Hedge Funds as Asset Management Complexes - The Day Has Come

Yesterday's story in the FT about DE Shaw making a push into traditional asset management was the straw that broke this camel's back. The theme of convergence is one I've written about on several occasions during my short stint as a blogger. Closely related to this theme is that of the structure of the hedge fund industry in general, which, in my opinion, will increasingly resemble that of a barbell (mega-institutional asset managers on one end and emergent single strategy managers on the other). But come on, a few days ago it was talk of the $20+ billion Fortress Investment Management's lingering plans to go public (at some say a valuation of, what, $6 billion?!?) and now this? It was the language in the FT story that really made me sit up and take notice:

Trey Beck, who is in charge of developing the institutional business for DE Shaw, said the group, which manages $23bn in hedge fund strategies, had only about $300m in traditional asset management but planned to increase this substantially and had just won three new mandates.

"We are in the [traditional] business to manage tens of billions of dollars, and I can envisage a time when DE Shaw will have traditional asset management funds in excess of the hedge fund business," he said.

"In ten years' time it will be less important whether you are a hedge fund or a traditional manager, but whether you can generate alpha [above-benchmark returns]", he said.

Trey is certainly sounding very institutional, very un-hedge fund like. He sounds like Barclays Global Investors' describing their Alpha Tilts (index plus alpha) strategy. Let me reiterate; very un-hedge fund like. This is not to say that what DE Shaw is doing is bad or wrong, or that Jim Simons earlier decision to open a long-only strategy at Renaissance is either, only that the hedge fund industry as we know it is changing and will continue to do so.

Take Fortress for a moment. They have special situations, macro, distressed, second-lien financing, and private equity. This, my friends, is an institutional asset manager. All they need is a long-only equity book and they'll have it all. DE Shaw itself has statistical arbitrage, both quantitative and bottoms-up long/short strategies, as well as Laminar, which does distressed debt investing and which occasionally takes an activist stance in reorganizations. I am sure they have other strategies under that massive umbrella as well. With the inclusion of a long-only (or primarily long with a limited ability to short) strategy of scale, DE Shaw itself will become a diversified asset management complex. But why?

Let me offer a few possible reasons:

1. Legacy: Managers like Jim Simons and David Shaw (not to mention Wes Edens and his partners) want to build something that will last beyond their personal involvement. By creating a diversified array of strategies and delegating a sufficient amount of investment and risk management control to their portfolio managers, one can envision a DE Shaw, a Renaissance or a Fortress being successful long after their rock star founders have moved on.

2. Scale: Long/short strategies, by their nature, do not have massive capacity. The short side is forever a constraint that weighs on asset growth beyond a certain threshold, depending upon the capitalization and float of the stocks being shorted. Long-only (or principally long-only) strategies have the benefit of growth far in excess of that of conventional hedge funds; one only need look at the monster funds run by Capital Research or Fidelity to see how performance can be maintained in the face of scale on the long side. Jim Simons said his long-only strategy had capacity of $100 billion. Even without the performance fee that kind of cash flow looks pretty good.

3. Addressing a market need: Top performing managers running high quality, institutional-caliber infrastructures are not easily found. DE Shaw is one of those managers as is Renaissance. There is, quite simply, excess demand for their services. Given the constraints mentioned above concerning scalability of long/short strategies, it stands to reason that they would look beyond their principal areas of focus to address this burgeoning demand. Further, given that they are both quantitatively-oriented shops, it is not a leap for them to adapt their algorithms to a long-only model. This is smart from a business sense and neatly helps to address points (1) and (2) above.

This emergence of the institutional asset manager from traditional hedge fund roots is a new thing and, I believe, a positive thing both for these firms and for their clients. I am very confident in saying that this won't be the last we hear of top hedge funds making the leap into the long-only domain, with the consequence being the development of a hedge fund uber class that dominates the alternative investment landscape.

Comments

[Greg Battle]

Roger, I promise to consult you before my next round of vodka induced betting.

