BNY Mellon and Casey Quirk & Associates
Please note: This article is in two parts, within two consecutive issues of Alternative Intelligence Quotient; this is the second section of the article, the first half was published in Issue #34.
Blueprint for the Enduring Firm
Flaws in the standard hedge fund business model have triggered investor demands for better alignment. These flaws must be addressed in a comprehensive fashion; selective tinkering will not solve the alignment conundrum. Our prescription involves redesigning liquidity terms, fee structures, and investment team compensation in the context of investors’ long-term objectives, starting by harmonising all three along a consistent time period, not necessarily a calendar year.
This means terms, fees and compensation will vary across managers and strategies and, therefore, the industry will move away from a standard and static structure. It also means some old dogmas, such as the high-water mark feature, have outlived their usefulness and should be let go. The result will be the Enduring Firm, a hedge fund business that has a real chance of surviving multiple downturns and becoming a multi-generational firm.
Beyond alignments, our blueprint for the Enduring Firm marks a clear break with hedge funds’ cottage industry roots and is characterised by excellence and balance across four functional areas: business management, investments, distribution and operations; each with their own set of best practices. These common attributes are applicable to a wide range of business sizes and types, and we outline four models which the Enduring Firm can pursue: single-strategy boutique, multi-capability platform, merchant bank, and converged traditional-alternative manager. Our conclusion is that the multi-capability platform model will see the greatest growth going forward.
We also explore a fifth emerging model, the alternatives holding company, which may facilitate growth and a form of ownership transition for single-strategy boutiques.
Finally, funds of hedge funds are facing their own set of unique business challenges. As outlined above, investors still favour funds of hedge funds as a means for investing in hedge fund strategies. However, we believe this demand relies upon funds of hedge funds adapting their product and service capabilities to meet new investor demands.
Hedge funds’ state of misalignment
The credit crisis has revealed the extreme degree of instability inherent to the hedge fund business model, largely a function of poor alignments between three parties: investors, hedge fund firms, and firms’ investment teams.
The legacy alignment structure has big flaws:
1. Business timing mismatch: A serious imbalance affecting all the alignment tools listed in the previous chart (liquidity terms, fees, performance measurement, performance payout, compensation structures) is the timing mismatch that has grown among them. For the majority of hedge fund strategies, there is little or no consistency within strategies for most of these tools. In times of stress, the result is, at best, investor surprise and frustration, and perhaps anger; at worst, a breakdown in a manager’s ability to remain a going concern, as survival comes to depend on locking assets against investors’ wishes.
2. Destructive incentives: Much has been written about the asymmetry in hedge fund managers’ potential payout, and the high-water mark was one way to reduce this asymmetry. Unfortunately, rather than protecting the investors, the high-water mark has become a toxic incentive, setting the three stakeholders against one another and leading to a vicious cycle of destructive behaviours: excessive risk-taking in an attempt to make up losses, fund (or firm) closure, and investor redemption due to fears of the first two. Any investment with a performance-fee component can never have completely symmetrical payouts, but we believe there are better ways to mitigate the payout asymmetry than with a high-water mark.