Hedge fund IPO
Hedge fund IPO? Proper hedge funds deliver because of upside incentives and downside disincentives that align client and manager interests. The much criticised "heads I win - tails you lose" compensation is a myth. Investors redeeming for weak performance, low pay if below high water marks and the principals' ENTIRE wealth in the fund assures clients of SHARED positive and negative outcomes and incentivizes managers to try to minimize losses, unlike the risky passive crowd, who get paid for doing NOTHING!
Investing in hedge funds is about REPLACING market risk with manager risk. If, like me, you believe in alpha NOT beta then that makes sense as markets are notoriously volatile. I'd rather bet on skilled people than alleged risk premiums. Even in bull markets stocks AND bonds have never adequately compensated for their risk. Hiring a hedge fund manager means you are paying 2 and 20 to someone who is incentivized to make money FOR YOU no matter what. Paying 0.20 to an index fund "manager" is an expensive way to reward an asset gatherer to lose lots of YOUR money in bear markets. Don't breach fiduciary duty to yourself or your retirement plan by investing in "cheap" toxic waste that buys everything!
Managers provide acumen, experience and their own capital and then investors provide more capital to LEVERAGE that skill to the MUTUAL benefit of BOTH parties. It is a business model that has proven a win-win for many years despite criticism from those who have never invested in a hedge fund themselves but still think they are experts.
A NEW diversifying source of return and keeping 80% of gross alpha is good for investors provided the manager is motivated to keep on making money, managing risk, restricting AUM to the size they can perform well with. Redemption fears, high water marks, personal wealth in harm's way and non-permanent capital if you don't do your job well are protective covenants for investors though, of course, nothing is guaranteed. We have seen the dangers of covenant-lite loans and there are possibly similar issues with covenant-lite fund capital. Permanent capital REMOVES the incentive to perform.
The traditionalists still say we don't need hedge funds. Necessity is NOT the mother of invention. Motivation is the REAL mother of invention. Lots of things weren't considered necessary until long AFTER they were invented. Life existed before wheels, electricity, cars, computers, internet or mobile phones and few said beforehand that we needed any of them. And remember all that demand for blogs in the 80s and 90s? I don't.
Hedge funds got invented because some were motivated to find safer, better ways of growing capital than simply owning assets. Incentive fees ensure managers keep working hard and figuring out even more ways to make money for investors. If, and only if, clients make money then you make money. It was an outstanding innovation for ALL investors permitted to access them.
"Cheap" funds mostly result in index hugging and asset gathering often at the cost of performance. Actively managed mutual fund and other relative return products have fees that are often HIGHER than hedge fund fees. Most mutual fund returns are at least 90% driven by the beta of whatever asset class they are investing in. Since beta fees are effectively zero as the holdings can be lent out to cover the indexation cost, that means a mutual fund charging 1% could be considered to be charging 10%(!) since it is actively managing only a small part of the portfolio and indexing the rest. Mutual funds are paid that outrageous fee whether they make or LOSE money. In contrast good hedge funds that can make money whether the market is up OR down are a bargain.
Hedge funds mostly charge that infamous 2% to cover much higher fixed costs on a generally smaller AUM; usually they ONLY get paid if they produce NEW profits of which they get a 20%. But in some cases now the 2% is also becoming a profit center and some hedge funds are sadly morphing from hunter gatherers into asset gatherers. Permanent capital reduces the fear of redemptions, falling too far below your high water mark and the many alignment benefits of ALL senior managers having wealth at risk in the fund.
Recently I was asked by an investor whether they should automatically redeem from an alternative asset manager that tries to IPO. Good question. After all, the IPO process, before and after, is a major management distraction away from focusing on portfolio management while the monetization of what are effectively future management fees may reduce motivation in subsequent years and also the interests of public shareholders and fund investors are not necessarily the same. It tends to emphasize the 2 rather than the 20 leading to more marketing and AUM raising usually at the cost of performance.
