Imagine for a moment that the hedge fund industry contains three parallel sectors, divided not by investment strategy or geography but by size of firm. One includes firms managing $1bn or more in assets - there are 703* of these accounting for 88%* of the total hedge fund industry AUM. This group’s star managers feature regularly in the pages of The Wall Street Journal and the Financial Times. Many of its constituents are big institutionalised businesses and its clients include some of the largest institutional investors in the world, such as sovereign wealth funds and public pensions. It contains only a little more than 10% of the industry in terms of numbers of firms but manages close to 90% of the assets.
Much attention focuses on the “billion-dollar club” and firms close to attaining this status. Industry research and performance indexes tend to be skewed to the larger firms. Consultants’ lists of approved hedge funds are dominated by the larger brands. The second sector contains firms managing between $500m and $1bn – there are 319* of these managing 6%* of the total hedge fund industry AUM. Its investor base includes large institutions but family offices and funds of funds are more prevalent. Many of its constituents are building brands and thinking about the steps they need to take to exceed the $1bn threshold.
Then come emerging managers - those that AIMA define as having AUM of up to $500m USD – there are 2052* of these, also managing 6%* of the total hedge fund industry AUM. These managers feature many entrepreneurs and start-up businesses. They are often the cradle for the industry’s innovations. Yet much less is known about these smaller firms. Until this research, we did not know, for example, that the average break-even point for sub-$500m firms is about $86m – or that a third of these firms run profitable businesses with less than $50m in assets. This is a significant finding, since other surveys - of the industry as a whole – have suggested that the average breakeven figure is several hundred million dollars. Those data points were heavily influenced by the largest businesses in our industry. It stands to reason that a firm with hundreds of employees and institutional clients in numerous jurisdictions would cost substantially more to run than, say, a five-person outfit managing assets for a small number of clients (as well as its own money).
Our research also sheds new light on the impact of broader trends and themes on this segment of the industry, such as fee pressures, the impact of post-crisis regulations, demands for ever greater methods of alignment of interests, and the optimum mix between in- and out-sourcing.
Smaller hedge fund firms comprise an essential constituency for both our organisations. Sub-$500m firms make up about two-thirds of AIMA’s fund manager members, while GPP is of course a leading prime broker for small and mid-sized hedge funds. We are pleased to be working together to provide insights into this important community, which reflect both the industry’s past, when hedge fund firms were generally smaller and more reliant on investment from family offices and funds of funds, and its future.
Chief Executive Officer, AIMA
Head of Prime Brokerage, GPP
Sample: We surveyed 135 small and emerging hedge fund managers worldwide with $16bn in combined AUM. Half of the sample are five years old or less. We also spoke to 25 institutional investors. About three-quarters of managers we surveyed fall into the big six categories: equity long/short; global macro; fixed income/credit; CTA/futures; event-driven; and multi-strategy. The rest include niche strategies such as risk premia, big data-driven investing, trade finance, long-only options, and special situations.
The findings are categorised into four areas: profitability; fees and expenses; operational challenges; and growth.
Profitability: Surveys of the industry overall have suggested that hedge fund firms need to manage several hundred million dollars in assets in order to break even. But those averages can be skewed by data from larger firms. Among respondents to our survey, the average breakeven point is around $86m, while around a third are able to break even with $50m in assets or less. By strategy, breakeven is highest for global macro hedge fund firms ($132m) and smallest for credit hedge fund firms ($77m).
At the same time, the costs of regulation continue to weigh on smaller firms, with almost 90% of respondents allocating up to one-fifth of their total expenditure to compliance, with this number expected to increase when firms adhere to MiFID II.
Fees and expenses: Our findings show that the 2&20 fee structure is less common among smaller managers. In terms of the management fee, only 14% charge 2% or more and about half charge 1.5% or less. For new fund launches, management fees among sub-$500m managers are now only 1.25% on average. In terms of performance fees, about two-thirds of smaller managers are charging less than 20%. About three quarters (77%) expect performance fees to remain unchanged over the next year; 11% expect a decrease and 12% expect an increase.
