The Problem with Hedge Fund & Investor Alignment
Investing in companies undergoing strategic transformation can be a stressful endeavor, given inevitable short-term underperformance.
Mimicking the herd invites regression to the mean – Charlie Munger
With all the coverage of idea crowding in active management, I think the entire concept is worth a philosophical examination. For the private-equity style – or permanent capital – investor, crowding should be a nuisance; at best short term noise which may provide a window in understanding momentum effects, or perhaps a disruption in trend to dip in/out of a fundamental position. For investors that want to hold core positions over extended holding periods, how fickle the mob is can be a distraction from fundamental analysis of a unique investment. So why has crowding become such a prevalent issue in active management?
The question has deep implications for the entire Hedge Fund ecosystem, which has been characterized by academics as nothing more than momentum beta and the equivalent of selling puts. However, our proprietary crowding factor has captured more than simply hedge fund beta trades; it consistently captures high quality businesses that compound annual growth and free cash flow generation. But how many hedge funds are truly ambivalent to short term noise? How many are in a position to behave as a true permanent capital investors?
The reality is that investing in companies undergoing some form of strategic transformation, or companies misunderstood/maligned by the street can be a stressful endeavor when it comes to inevitable short-term underperformance. Explaining this to LPs can stretch their patience and trust. Besides Seth Klarman, Howard Marks, or Stephen Butt (to name a few), most fund managers do not have this exceptional luxury. The problem is inexorably tied to the economic model of active funds best understood through the GP/LP model.
The central truth of the investment business is that investment behavior is driven by career risk. – Jeremy Grantham
The GP/LP Dilemma: Alignment of Interest
Before getting into the problem with GP/LP relationships, let’s take a bit of time to talk about the fundamental economics behind launching a Hedge Fund. At Novus, an appreciable percentage of our Hedge Fund clients are new fund launches, and we are well tuned to the economic realities of launching a Limited Partnership.
For most New York based launches, these startups require LP capital to transition the business model from a “keep the lights on” cost basis to a profitable endeavor.
Through our experience, that inflection point hits at close to $150 – 200mm of LP assets after you factor in costs for talent (back office, front), systems (admins, OMS, Analytics, Bloomberg), office space, and execution (trading, counterparty management)*. However scrappy launches need to be in order to reach this inflection point without shuttering, unlike many conventional startups, hedge fund profitability can grow exponentially once assets begin to multiply.
Case in point: let’s look at Startup Long Short, Ltd (“fund”). Let’s assume that the fund charges 1.75% in management expenses, and the entirety of that revenue at a $150mm capital base is used to cover the aforementioned expenses. That means that a “keep the lights on” annual burn rate is in the order of 2-3 million dollars. As I show with an admittedly naïve hypothetical model, even if a fund consistently generates above market returns, profitability only comes with a margin of error once the fund crosses $300mm of assets. We also quickly can see that the fund becomes immensely profitable – almost irrespective of performance – as it reaches (and exceeds) a billion dollars of assets:
Of course, this is an oversimplified model, but it elucidates a stark truth. While this model can be very profitable the successful GP, it presents some unintended consequences as well.
Let’s assume our scrappy startup has spent 3 years under the $200mm mark, posting consistently fantastic returns and finally attracting interest from institutional investors. These investors, who often write big checks, want to find promising and nimble funds, but can be reticent to seed managers given the heightened uncertainty of success at launch. This leads to an underreported phenomenon of crowded LP interest for promising young funds that have crossed the $1-200mm threshold and have demonstrated several years of alpha generation. With an effective marketing campaign, the asset accumulation of these funds can quickly climb to $1bn in a matter of months.
The expectation of these “growth capital” LPs is a continuation of the prior alpha generated during the “startup” phase. As the GP, once you cross this Rubicon, you become beholden to consistent outperformance, irrespective of your investment style or the opportunity set. You do this to optimize your risk-adjusted profitability, as any savvy business person would. Besides the added complexity of dealing with chunky institutional investors (e.g., side letters, monthly calls with the principals, separately managed accounts), this puts pressure not only on the GP’s absolute performance but on that relative to its peers. Remember the institutional LP is more than likely invested in dozens of hedge funds. The end result of this dynamic shift for the GP is it more often than not begins playing the Keynseian Beauty Contest rather than the true execution and evaluation of merit-based investment decisions.