Hedge fund managers have always been able to monetize their skills through the performance fee. The more INVESTORS make the more the manager gets paid. Jim Simons, George Soros, Michael Steinhardt, Julian Robertson or Bruce Kovner among many others never went or have never expressed an intention to go public yet seem to have monetized their businesses fairly well and attracted talented employees. For a quality hedge fund there is no need to IPO. Selling a stake to a strategic investor might make sense, listing a fund might be a logical move but the manager itself going public is a clear short sale signal.
Fees for failure have impacted shareholders of financial corporations where senior management were neither competent nor motivated to prepare for difficult times. While PROPER hedge funds are structured in ways that provide upside AND downside alignment, this is NOW not always the case. There needs to be financial punishment for being wrong or taking on too much risk. Allocators of capital need to ensure that fear of failure, ongoing motivation and single-minded FOCUS on running the fund are present. There are many good hedge funds around where that remains true.
There are a few funds now more motivated by the 2 than the 20. Shareholders like the 2 while obviously limited partners should like the 20 since the more fees they pay the higher the returns. Asset size is usually the enemy of performance. Surely the best motivator is that if you don't perform then the money will desert you. Lockups and redemption penalties reduce this fear but are only appropriate for some strategies. With permanent capital the fear of losing the assets is taken away. As we have seen with subprime CDOs, SIVs or executive compensation, take fear out of the equation and greed ALONE leads to problems. There is little wrong with greed per se provided it is not a free call option with no downside.
A large proportion of new assets into hedge funds have recently gone to more established funds. With most investors it made sense to enter the space through funds of funds but as their familiarity has grown direct investment into larger funds is the stage we are in now. But with the superiority of early performance and higher returns on smaller asset sizes there is always going to be capital for niche managers with new ideas and strategies. With the industry still so tiny compared to future demand there will be plenty of space for large AND small hedge funds. Core-satellite is how the traditional world evolved and is how the hedge fund space will evolve. A core of fund of funds and multistrategy behemoths enhanced with specialist managers filling a specific portfolio gap. Lots of room for good hedge funds of ALL sizes as long as the people in charge are incentivized AND feel fear.
Almost all QUALITY hedge funds operating today BEGAN with less than $100 million under management. Every one of those funds was motivated primarily by the performance fee. So the argument that the biggest funds will win ignores factors that have underscored the success of the industry since inception. There is strong empirical evidence that newer and smaller hedge funds perform better. Yet currently more money is flowing to the biggest funds by naive investors operating under the delusion that large AUM equals large FUTURE returns. There seems a strange dichotomy here. Isn't money supposed to go the funds likeliest to perform better? Whether a firm has $500 billion or $500,000 under management gives little indication of its abilities. People should have learnt that expensive lesson from the traditional world by now.
Motivation and incentives are the fuel of any functioning economic model. Fees for failure threaten that system. There are plenty of billionaires working just as hard today as when they started out. But there is a danger that some managers might lose their motivation if the worst case scenario isn't that bad and when shareholders generally reward AUM more than performance fees. Will the Och-Ziff OZM partners burn the midnight oil in 2008 as much as in 1994 even if the Och-Ziff IPO proceeds have been reinvested in the fund? Hopefully they will but it is yet another question investors will have to ask themselves.
Nomura and the China and Dubai sovereign wealth funds can't be very impressed with the post-IPO performance of Fortress FIG, Blackstone BX and now Och-Ziff OZM. It is not often such obvious short sells come along but when someone stands on a street corner throwing free money around, you try to grab all you can. Some shorts this year like credit or the dollar weren't completely obvious unless you did your homework but shorting those IPOs WAS blindingly obvious. If the principals are selling it is logical to sell alongside. Since there was previously no easy way to short hedge funds it makes sense to short OZM even if you think Och-Ziff is a good firm. OZM now serves as hedging instrument in the same way the FIG and BX IPOs enabled a way to short private equity.
When a hedge fund manager "takes home" a billion it is GREAT news for their clients since it is FAIR compensation for strong performance. Any management team should be incentivized to do a good job. But with an IPO there is a danger of becoming similar to a CEO of Bear Stearns, Merrill Lynch or Citigroup as it does not align shareholder or client interests with management. Those properly motivated don't play bridge or golf when their firms are taking massive losses. Any hedge fund manager worthy of the name was available 24/7 during the recent problems. Non-permanent capital and easy redemption rights forces managers to work hard especially if their net worth is also threatened. Keeping AUM at a suitable size keeps attention on performance for that uncertain 20 NOT gathering assets for that certain 2.
