Hedge Fund Hotels: Is the Model Broken?
Overview
Jenny Anderson’s story in today’s New York Times has caused a bit of stir. So UBS is now being scrutinized by the State of Massachusetts for commission practices in their hedge fund hotel, yet another angle on the “soft dollar” debate that has been raging for the past decade. From my perspective the analysis is fairly simple: if UBS and others running these hotels are somehow jacking these nascent funds by charging excessive commissions, and using this as the mechanism for absorbing the costs of providing infrastructure support, they are truly stupid and should be hit - hard. Then there is the issue of disclosure, i.e., how the funds operating out of hedge fund hotels are disclosing payment for services rendered, and if soft dollars are being used to pay for expenses that are not soft dollar-eligible. Bottom line: if institutions like UBS are operating in an improper manner, after all that they and others have been through in the IPO “spinning,” mutual fund timing and research settlement cases, I will be dead shocked. I just can’t see it.
Hedge Fund Hotel Operators and VCs - Birds of a Feather
The economics of firms running hedge fund hotels are somewhat similar to that of firms running venture capital funds: you will have a whole bunch of duds that are hopefully offset by a few home runs. Home runs are a function of variables such as assets under management (which drives loan balances, borrows, capital introduction, etc.) and the profitabilty of the strategy for the prime broker (driven by trading volume and the complexity of the products traded (derivatives, emerging markets instruments, etc.)). Think about it - the costs of setting up a hotel are not small. Solid real estate, high-technology intensity and high quality people support are the tickets to play the game. And the ongoing operating costs of supporting platforms like these are not small. So, the goal is to pick the funds that are most likely to succeed, with the potential for generating the most business for the prime broker.
It Ain’t Easy Picking Winners - Adverse Selection at Work
But picking winners is really hard, and there is a measure of adverse selection built into the process: true “rock star” managers aren’t going to operate out of a hotel because they don’t need to - they have enough cash to start up themselves and to hire a top COO while attracting several billion in AUM on day one. So what you tend to get in hotels are lesser known, riskier names who may well be very bright but may be been the #2 or #3 at a mid-size fund or a strong analyst at a big fund. Again, this is a risky business. But if you catch it - that fund you’ve helped to incubate turns into a $3 billion multi-strategy colossus - you can ride the gravy train for a long, long time. Once a prime broker becomes embedded in a firm it is pretty painful to rip them out. This is the fervent hope of the hotel operator.
Hotel Operators and Prime Brokers - Supporting Capital Formation
I think prime brokers in general and hedge fund hotels in particular play an important role in the capital formation process. It enables potentially able and talented yet little known managers to get their shot, while both minimizing costs and distractions to the investment process. And this is key to the young manager, who wants nothing more than to generate returns with a couple of trusted partners without having to worry about whether a trade will clear or if a phone will be answered. Some may say, “Screw them; if they can’t run an office on their own then they shouldn’t be managing money anyway.” I take a somewhat less cynical view. There are invariably nuggets of greatness to be found embedded in large firms, where the individual in question may not get their chance to run a big book because of talented people in front of them. Hedge fund hotels simply add incremental liquidity and opportunity into the investment landscape. If a manager can’t cut it, they fail and go home. If they do make it, however, riches are bestowed upon them with lesser yet significant riches going to their prime broker. And this is the way it should be.
Conclusion
Do the hotels need to do unethical and illicit things to be successful? I don’t think so, especially if the firm has the ability to seed top prospects, reserve future capacity and potentially get a piece of the GP. That said, it is not a business for the faint of heart of thin of wallet, as it requires substantial upfront investment and skill to make it work. And this is my guess as to how UBS is doing it. But if they’re not, it will represent yet another unnecessary black eye for the hedge fund business.
