The Pressures of Scale in the Hedge Fund Industry

The hedge fund industry is rapidly becoming an amalgam of “haves” and “have nots,” with the larger, more established, “institutional” funds getting larger with the small and mid-size funds more or less bumping up against an AUM ceiling. Of course there are exceptions, but this is the general trend I’ve been witnessing for the past year or so. In fact, I wrote about this in one of my first posts as a blogger, titled Where is the Hedge Fund Industry Going, 7/17/2006:

As noted above, it seems that the “middle class” is getting squeezed and will have to make a decision - to “go global” or “go local.” To be truly multi-strategy and have access to the best investment ideas across the spectrum,  a firm really needs representation in New York, London and Hong Kong, at a minimum. This is not cheap. A close friend of mine, who happens to be a very successful  long/short hedge fund manager running about $1.2 billion, recently told me that he feels at a competitive disadvantage to some of his peers who are running $3 billion and more. Why? Because they have the resources to set up offices in these locales (without presumably placing pressure on team compensation in the process) and gaining better access to information and ideas in these regions, and he feels somewhat strapped, especially in a tough market like this one. I couldn’t believe I was hearing this from a friend running over a billion dollars, but times really have changed. So, if a guy running a billion is feeling pinched, how large do you need to be? $3 billion? $5 billion?

It seems 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. So what about going local, staying pure to your initial style and demonstrating superior alpha generation across a manageable asset base? I think this is a viable and rewarding strategy for someone who either runs their firm as a lifestyle business, or is setting the stage to build a track record sufficiently attractive to garner the assets necessary to make the jump from local to global. This will serve to create a dynamic where you have a group of large, global players populating the upper end of the spectrum with a churning, roiling lower end where some simply die off while others make it happen and jump to the big leagues after putting up serious numbers over a 2-3 year period. At the  end of the day, you end up with an industry that has the characteristic shape of a barbell.

Just as I was thinking about discussions I’ve had recently with several friends at hedge funds large and small, I read about Perella, Weinberg’s acquisition of Xerion, a $400 million AUM special situations fund. And if you read the comments from Xerion’s founder, it appears that he and I arrived at the same conclusion as it relates to the pressures of scale.  From the Wall Street Journal 10/02/2007:

Behind the trend is the growing realization by those who run smaller hedge funds like Xerion that their job has gotten much harder. The firm has scored gains of 30% so far this year betting against financial companies and subprime debt, and by making wagers on so-called special situations, such as shares of early-stage commodity producers, according to one investor. Xerion, which was formed in January 2006, was up about 12% last year.

But its founder, Daniel Arbess, said so much money is flowing to larger funds that it makes it harder for smaller firms to raise cash. The 100 largest hedge funds control about 70% of the money in the hedge-fund world, up from less than 50% at the end of 2003. That leaves thousands of smaller players scrambling for the rest.

“We don’t need to sell out now,” Mr. Arbess says. “But the hedge-fund industry is becoming winner-take-all, with the vast majority of capital going to the largest, most institutionalized firms.”

Daniel is right. He could keep right on growing incrementally, but not getting the big allocations necessary to bring him to the next level any time soon. And then the question becomes: is it important to get to the next level to be competitive? My friends who run the $1.2 billion long/short fund found their budget too tight given their goals, namely to source and due diligence ideas globally and to build a local presence in the key global financial hubs. So their rush to scale is not driven by more management fees to pad their wallets - they are spending virtually all of their management fees on running and growing their business; it is to have the fee stream necessary to support multiple offices and to build a bench of top talent that can operate a global platform. This is not growth for growth’s sake but growth for the sake of incremental alpha generation. Other funds might not feel the same way, such as a geographically concentrated small-cap hedge fund whose capacity really maxes out in the $300-$500 million range. This can be a nice, profitable business run by a small team - as long as performance is strong. But if performance wanes, poof! Not such a nice business any more.

The WSJ story goes on to describe some of the perils of growth, where the motivations aren’t quite as straight-forward and returns-based as those of my friends:

Still, some investors are concerned that the rush to
establish large, “multiple-strategy” hedge-fund firms that embrace
different investments might not work out. They cite Amaranth Advisors,
a multiple-strategy fund that collapsed last year after heavy
energy-trading losses. They worry that some of the hedge-fund managers
selling out are simply cashing in while the money continues to flow.

Others say the push to purchase hedge funds and offer
more strategies to clients is simply a way to increase management fees,
rather than a means to deliver top-notch returns.

As large firms buy up hedge funds and bolt them
together to form multiple-strategy funds, many could prove unable to
appropriately allocate capital and manage the risk of these varied
investments, says Gregory Curtis, chairman of Greycourt & Co., a
Pittsburgh firm with $10 billion in assets that invests in hedge funds
for wealthy individuals. He says that even successful hedge-fund
managers usually know little about allocating money among different
strategies — or how to manage all the risk.

