Levelling the Playing Field for Emerging Managers
As featured on institutionalinvestorsalpha.com
The Securities and Exchange Commission is increasing the number of its annual exams. Investor due diligence questionnaires are becoming longer, with more requests for detail. To meet these growing investor and regulatory best practice demands, hedge fund managers will need to embrace technology – and emerging managers in particular, a multitude of service providers.
Managers have to hire the staff to cope with these requirements and take on added duties themselves, while still making time for marketing and raising capital, not to mention squeezing out a return. These demands are tough for most hedge fund managers but are virtually unattainable for most emerging managers. As a result, we are seeing an industry drift into haves and the have-nots.
Citi produced a survey last year that stratified hedge funds by size and then published data related to their business expenses. After I read the survey, a vivid image came to mind of the emerging hedge fund manager pushing the proverbial boulder up steep hill. How can such a manager ever compete with larger peers? For several reasons, it is almost impossible.
To start, management company expense for an emerging manager with assets of $100 million is an astounding 244 basis points, or 2.44 percent of assets under management. That factors in salaries for investment and business personnel and other amounts charged directly to the management company itself. The cost decrease dramatically as you go up the asset ladder; a $500 million fund averages 90 basis points, and a $5 billion fund averages a little under 60 basis points. The survey concluded that a fund needs to reach $300 million in assets before it can break even.
Another problem, according to the Citi survey, is that a $5 billion fund will spend, in absolute dollars, almost 15 times more on technology than a $500 million fund. While digesting this statistic, one should contemplate the implications. The fundamental question is: Why? Is it that the larger manager is needlessly spending money, or is it that the larger manager thinks it needs the technology? It is reasonable to conclude that the larger manager is responding to increasing business demands by investing in technology. Does the emerging manager have the same business demands? Presumably it does, so how does the emerging manager ever hope to compete?
The competitive landscape is further challenged if we consider the actual basis points involved when a fund manager charges third-party expenses directly back to the fund (known as chargebacks), rather than use management fees to pay for the expenses. Incredibly, a $100 million fund will charge back, on average on basis, 46 basis points, but once the fund grows to $5 billion fund is significantly higher, the proportion of remaining assets is actually less for the smaller manager, causing a dampening effect on an emerging manager’s net performance. It is worth noting that the pressure to compress management fees is causing more funds to increase their chargebacks. This hinders net performance for all managers, but again this proportionally disadvantages the emerging manager.
As an industry we need to adapt, innovate and help emerging managers overcome these many challenges. If newer fund managers can’t compete for the invested dollar, we may witness the choking of our manager pipeline. Not only will this ultimately diminish choice for investors and stifle competition, but it will also have an adverse effect on the industries that support and serve the hedge fund market. The cost of supporting disparate technology systems within an enterprise for separate areas of the business is high, even for multibillion-dollar hedge funds, though this has been standard practice for years. Many fund managers are running as many as four or five different systems is affectionately known as Straight-Through Processing, a label that makes it sound like a net positive for the manager. In the 1990s maybe that was the case, but today it could be more appropriately described as Financial Leakage, referring to all the money that is drained out of a firm to support and maintain all of these systems. But today there are technology platform providers that can design all-inclusive models that are as competitively thorough, or almost as thorough, as the best-of-breed systems currently is use. These all-inclusive systems cost much less than running multiple technology systems.
Service providers and technology firms are also starting to offer flexible pricing models. Notably, they are increasingly setting up agreements to share in financial exposure by offering short-term financing, which allows the new manager to actively participate in this new era and attain a higher degree of institutionalization.
In the end, it is in everyone’s interest to find ways to adapt and support our manager pipeline, so that emerging managers can compete on a level playing field.