable business. These costs have been divided in two: those from ‘internal’ sources and those from ‘external’ sources. In the next two sections, we will look at the key trends in internal and external costs and the techniques that emerging and established managers are using to save money.