Methods of aligning interests between smaller managers and fund investors are growing. Close to 90% of funds have a high watermark – a peak value above which performance fees can be charged. Roughly one-in-three have hurdle rates – a further trigger for performance fees agreed between the manager and investor. And while less common, 8% of smaller managers say their flagship fund provides fee clawbacks to investors under certain conditions.
Operational challenges: Legal services are the most outsourced function - only 16% have this as an in-house resource. COO, marketing/IR, risk and compliance functions are more likely to be filled by in-house roles, with 88% or respondents having an in-house COO.
Growth: More than 80% of respondents plan to increase their headcount in the next 12 months. Half of those intend to increase staff numbers by up to 50% over the coming year. Plans for increases were particularly common amongst those managing equity long/short, event driven and multi-strategy funds.
Two-thirds of managers’ primary method of capital-raising is via marketing and IR activity, followed by presenting at conferences (37.5%) and working with a third-party marketer (34%). A further 14% say they are pursuing seed funding.
In conducting this survey, we reached out to small and emerging manager hedge funds (defined as those managing less than $500m in assets) to understand better how they are balancing fees and costs, whether they are outsourcing or hiring dedicated personnel, and how they are growing and differentiating themselves in the current environment.
In addition to the above, we surveyed various hedge fund allocators to help us understand better their views and expectations on the emerging manager universe.
- Hedge fund manager survey with input from 135 hedge fund managers globally representing approximately $16bn in assets under management (AUM)
- Input from global investors including pension plans, endowment and foundations, and fund of hedge funds, who allocate up to $79bn to hedge funds.
- Input from AIMA’s Next Generation of Managers Working Group during a series of round table meetings to discuss initial findings.
- Demographics of respondents: emerging managers at a glance
- Demographics of respondents: allocators at a glance
- Fees and expenses
- Operating model
- Growing the business
- About GPP
- About AIMA
Breaking even is doable
Making a profit is the key aim for any business. A crucial milestone to meet in delivering profit is being able to break even1 in the first instance. As with any start-up business, this is especially pertinent. Businesses of all types that are starting out incur a high burn-rate on their working capital. Hedge funds are no different. That said, the firms that participated in this survey suggest that cost containment within these early years is achievable.
Across the firms that we surveyed, global macro managers stand out as the most expensive hedge fund business to operate, with an average breakeven of $132m. Making up the top three most expensive hedge fund businesses (according to their strategy) were event-driven strategies, which had an estimated breakeven of $108m, followed by multi-strategy hedge funds with an estimated break-even of $98m.
Each of these strategies have among the highest number of employees (or headcount) on average. The weighted-average, median headcount for global macro was the highest of all strategies with the average firm employing 12 people. In comparison, CTA/managed futures, which are typically more computer automated and systematic in nature and need less human capital, have a more competitive break-even level. The average CTA that responded to this survey had a staff size of just three people.
Will the breakeven point change?
An absolute majority (55%) of firms believe that their breakeven point will remain the same. In contrast, approximately 40% expect their breakeven level to increase while just under 5% expect it to decrease.
Despite the majority of respondents anticipating that their firm’s breakeven is unlikely to change, one may be tempted to exercise some caution, especially for those managers who are required to be MiFID II compliant (starting from next year). Perhaps, another cost challenge that some managers may need to consider (particularly any UK based managers) is the impact that Brexit may have on their business and their ability to carry out business in any new regime outside of the EU.
Across the industry as whole, hedge fund fees have been the subject of increasing scrutiny, but managers and investors are showing their willingness to work with various structures to align with investor demands better and help ensure that their businesses remain viable.
When we asked what the typical management fee that small and emerging managers were charging to their investor, we observe fee pressure being most acute for start-up managers. In contrast, the findings from this survey reveal greater resilience from some of the more established managers. Overall, metrics to support the performance fee seem more resilient.
Management fees: Half of emerging managers charge a management fee in excess of 1.5%, but pressure is beginning to show for start-ups
Key topics regarding fees and expenses that are covered, include:
- Digging deeper into the management fee by strategy
- What price for the next big allocation?