We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be – John Maynard Keynes
The Keynesian Beauty Contest
John Maynard Keynes coined the concept as a means of explaining the unintended behavior that fund managers engage in once career risk and competition becomes part of their investment process. It’s an analogy for actors who are motivated to judge the beauty of a contestant (or an investment) based upon the other judges responses rather than the merit of that which they are judging. For investors, it points to those that are more worried about their peers and the herd, rather than the intrinsic fundamentals of the very investment.
As an example, assume a security’s price decouples from its underlying fundamental principles (earnings power, growth, free cash flow generation, transformation, et al.) as a herd of hedge funds pour into it. Not wishing to miss the party, the Keynesian Beauty Judge views the security as an attractive investment, judging that his peers are willing to continue to buy (and thus he may generate a profit on it). We saw this quite clearly in the tech bubble, as a fear of generating outsized returns lead many to wade in far after securities were divorced from their fundamentals. Of course, there is a quantitative strategy for this, known as trend following, but for the purpose of this piece, we will focus on fundamental managers.
Going back to our successful growth-stage hedge fund who just attracted hundreds of millions of institutional capital, she now has the added pressure of not only delivering consistent performance to anxious LPs, but also to ensure that they are consistently performing above their peer medians. After all, you may be underperforming by demonstrating a contrarian perspective, but that leaves you vulnerable to capital flight, as the fickle LP fires you for the flavor of the quarter. And so, concepts such as crowding and underlying security illiquidity become necessary inputs (or risk factors) for your investment process. Savvy LPs will use tooling like overlap and uniqueness as lenses of evaluation and criticism.
This may frustrate the PM whose time horizon on a security’s intrinsic value may be misaligned with the pressure felt when keeping up with the Joneses. After all, those $100mm checks need to be placated to make the business consistently profitable. This misalignment can divert the fund from its core investment style. Those frustrated with this reality have increasingly converted to a family office, ridding themselves of the nuisance of external capital. Of course, one has to be massively successful (as George Soros and others have done) to make that decision. That is because – as we’ve demonstrated – the loss of profitability in returning external capital is overwhelming, especially if you manage in excess of $1 billion of LP capital. This is a classic game theory outcome that afflicts HFs and the institutions that lean on them for generating alpha in their portfolios.
Having great clients is the key determinant to success in money management – Seth Klarman
A Better GP/LP Symbiosis
Clearly the solution to this dilemma is to engender better GP/LP alignment. The question is how? Certain funds (such as Adage Capital) have caught on to this and have instituted novel approaches to ensure better alignment. The debate around hedge fund fee structures is ongoing, and its origins are something of an enigma, but it clearly started from a desire to incentivize – and thus align –outperformance between GP/LP. This model, while fine on a surface level, didn’t scale adequately for what has become a $3trn global industry.
Hurdles have increasingly been discussed, but that has arisen more due to perceived underperformance than misalignment of interest. The collective ecosystem of hedge fund investors can address this issue with one simple but substantive shift: The standard for management fees – not incentive fees – should progressively decrease once assets rise beyond certain logical thresholds.
While this may sound like a leap of faith (and an expensive one at that), it will ultimately drive better alignment.
I can see many hedge fund PMs reading this and scoffing at relinquishing the stability of management expenses with nothing in return. Before you do, there is a quid-pro-quo to this proposal, as this shift shouldn’t be wholly punitive for the GP: Fee compression should be accompanied by longer lockups from the LP to ensure GP/LP alignment is addressed. This gives GPs more degrees of freedom to express their ideas without fear of reprisal for short term underperformance. It allows for differentiated thought; for managers to divorce themselves from competing against their peers. After all, after your endeavor has scaled successfully (presumably through a track record of proven alpha generation), you should have earned the liquidity premium and the commensurate freedom. This change will ultimately solidify the alignment between GP and LP, so Hedge Fund managers can stop playing the Keynesian beauty contest and focus solely on generating alpha.
*Of course, this can vary demonstrably given strategies. E.g., quant strategies often require a greater capital base given the added infrastructure and trading costs, versus fundamental equity long/short.