Alternative Asset Managers: Does Going Public Skew the Risk-Reward Continuum?

I think of the financial markets and its components as a mish-mash of overlapping, yet compressed Kondratiev waves (instead of long cycles of 50-60 years, say, 20 years), with boom/bust cycles characterized by overshooting in both directions (assets become too dear at market tops and too cheap at market bottoms). And I view both returns and assets under management (AUM) in the alternative asset space in the same way. When returns are relatively attractive assets flow in, after which point it becomes harder and harder to maintain relative out-performance. During this phase risk goes up as market participants reach for return, increasing volatility near market tops. Predictably, both fewer good investment opportunities and heightened risk leads to decaying returns, causing assets to flow out. Once enough assets have left, fear and uncertainty prevails and relatively attractive investment opportunities again become available. Returns can once again begin their ascent.

There exists an efficient frontier of investment, with returns on the y-axis and risk on the x-axis, which slopes upward and to the right. At the far left you have instruments like T-Bills and short-dated, AAA-rated agency paper. These instruments are characterized by high liquidity, low repayment risk and relatively low returns. Basically, near-cash assets. At the far right you have private equity, venture capital and other long-dated, illiquid investments. These investments are characterized by poor liquidity, high repayment risk an relatively high returns. If one sought to liquidate these investment before they fully matured, there would be a large haircut suffered by the investor. Now, it is possible (in my opinion) to generate alpha all across this continuum, though alpha needs to be normalized relative to the risk being taken to extract this excess return.

Through economic and market cycles this efficient frontier will shift, and will generally flatten in boom times and steepen in bust times (as the premium required to hold risky assets rises in adverse market circumstances). This is the way things have generally worked, with motivations around performance pretty well-aligned, particularly in the less liquid, alternative asset space where the concept of carried interest prevails.

But what happens if this carried interest model is broken and some other motivation begins to effect manager decision-making? Say, if someone was willing to pay you more money not for performance fees, but for management fees. Seems kind of perverse, right? Well, think about the motivations inherent in alternative asset management firms that go public:

Equity investors like annuities, cash flows that exhibit relatively low volatility, high persistence and, therefore, good predictability. What is a cash flow like this called in an alternative asset management firm? A management fee.

Jenny Anderson had an interesting piece in today's New York Times  on this very issue today.

The crucial factor in that argument (for alternative assets) is, of course, those stellar returns. So it is not altogether surprising that some pension funds and endowments are a bit flummoxed over the current stampede of private equity funds and hedge funds lining up to go public.

As large investors, or limited partners, in the funds, the endowments and pension funds are concerned that the short-term interests of public shareholders might make it harder to deliver the same kind of returns. A public company takes time and attention that were formerly focused on investing.

“All things being equal, we would rather they stay private,” said Christopher Ailman, chief investment officer of the $170 billion California State Teachers’ Retirement System. “But we understand why they are doing it.”

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Then there is the alignment of interests and compensation. Private equity and hedge fund managers argue that the genius of their compensation is not just the size of it, but the fact that their interests are aligned with investors. They take 20 percent of the profits and investors get 80 percent.

But managers also earn a management fee, usually 2 percent of assets managed, which was originally intended to cover the cost of running the business. In public companies, management fees are awarded a higher multiple of earnings than incentive fees, which means that bigger management fees translate to a better share price. The best way to raise the management fee is to manage more money, which inevitably makes bigger returns harder (size, it is said frequently in money management circles, is the enemy of performance).

So to help shareholders, the public firms need to pump up management fees (gather more assets) and manage buying and exiting more carefully (to make the earnings stable) and further diversify the revenue streams. None of those things are necessarily good for limited partners.

So, in theory, the rational play for these newly-public alternative asset managers is to create massive, diversified asset gathering machines, maximizing management fees while being more risk-averse as it relates to their core investing activities. Why kill the golden goose by overreaching for return? The risks to AUM and brand value posed by a big investments with large but highly volatile payoffs just aren't worth it. If the true economic motivation is to grow assets and, therefore, management fees, then you can understand an increase in risk aversion among the principals of newly-public alternative asset managers.

Now consider with this behavior does to the efficient frontier discussed above:

I'd posit that public alternative asset managers almost become a new asset class in and of themselves, shifting to the left along the risk/return continuum. Lower risk, lower return, due to the emphasis away from maximizing carry and towards maximizing the more highly-valued management fees in a public format. Private managers, however, will remain where they are, naturally buffeted by the ups and downs of economic and market cycles that directly impact their returns and, therefore, their carry. Their public brethren, however, will be far more insulated against the vagaries of the market due to their scale and the relatively high ratio of management fees to overall fees.

So you can see why legacy LPs are squawking - they want this IPO trend to go away. But they are powerless to do anything about it.

Comments

[Eclectic Contrarian]

As these large hedge funds IPO and move their asset allocation down the risk spectrum, wouldn't that also decrease the amount of attention being paid to assets higher up the risk spectrum relative to the pre-HF IPO world? Sure, they get more stability, but that could also open up opportunities that wouldn't have existed had they remained private. I certainly wouldn't complain if this happened in any shape or form!

[Soren]

Roger,

Great post. What do you think of the Och-Ziff excuse/explanation of using an IPO to raise "hurt money" (link here: http://www.financialnews-us.com/?page=ushome&contentid=2448323994 )?

Is this just clever marketing and Daniel Och is just after exactly what you laid out above, or is there something to using the IPO to more closely align the partner's and the investor's pain points?