The Alternative Asset Management Industry: Inexorable Forces for Change

Hedge funds (HFs), private equity firms (PEs) and venture capital funds (VCs) are facing historic challenges, many of which are of their own doing. It is easy to point to difficult market conditions and conclude that their problems are largely due to the environment. This would be a convenient, but less than truthful, explanation. The fact is that the top tier of HFs, PEs and VCs are no longer style pure; the are all institutional asset management firms, motivated by ever-increasing assets under management and the sticky management fees that come along with it. And structural issues brought about by fees schemes and scale  have been the source of other bad behaviors.

In the hedge fund realm, the incentive fee structure is designed to motivate managers to swing for the fences when markets are against them. Big management fees. Quarterly incentive fee payouts. High water marks. These three features have caused many "top" managers to lose their senses and drop prodigious amounts of capital, risk management principles be damned. Many recent mega-losses aren't the case of simply taking the long view and getting stung by short-term volatility; this is getting carried out because of either too much leverage (the most prevalent cause of failure) or too much concentration. I had always thought that hedge funds were supposed to hedge, and were designed to generate attractive absolute returns regardless of market conditions. Such thinking is clearly a remnant of bygone days for much of the industry, where managers want the best of all worlds: stable management fees, quarterly performance fees, and the ability to suspend redemptions. There just aren't that many Steinhardts and Robertsons any more. And this is too bad for the industry and its investors.

Private equity and venture capital firms have a different set of issues. The largest shops have become fund-raising machines, coming out with Funds XIII and IX before generating returns on Funds III and IV. Cumulative management fees on the whole lot, with only modest absolute returns relative to the massive amount of capital committed by LPs. These funds have traded on early successes when assets were small, built a brand, and have been living off that brand ever since. Again, not really what investors had in mind. But LPs have made their own bed, constantly re-upping for new funds before getting paid out on prior funds. "If you don't get in on this fund you won't get in on the next one" is the constant threat. But LPs are starting to push back. Oh yes, and I predict this will show no signs of abating for a long, long time. The model is broken, and the market will fix it. But it won't be that painful for the incumbents with big brands but little absolute performance. They have already made so much money off management fees, they're sitting pretty no matter what. But this is another reason why true seed stage investing, real venture capital investing, has been deserted by the biggest names in the business. They just can't be bothered putting $1-$2 million in companies when they are investing out of an $800 million or $2 billion fund. They need to put $50 million, $100 million to work over the life of a deal. Series C and D. Not seed, A and B. The industry needs to get back to its roots. And it will. The market is pushing it there as we speak.

Today there is a historic chance for LPs to help re-shape these segments of the alternative asset management industry, and to bring them back to their original missions and risk and return profiles. But LPs need to vote with their wallets. They have been so caught up in the big brands as insurance against looking stupid for so long that many have forgotten why they got into alternative assets in the first place. Because at massive scale, the alternative asset world kind of starts to look like the traditional asset world. The world of relative returns. Not what the pioneers of and late-comers into alternative asset investing had in mind.

Comments

[Buck Woodford]

I could not agree more. Love your capitalistic mentality. The invisible hand simply works best.

[Chris S.]

"There is an increasingly efficient market in smaller venture, but in my opinion there is still a dearth of capital in true early stage venture. "

Roger: Care to square that comment? Is the market more efficient (i.e., reducing the # of poor investments -- your 1 in 25 ratio is pretty darn good), but at dollar volumes that are tiny (i.e., angels might be banding together but the total $$$ isn't there yet)?

[Greg Battle]

Andrew: it's definitely trending toward a relative returns world, especially at the megafund level with LIBOR++ style returns net of fees. However, when you adjust for the liquidity risks, with multi-year lockups and quarterly, hell, even ANNUAL redemptions on top of gating provisions, that "++" shrinks considerably. Sadly, the style-drift that investors keep such a close eye on isn't at the investment/trade level, but the management firm's purpose level as they quietly drift from being a performance business to an asset gathering business.