- Performance fees: while there has been some pressure on management fees, incentive (or performance) fees are relatively unchanged
- Fee structures are evolving to align manager and investor interests
- The ultimate alignment of interests: skin in the game
- Costs: emerging managers are just as vulnerable to costs than their more established peers
- Operating costs
- Regulatory costs
Alive and kicking
Taking all of the above analysis on fees and costs, we can observe that it is possible for start-up and emerging managers to operate a business. That is, they are able to cover their costs and remain viable with a relatively modest AUM, even before considering what performance fee revenue they might generate.
This section looks at how emerging managers are operating their businesses, and how they are using the outsourcing model to their benefit in some areas but opting for in-house, specialist resources for certain key functions.
Across our sample of managers, the core pillars of the firm’s operations are managed in-house. Arguably, after the Chief Executive Officer (CEO) and the Chief Investment Officer (CIO), the Chief Operating Officer (COO) is the next most important role in the hedge fund business. Not surprisingly 88% of the manager respondents confirmed that this position was managed in-house. Indicative of the increasing regulatory challenges, and the variety of hedge fund strategies pursued by respondents to this paper, we observe that another prominent in-house role is that of the Chief Risk Officer (CRO) with over 80% of our respondents having this as an in-house role.
Related to this, both the roles of Chief Compliance Officer (CCO) and Chief Technology Officer (CTO) are also carried out in-house with over two-thirds of all respondents declaring that they have a dedicated in-house chief-compliance resource and nearly half of all respondents declaring that they have a dedicated resource working as a CTO. Capital raising and business development are integral to any start-up and growing business. Indicative of the increasing importance of this role in the small and emerging manager universe that we surveyed, nearly 90% of all respondents have a dedicated in-house resource to this area.
Perhaps unsurprisingly, the resources most often obtained from outside of the funds are legal, Human Resources (HR) and technology. This is especially true of funds with a smaller AUM.
According to allocators that were surveyed, 61% require emerging fund managers to have dedicated back office personnel (reports and reconciliation): 57% favour dedicated middle office staff (trade support predominantly). Dedicated personnel in capital raising (4%), legal (13%) and treasury (13%) were the least required.
Anecdotally, we recognise that in smaller firms, one person often carries out multiple roles. For example, the COO could perform the risk management responsibilities in addition to managing operations, and Legal Counsel can sometimes cover the compliance role in addition to their legal oversight role.
Only 39% of allocators say that excessive outsourcing weighs on their investment decisions. Hedge fund firms could outsource more. The pedigree of the hedge fund’s service providers does weigh on 78% of allocators’ investment decisions, as allocators recognise the benefit of working with best-inclass providers.
Outsourcing versus-in house
Our survey shows that managers and allocators alike have fully embraced the concept of outsourcing, which can lead to efficiency gains for the manager. The role of Chief Operating Officer (COO) and marketing, investor relations, risk and compliance functions are the most favoured to be conducted in-house. Legal services is the most popular function considered for outsourcing.
What are the most popular hedge fund strategies that outsource?
When we analyse the data across the various hedge fund strategies that reported, we find that event driven managers outsourced the most on a proportional basis versus their peers. Conversely, multi-strategy did the least outsourcing.
There were also some clear trends when drilling down into the individual roles and the various hedge fund strategies that they supported. A Chief Legal Officer was one of the least likely roles within the hedge fund firm to have a dedicated in-house position. Within that result we see that none of our global macro and event-driven respondents have made internal appointments in this role whereas multi-strategy hedge funds bucked the trend somewhat with higher than average hires here.
The most insourced role was the COO. Reassuringly, all the manager respondents followed this trend; there were no significantly underrepresented strategies here.
As mentioned previously, event driven was generally the most prominent at outsourcing. When investigating further, we found that this was consistent across all the roles surveyed, apart from the COO, which they did not outsource at all. Conversely, multi-strategy consistently outsourced less than average in every role surveyed, which could go some way to explaining their higher-than-average breakeven.
Alive & Kicking
AIMA/GPP Emerging Manager Survey 2017
The next generation of hedge fund firms
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