Given I'm the sporting type, I'll give you another prediction (wish that I could, but I can't claim authorship because it's already happening). If what we say is true, where will all these fund of funds folks go? Well, why be an allocator, with all the fuss with investors, fund administrators, due dilligence, paperwork, lawyers, etc., when you can change your business into being a third party marketer for funds. FoF's already have access to investors and hedge funds. Given the profitability I've detailed from management fee income, asset hungry funds will gladly give a nibble, say 50-75bps, to raise assets, leaving the investor unaffected, and the third party marketer with an annuity on assets raised for the duration they remain in the fund.

This is, without question, the purest and cleanest hedge fund "play" out there. For every $100mm I raise for a fund, for 50bps, I get $500K per annum in perpetuity (actually, $125K quarterly in advance!), for as long as that $100mm stays in the fund. No paperwork. No monthly letters. No allocation. No stock picking. No annoying investor calls. No employees. Nothing but cuh-ching.

If only I knew people who could write those big checks. Anyone? Anyone?

[Roger]

Clearly I agree. The value placed on fund-of-funds research will eventually go the way of Wall Street sell-side research. The result? Low, fixed fees, and only for those that really add value. It is only a matter of time. I think your bet is money-good. The only difference in my perception is that the fee compression will happen faster than either you or your trader-friend think.

[Greg Battle]

If I may go even further, there's another reason why the mono-strategy single manager fund is going the way of the dodo. Competition.

As my old boss so eloquently put it, "as hard as it is to manage money, it's MUCH harder to raise money." The new push for multi-strategy megafunds exist for the sole purpose of disintermediation - a way of removing the fees-on-fees structure of the fund of funds business. Remove the retail layer and "share" the savings (the internet would be an incredible aid in this effort, if it were LEGAL - c'mon Cox, "welcome to the 90s" buddy).

As more and more funds adopt a multi-strategy mandate in an effor to normalize returns through diversification (organically, via M&A, or via submanagers), there will be massive fee compression in the fund of funds world.
I actually have a running $1000 bet with a trader friend of mine that within five years, the new competitive landscape will introduce a fund of funds segment with a flat 75-150bps fee structure.

Porter's five forces in action folks.

[Greg Battle]

OK, let's explain one reason why DE Shaw, Rennaisance, and any of the other mega-funds are are going from being alpha generators to asset aggregators. It's just dollars.

For a 2% mgmt fee and 20% performance fee fund, let's do some back of the envelope calculations. A $20bn fund makes $400mm in management fee income. That's equivalent to the performance fee income on a 10% return (net). The latter is treated as variable income while the former can be treated as an annuity.

The question now is, who feeds from which trough? Between 40-80% of the performance fee is used to compensate the investment professionals, with the remainder running to net income for the equity holders in the management company. After paying for costs not expensed to the fund, the management fee income again goes to the equity holders of the management company.

Do you really think it costs $400mm/year to run a 200 some-odd person firm like DE Shaw? Do you think these expenses (headcount, rent, whatever) will double when the fund goes to $40bn? Nope and nope. (Note: Renaissance is a 5 and 40 fund!)

If I'm Simons or Shaw (or Cohen, or Lampert, or Soros, or ...), all of whom own the overwhelming amount of equity in the company, want to double their future wealth (with annuity-like assurance), double the assets under management and do t-bill+ or index+ returns.

[Did I mention that that as an equity holder in the management company, the management fees on all that money is waived - thanks LP's for subsidizing their ability to invest fee income.]

What a great business model!

[Inside Guy]

I'm pretty sure D.E.Shaw is not public.

[Yaser Anwar]

I would like to add that recently, HSBC's Alternative Fund Services (AFS) set up a structure that will enable it to service German domestic hedge funds using INKA (INKA is one of Germany's well established capital investment companies), which is already one of the largest administrators of traditional long-only funds.

In your post "Where is the Hedge Fund Industry going?" you mentioned that, "that the high end will be defined by those with the resources to support and sustain a global multi-strategy platform, with a world-class infrastructure to support the operation."

DE Shaw has those resources in place. Being a public company, like one of its competitors MAN Group PLC & Permal (recently bought by Legg Mason), DE Shaw can expand into traditional asset management businesses.