I find these arguments pretty weak when it comes to well-managed firms, and right on when it comes to hype-machines that are great at asset gathering but lousy at investing. But at the end of the day there will always be good and bad funds, and it is incumbent upon potential investors to say “Hey, these returns aren’t sustainable. They were concentrated in a few trades and their risk management culture is marginal.” It is so easy to follow the herd and get caught up in the group-think - which inevitably leads to pain. And we’ve seen this time and time again.

But I think Xerion’s move is rational and a sign of the times. If good small and mid-size firms want to achieve scale they might be best served selling out, and getting a smaller share of a much larger pie:

Mr. Arbess, who will become a partner at Perella, said that selling out
to the larger firm will help cut Xerion’s trading costs, give it better
client service and technology — and enable it to raise more money.
Since large institutions such as pension plans generally want to invest
at least $50 million in a fund, and don’t want to hold more than 10% of
assets, it makes them less likely to shift money to a mid-size firm
like Xerion. That adds to the attraction of selling out to Perella, Mr.
Arbess says. Perella will put $100 million into Xerion’s funds as part
of the agreement.

Rock on, guys. You are on the leading edge of an inexorable wave that will ripple throughout the industry for the next 24-36 months.

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COMMENT:

AUTHOR: jcb

EMAIL: jcb@boglefunds.com

URL: 

DATE: 10/04/2007 07:45:12 AM

really interesting issue- as usual with your posts i have many thoughts, but will share just a couple.  knee jerk response- there will always be a market for alpha.  always, always, always.  no matter what the scale of the fund, or how concentrated in one strategy.  don’t need to be multi strategy to attract assets, as multistrategy capital will find you with its ability to diversify away your risk.  what these sellers are really saying is that they don’t want to wait to raise capital slowly and organically, ramping up the business as a lengthening track record of good alpha will allow.  they prefer the instant gratification of rapid, high pressured fund raising, which results in a low quality book of business, though with larger fees, getting into their pockets sooner.

these explanations for selling involving trading costs are a red herring.  trading costs are an issue and have a measurable impact on only a very few funds, namely stat arb, hi frequency strategies.  the hypocrisy of say they are selling to reduce trading costs, at the same time (in the same sentence!) they say they are selling to raise more capital, that will, for certain, raise trading costs, is beyond laughable. 

interesting stuff.

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COMMENT:

AUTHOR: Tom

EMAIL: anon@anon.org

URL: 

DATE: 10/04/2007 08:36:42 AM

What sort of unique alpha are you generating in a crowded field with a multi-billion, multi-location fund that relies on outsiders to generate ideas?

Modern hedge funds, the upper part of that bar bell, basically look poised to become the next generation of mutual funds. (That’s the inexorable wave, I guess. Perhaps not a bad thing.)

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COMMENT:

AUTHOR: Roger

EMAIL: roger@informationarbitrage.com

URL: http://www.informationarbitrage.com

DATE: 10/04/2007 09:16:55 AM

Thanks for the great comments.

jcb, I think you are directionally correct but certainly not in all cases. There are funds, and I know many of them, who see lots of high-value opportunities in today’s market but simply can’t take advantage due to lack of scale (read: firepower to increase the size of their book). These are good ideas, real, alpha-generating ideas, exactly the kind of ideas you want your managers to pursue, but the simply lack the excess capacity to take them on. These are the funds of which I am speaking. I also agree with you that the trading costs argument is weak for anyone other than a high-frequency strategy, except possibly when it comes to the short side where scale is helpful and the difference in rebates can be large. Also, there is a benefit to smaller managers having the infrastructure support such that they can worry about running the business less and putting on good positions and managing risk more.  This was the model I ran at DB Advisors at it worked very well. That said, I share much of your cynicism with many of the transactions we’ve seen over the past 12-18 months.

Tom, I agree with elements of your comment as well. Certain large hedge funds will look increasingly like institutional asset managers, with dampened-down returns but infrastructures, reporting and controls that won’t get a pension fund CIO fired. That said, there is still alpha out there to be gotten, especially by dogged value-oriented researchers who can scour the globe for great ideas. Just my two cents.

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COMMENT:

AUTHOR: Bill aka NO DooDahs!

EMAIL: nodoodahs@aol.com

URL: http://billakanodoodahs.com

DATE: 10/04/2007 11:28:18 AM

Hey, look at your comments php and widen the box.  It’s really small and annoying.

I clicked on this expecting the post to be about the inverse relationship of AUM to achieveable outperformance, not about a problem gaining AUM.  

Interesting.

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