Sat, 01/10/2005 - 22:00
Only 10 years ago, the image of a typical hedge fund operation would have been of a compact office on Park Avenue or Wall Street, a small yet highly motivated team and a single autocratic manager. And indeed, many hedge fund firms continue to be like that today.
True, the geography has now expanded to include Mayfair and some of the fashionable streets of Milan, Paris and Hong Kong. Equally true, many managers now operate in pairs with very extensive support teams. And again, the amount of money required for a viable start-up and, on the other side of the coin, the amount of money available to a successful manager, has risen meteorically. But even with this evolution, the concept and structure of the investment boutique still largely maintains.
Of course some managers - indeed the majority of large firms - now operate internationally, maintaining research teams in two or more financial centres. At the same time everyone - everyone that is who is still open to new investment - attempts to sell internationally (although often through agents). But, in my view at least, mere international diversification does not automatically create major business growth. The first step on the road 'from boutique to department store', or at least to becoming a large shop, requires at its core a business structure radically different from the manager-at-the-top-of-the-pyramid organizations of past years.
Church and State
The key is the recognition that hedge fund management is a formal business rather than an investment lifestyle choice and the related recognition that the single most dangerous risk for a hedge fund, as measured by causes of fund failures, is operational risk and not poor performance. These issues should lead hedge fund managers away from the concept that they can be all things to all men - investment star, principal marketer, managing director and risk manager (although almost everyone draws the line at compliance). So, succinctly, the internal organization I am advocating is a sort of separation between church and state, in other words between the investment management/research side of the business and the operations/sales side.
Funds of funds groups have tended to lead the way here probably because for them there is a greater onus on sales and distribution and less emphasis on direct money management (except, of course in the vital areas of manager selection and monitoring) than in a hedge fund itself. Also, to my knowledge, few if any funds of funds groups are closed to new investment and are therefore continuous participants in the more commercial end of the business.
Hedge fund managers, by contrast, may be closed to new investment having reached either temporarily or permanently what they perceive to be their optimum size; equally they may, if they are sufficiently high-profile, allow their reputation to do their marketing for them without making many formal moves in that direction. There is, for example, one major fund group where the individual who in other operations would be called the senior salesman, is in this instance a sort of financial gate-keeper holding back a milling crowd of eager (potential) investors and, on occasion, allowing a few friends to enter when space becomes available.
Sadly (from my point of view) this level of investor enthusiasm is very rare and those of us who are obliged to engage in the daily struggle to develop our businesses recognize that operating a boutique with irregular opening hours and little in the way of marketing is an almost sure-fire way to decrease personal wealth.
The hedge fund industry is unusual in that some managers can attain substantial size (in terms of assets under management) without significant diversification of strategies or products. Today, a very big fund manager could be running in excess of USD 10 billion. Impressive as this is, the numbers are small when compared to traditional fund management where, for example, Peter Lynch at Fidelity Magellan was running, at his apogee, over USD 150 billion. But there appear to be limits on the size of individual hedge funds that include, the capacity of different investment strategies to run efficiently with large amounts of money and the preparedness/ability of hedge fund managers to undertake the level of client relations required. In addition the income generated by a successful hedge fund is generally thought large enough to discourage managers from putting themselves out to make more. For example, on fees of 2.5% management and 25% performance (higher than the norm but not uncommon among the big boys), a USD 10 billion portfolio achieving 15% gross returns will generate some USD 625 million in a year!
Clearly this is a very attractive arrangement but, from a commercial perspective, it is not as durable as a diversified structure. Boutique investment operations running the same or a series of closely related strategies do run the risk (albeit only slightly) of catastrophic failure - either of their own making or brought on by unexpected external factors.
One such factor can be a crisis of confidence brought on by regulatory scrutiny. Clinton Group, a US major hedge fund firm focused on arbitrage strategies, recently suffered redemptions by investors frightened by an investigation by the SEC (Securities and Exchange Commission). The SEC subsequently exonerated Clinton from any charges or implications of misdeeds but that did not stop its beleaguered principal, George Hall remarking at a recent hedge fund conference that for anyone concerned about investment capacity getting tight, he had some $5 billion worth to spare.
Diversity of products and geography
So given that the boutique structure has limitations, what are the implications of the 'department store' of the title beyond the separation of operations and investment I referred to earlier? The aim here is to create strength through diversification, to offer a series of unrelated 'lines' or investment products and to establish broad-based international distribution.
The pre-eminent players in this section of the market generally had the luck or foresight to get involved in the alternative investment industry in the 1980s and to use the capital generated by early products to develop organically prior to embarking on a series acquisitions (or, in the case of GAM, getting acquired themselves). The model requires wide product diversification and strong international distribution combining full representative offices across the globe supported by a series of intermediaries.
The Platinum Model
The problem with this model for a comparative newcomer to the industry, such as Platinum Capital Management, is that it is prohibitively expensive to establish from a standing start (unless one has the advantage of being an investment bank) and too time consuming, given the dynamic developments taking place almost every day in hedge funds, to achieve organically. Platinum has, however, built a useful stable of products that includes structured products, funds of funds and single strategy investments managed by leading managers. At the same time we have also built extensive international distribution. (Of course, both these processes are ongoing).
How has this structure been achieved? Experience and hard work would be the pat answer but in terms of product development, there is an essential requirement to develop in-house measures and filters to support the manager selection process and at the same time, to pay close attention to defining the market for a specific product. For example, for retail investors, tax considerations are very important, as can be the ability to invest via regular contributions rather than a substantial lump sum.
Separately, institutions are more likely to interest themselves in funds of funds and will generally not require income-generating structures. On the other hand, when faced with a guaranteed structure, institutions may be prepared to accept longer maturities than private investors.
In terms of international distribution, there is to my mind, little doubt about the advantages of one's own offices over a network of intermediaries. Among these benefits are control, consistency of message and exclusivity. In Platinum's model, however, we have avoided the major costs inherent in developing such a structure by undertaking a series of joint ventures with local and often very senior financial executives. In essence they are part owners of the business and so are we. This approach, which brings with it the considerable plus point of local access, has already borne fruit. Our Swiss-based operation, for example, organized almost immediate access into the German markets as their regulations changed; similarly our Far Eastern operations led us to become one of the earliest groups to register hedge funds in Singapore.
Scalability and Durability
Overall, the key thing about the Department Store model for a hedge fund group is that it is highly scalable. There are no apparent limits on size and, as I write there are a least two alternative investment groups built along these lines which each manage in excess of $30 billion. Furthermore and in contrast to the individual manager approach, department store groups should be durable - at the worst poor performance in one sector should be compensated by another - although in the hedge fund business it always pays to expect the unexpected.
At a recent hedge fund conference a session chairman took a straw poll of the audience asking them how frequently one should anticipate a so-called 'hundred year event' (i.e. an event so rare and so potent that it should, statistically speaking, occur only once a century). The audience no doubt mindful of the markets of the past three or four years suggested the frequency should be between once a year and once every three years. This being the base, it seems to me that bigger and diversified is much safer for the house and its investors than smaller and concentrated and thus we continue, at Platinum Capital Management to continue to go flat out for expansion.
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