Alignment of economic interests matter. Why buy an investment banking stock when the CEO and other senior managers can still parachute out no matter how bad a job they do? Why listen to a sell-side "economist" opine that the economy is strong when they aren't impacted for not realising that credit and real estate were absurdly mispriced and that would weaken the economy? Why buy an "AAA" rated CPDO when the ratings agency won't be financially damaged if it drops to a C rating? Why purchase a "Strong Buy" equity pushed by an analyst who won't be punished for being wrong? Why buy into hedge fund or private equity IPOs when the founders are selling? Why provide permanent capital and permit monetization of future fee cash flows when the possibility of having that capital taken away is such a powerful incentive to keep performing? Permanent returns guarantee permanent capital.
As in any industry if you want cheap you can get cheap. "Cheap" hedge fund clones and replicators are out there as are so-called "hedge fund" style mutual funds. As usual you get what you pay for. While proper hedge fund fees remain stable there has been some recent fee reduction in the funds of funds arena. An investor may be proud of getting "lower" fees instead of the modal 1% and 10% second layer but the chances are they are being penny-wise, dollar-foolish. There are costs to due diligence, infrastructure, monitoring and attracting the quality of staff able to identify good hedge funds. It is easy enough to just pick names that had good recent performance and charge less and cut corners on the massive due diligence you claimed in your powerpoint. It is much harder and expensive to do a good job picking quality hedge funds that WILL perform.
Someone asked me what I expected to be the best performing strategy over the next 10 years. I answered that considering financial incentives and innovation that the chances are the top returning strategy over 2008-2018 probably hasn't been invented yet and that the managing firm is likely not YET in existence. They figured "China short only" would be the best performer which was interesting.
They might be right or they might be wrong but if they do find such a manager they need to make sure anyone they provide non-permanent capital to is properly incentivized to 1) make money 2) not lose most of it. Managing money is a vocation which needs full-time focus, proper incentives and close attention.
Investing in hedge funds is about REPLACING market risk with manager risk. If, like me, you believe in alpha NOT beta then that makes sense as markets are notoriously volatile. I'd rather bet on skilled people than alleged risk premiums. Even in bull markets stocks AND bonds have never adequately compensated for their risk. Hiring a hedge fund manager means you are paying 2 and 20 to someone who is incentivized to make money FOR YOU no matter what. Paying 0.20 to an index fund "manager" is an expensive way to reward an asset gatherer to lose lots of YOUR money in bear markets. Don't breach fiduciary duty to yourself or your retirement plan by investing in "cheap" toxic waste that buys everything!
Managers provide acumen, experience and their own capital and then investors provide more capital to LEVERAGE that skill to the MUTUAL benefit of BOTH parties. It is a business model that has proven a win-win for many years despite criticism from those who have never invested in a hedge fund themselves but still think they are experts.
A NEW diversifying source of return and keeping 80% of gross alpha is good for investors provided the manager is motivated to keep on making money, managing risk, restricting AUM to the size they can perform well with. Redemption fears, high water marks, personal wealth in harm's way and non-permanent capital if you don't do your job well are protective covenants for investors though, of course, nothing is guaranteed. We have seen the dangers of covenant-lite loans and there are possibly similar issues with covenant-lite fund capital. Permanent capital REMOVES the incentive to perform.
The traditionalists still say we don't need hedge funds. Necessity is NOT the mother of invention. Motivation is the REAL mother of invention. Lots of things weren't considered necessary until long AFTER they were invented. Life existed before wheels, electricity, cars, computers, internet or mobile phones and few said beforehand that we needed any of them. And remember all that demand for blogs in the 80s and 90s? I don't.