Roger: Efficiency and change in the hedge fund arena will only occur when LPs start demanding that funds compete on price at least as much as performance, especially at the megafund level. I'm sorry megafunds, but it doesn't cost $600m in management fee income a year to run a $30b fund. I look forward to seeing a fund of non-trivial size revolutionize the fee game (ie. adopt economies of scale on fees where the more LPs/higher AUM, the lower the fees). When you remove the asset gathering incentive, trust, funds will not only become better pure performance/alpha generating machines, they'll also right-size themselves in terms of AUM to maximize that performance.

Matt: From what I've detailed above, I actually think the larger hedge funds are taking LESS undifferentiated risk, not more, ergo the relative returns (ie. more beta, less alpha).

[Philip]

The hedge fund business is a parallel of the long only business 20 years ago. Initially we all tracked mutual fund managers and their outperformance. The long only business became addicted to asset growth (and subject to the whims of the pension consultants) and went the way of indexing...the hedge fund business has gotten the same addiction (via the fund of funds) and now all managers perform roughly the same.
In addition many hedge fund strategies were an arbitrage of the slowness of how large pension funds and long only managers invested...now that hedge funds are such a large portion of the market they no longer have this advantage.
It is also foolish to think that any investment strategy that worked at $100 million in capital would continue to work at $10 billion in capital.
Remember that Michael Steinhardt and Julian Robertson achieved their outperformance in terms of returns when they were managing less money.

[fred wilson]

and i reblogged my favorite part of this post on fredwilson.vc

hopefully a few more people will read it.

we need more people talking about these issues

[fred wilson]

roger - i am not sure the LPs wil ever fix what's wrong with the VC/PE business because the largest amounts of money come from very large pension funds and endowments that work off of asset allocations. and i don't see those allocations coming down anytime soon. and most of the people who manage this capital are not paid for performance. they are more interested in getting us to pay for a nice hotel in NYC for three days than a 5x on our next deal. i find it hard to take to be honest. thank god i don't have any of my money in a pension plan.

if the VC business is going to get fixed, it will be fixed by GPs who are doing it for the love of the work instead of the love of the almighty dollar. we could be managing $500mm to $1bn if we wanted to, but we don't because we hate to make the kind of investments that would entail.

[Joe Seibel]

Very interesting post. I think the thing to remember here is that the world of asset management is a dog eat dog world. Investors will usually give a fund manager a second chance if that manager has done well for them in the past, but has recently hit a rough patch. This second chance does not last for long though. A perfect example is ever so famous portfolio manager from Legg Mason, (you know, the one that beat the S&P 500 13 years in a row). This manager is now bleeding funds almost as fast as he collected them. Once the tech bubble burst and everyone saw how much money the alternative investment managers were making the market was flooded with wannabes. All that was needed was one big investment and the flood of funds followed. There is no guidelines for these investments so managers invested any way they could to generate the quick return as you stated above. Now the party has ended and the men are being separated from the boys. So I don't think it is a matter of IF the LPs will speak with their wallets, its a matter of WHEN.

[Matt]

I agree that some hedge funds have taken more risks to take advantage of the fee incentive structure. However, I think that is a short term strategy. High watermarks are what hold this risk taking strategy back. If a hedge fund has very poor performance one year, the fund only starts to earn performance fees after making up those losses. I think the large hedge funds have long-term mindsets. This long-term thinking is the type of strategy that large institutional investors also seek.

[Roger]

Andrew, you are absolutely correct. This is specifically what I meant when I said "The model is broken, and the market will fix it. But it won't be that painful for the incumbents with big brands but little absolute performance." There is an increasingly efficient market in smaller venture, but in my opinion there is still a dearth of capital in true early stage venture. It's getting better but we've got quite a way to go.

[Andrew Weissman]

Couldn't agree more that alternative asset class could be trending towards relative returns. But, with respect to venture, while "true seed stage investing, real venture capital investing, has been deserted by the biggest names in the business" havent there also been a ton of new entrants to fill the gap - new funds and people - and maybe that suggests the market in that small segment is clearing, becoming more efficient?