Emerging managers have a lot to be bullish about because even though the fund raising environment remains challenging, the break-even cost of running a hedge fund is surprisingly less than people might believe.
A new emerging manager survey* produced by AIMA, in conjunction with GPP, a London-based boutique prime broker, canvassed the views of 135 global small and emerging managers – defined by AIMA as those with less than USD500 million in AUM – and the results are likely to allay concerns that running a hedge fund has become too expensive in today’s post-regulatory world.
According to the survey, in which the total AUM of those surveyed totalled USD16 billion, and where the average fund size was USD133 million, the average break-even figure across all fund strategies, came in at approximately USD86 million.
Improvements in technology, increased adoption of outsourcing, and a shift in mindset whereby managers understand it is not always necessary, from a cost perspective, to appoint tier one providers, could all be contributory factors. And a sign that the barriers to entry for operating a successful hedge fund are far from onerous.
“We serve this group and we want to be their voice – what are the challenges they face? What are the aspirations of this group? That’s what we wanted to find out in this survey,” comments Sean Capstick (pictured), Head of Prime Brokerage, GPP.
In many ways, this flies in the face of perceived industry wisdom that today’s hedge fund manager needs USD200 million or more to operate a profitable business. Part of this is because the tier one primes see the industry through a specific lens. Faced with their own regulatory costs, namely Basel III, banks are more inclined than ever to service large established hedge funds; the 703 ‘billion dollar club’ funds that control 88 per cent of the hedge fund industry’s AUM.
The economic realities, if AIMA/GPP’s survey is anything to go by, are far more modest.
“The key finding of the survey is that these managers can be profitable at a small size. One third of managers surveyed said they were profitable with less than USD50 million. We therefore dispute the claim that you need USD200 million or more to break even. We think there is tight evidence that you can do it at a lower AUM number,” asserts Capstick.
Breaking it down by strategy, the survey found that global macro funds need the most assets to break even: USD132 million, followed by event-driven (USD108 million) and multi-strategy funds (USD98 million).
CTAs are the most profitable and have the lowest break-even figure – USD78 million – largely because they are systematic and require lower headcount. The same could probably be argued for quant funds. The average CTA that responded to the survey had just three staff compared to 12 staff for global macro managers.
The above profitability figures are likely to raise morale among emerging managers and should provide a considerable dose of encouragement to those who are thinking of setting up hedge fund businesses.
Like the prime brokerage point made above, another myth that this survey would appear to dispel is that if you haven’t got a seeder in place, you haven’t got a chance.
One aspect of the survey that comes through loud and clear is that outsourcing could, and perhaps should, be embraced more than is currently the case. The COO role is largely kept in-house (only 6 per cent outsource), closely followed by marketing investor relations and business development (10 per cent outsource) and the Chief Risk Officer (15 per cent outsource).
The legal function is the most likely function to be outsourced, as cited by 62 per cent of respondents, but less than half of respondents (44 per cent) outsource the Chief Technology Officer role.
“As part of the survey we approached and got responses from 25 hedge fund allocators with over USD500 billion in AUM, of which USD79 billion is invested in hedge funds. When we asked allocators what their views were on outsourcing, only 39 per cent said they saw it as a problem.
“The big conclusion to draw from this is emerging managers need to be outsourcing more. There is no damage to doing so,” says Capstick.
It is not inconceivable to suggest that were global macro and event-driven funds able to reduce their internal headcount by outsourcing, they could lower their operation expense ratios and, in turn, their break-even point.
One important caveat to note, however, is the likely cost of future regulation; most notably MiFID II, which comes into effect on 3 January, 2018. Some 40 per cent of managers expect their break-even point to increase, rather than decrease.
Still, as the survey reveals, an overwhelming majority (89 per cent) of respondents are paying up to 20 per cent of total management company expenses on regulatory and compliance expenses. Against the backdrop of ever-increasing regulation and operational due-diligence standards, these figures are encouraging, notes the survey.
“With respect to the average operating expense ratio, we found it to be 1.1 per cent across the survey. This group has higher operating expenses than larger funds as a function of AUM. Ten per cent of their costs come from regulation and this is expected to rise to 15 per cent under MiFID II but we think operating expenses are controllable. Every strategy in the survey is earning higher fees than their operating costs,” confirms Capstick.
That is the key point: this business is profitable for emerging managers across the strategy spectrum, and that’s before one even factors in performance fees. Given that these managers are the lifeblood of the industry, there is a lot of encouragement to take from this survey.
* http://gpp.group/application/files/3214/9942/0832/AIMA_GPP_survey_report_-_Alive__Kicking.pdf