Hedge funds got invented because some were motivated to find safer, better ways of growing capital than simply owning assets. Incentive fees ensure managers keep working hard and figuring out even more ways to make money for investors. If, and only if, clients make money then you make money. It was an outstanding innovation for ALL investors permitted to access them.
"Cheap" funds mostly result in index hugging and asset gathering often at the cost of performance. Actively managed mutual fund and other relative return products have fees that are often HIGHER than hedge fund fees. Most mutual fund returns are at least 90% driven by the beta of whatever asset class they are investing in. Since beta fees are effectively zero as the holdings can be lent out to cover the indexation cost, that means a mutual fund charging 1% could be considered to be charging 10%(!) since it is actively managing only a small part of the portfolio and indexing the rest. Mutual funds are paid that outrageous fee whether they make or LOSE money. In contrast good hedge funds that can make money whether the market is up OR down are a bargain.
Hedge funds mostly charge that infamous 2% to cover much higher fixed costs on a generally smaller AUM; usually they ONLY get paid if they produce NEW profits of which they get a 20%. But in some cases now the 2% is also becoming a profit center and some hedge funds are sadly morphing from hunter gatherers into asset gatherers. Permanent capital reduces the fear of redemptions, falling too far below your high water mark and the many alignment benefits of ALL senior managers having wealth at risk in the fund.
Recently I was asked by an investor whether they should automatically redeem from an alternative asset manager that tries to IPO. Good question. After all, the IPO process, before and after, is a major management distraction away from focusing on portfolio management while the monetization of what are effectively future management fees may reduce motivation in subsequent years and also the interests of public shareholders and fund investors are not necessarily the same. It tends to emphasize the 2 rather than the 20 leading to more marketing and AUM raising usually at the cost of performance.
Hedge fund managers have always been able to monetize their skills through the performance fee. The more INVESTORS make the more the manager gets paid. Jim Simons, George Soros, Michael Steinhardt, Julian Robertson or Bruce Kovner among many others never went or have never expressed an intention to go public yet seem to have monetized their businesses fairly well and attracted talented employees. For a quality hedge fund there is no need to IPO. Selling a stake to a strategic investor might make sense, listing a fund might be a logical move but the manager itself going public is a clear short sale signal.
Fees for failure have impacted shareholders of financial corporations where senior management were neither competent nor motivated to prepare for difficult times. While PROPER hedge funds are structured in ways that provide upside AND downside alignment, this is NOW not always the case. There needs to be financial punishment for being wrong or taking on too much risk. Allocators of capital need to ensure that fear of failure, ongoing motivation and single-minded FOCUS on running the fund are present. There are many good hedge funds around where that remains true.
There are a few funds now more motivated by the 2 than the 20. Shareholders like the 2 while obviously limited partners should like the 20 since the more fees they pay the higher the returns. Asset size is usually the enemy of performance. Surely the best motivator is that if you don't perform then the money will desert you. Lockups and redemption penalties reduce this fear but are only appropriate for some strategies. With permanent capital the fear of losing the assets is taken away. As we have seen with subprime CDOs, SIVs or executive compensation, take fear out of the equation and greed ALONE leads to problems. There is little wrong with greed per se provided it is not a free call option with no downside.
A large proportion of new assets into hedge funds have recently gone to more established funds. With most investors it made sense to enter the space through funds of funds but as their familiarity has grown direct investment into larger funds is the stage we are in now. But with the superiority of early performance and higher returns on smaller asset sizes there is always going to be capital for niche managers with new ideas and strategies. With the industry still so tiny compared to future demand there will be plenty of space for large AND small hedge funds. Core-satellite is how the traditional world evolved and is how the hedge fund space will evolve. A core of fund of funds and multistrategy behemoths enhanced with specialist managers filling a specific portfolio gap. Lots of room for good hedge funds of ALL sizes as long as the people in charge are incentivized AND feel fear.
Almost all QUALITY hedge funds operating today BEGAN with less than $100 million under management. Every one of those funds was motivated primarily by the performance fee. So the argument that the biggest funds will win ignores factors that have underscored the success of the industry since inception. There is strong empirical evidence that newer and smaller hedge funds perform better. Yet currently more money is flowing to the biggest funds by naive investors operating under the delusion that large AUM equals large FUTURE returns. There seems a strange dichotomy here. Isn't money supposed to go the funds likeliest to perform better? Whether a firm has $500 billion or $500,000 under management gives little indication of its abilities. People should have learnt that expensive lesson from the traditional world by now.
Motivation and incentives are the fuel of any functioning economic model. Fees for failure threaten that system. There are plenty of billionaires working just as hard today as when they started out. But there is a danger that some managers might lose their motivation if the worst case scenario isn't that bad and when shareholders generally reward AUM more than performance fees. Will the Och-Ziff OZM partners burn the midnight oil in 2008 as much as in 1994 even if the Och-Ziff IPO proceeds have been reinvested in the fund? Hopefully they will but it is yet another question investors will have to ask themselves.
Nomura and the China and Dubai sovereign wealth funds can't be very impressed with the post-IPO performance of Fortress FIG, Blackstone BX and now Och-Ziff OZM. It is not often such obvious short sells come along but when someone stands on a street corner throwing free money around, you try to grab all you can. Some shorts this year like credit or the dollar weren't completely obvious unless you did your homework but shorting those IPOs WAS blindingly obvious. If the principals are selling it is logical to sell alongside. Since there was previously no easy way to short hedge funds it makes sense to short OZM even if you think Och-Ziff is a good firm. OZM now serves as hedging instrument in the same way the FIG and BX IPOs enabled a way to short private equity.
When a hedge fund manager "takes home" a billion it is GREAT news for their clients since it is FAIR compensation for strong performance. Any management team should be incentivized to do a good job. But with an IPO there is a danger of becoming similar to a CEO of Bear Stearns, Merrill Lynch or Citigroup as it does not align shareholder or client interests with management. Those properly motivated don't play bridge or golf when their firms are taking massive losses. Any hedge fund manager worthy of the name was available 24/7 during the recent problems. Non-permanent capital and easy redemption rights forces managers to work hard especially if their net worth is also threatened. Keeping AUM at a suitable size keeps attention on performance for that uncertain 20 NOT gathering assets for that certain 2.
Alignment of economic interests matter. Why buy an investment banking stock when the CEO and other senior managers can still parachute out no matter how bad a job they do? Why listen to a sell-side "economist" opine that the economy is strong when they aren't impacted for not realising that credit and real estate were absurdly mispriced and that would weaken the economy? Why buy an "AAA" rated CPDO when the ratings agency won't be financially damaged if it drops to a C rating? Why purchase a "Strong Buy" equity pushed by an analyst who won't be punished for being wrong? Why buy into hedge fund or private equity IPOs when the founders are selling? Why provide permanent capital and permit monetization of future fee cash flows when the possibility of having that capital taken away is such a powerful incentive to keep performing? Permanent returns guarantee permanent capital.
As in any industry if you want cheap you can get cheap. "Cheap" hedge fund clones and replicators are out there as are so-called "hedge fund" style mutual funds. As usual you get what you pay for. While proper hedge fund fees remain stable there has been some recent fee reduction in the funds of funds arena. An investor may be proud of getting "lower" fees instead of the modal 1% and 10% second layer but the chances are they are being penny-wise, dollar-foolish. There are costs to due diligence, infrastructure, monitoring and attracting the quality of staff able to identify good hedge funds. It is easy enough to just pick names that had good recent performance and charge less and cut corners on the massive due diligence you claimed in your powerpoint. It is much harder and expensive to do a good job picking quality hedge funds that WILL perform.
Someone asked me what I expected to be the best performing strategy over the next 10 years. I answered that considering financial incentives and innovation that the chances are the top returning strategy over 2008-2018 probably hasn't been invented yet and that the managing firm is likely not YET in existence. They figured "China short only" would be the best performer which was interesting.
They might be right or they might be wrong but if they do find such a manager they need to make sure anyone they provide non-permanent capital to is properly incentivized to 1) make money 2) not lose most of it. Managing money is a vocation which needs full-time focus, proper incentives and close attention.
© posted by Hedge Fund on 2:16 AM
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