Wednesday, December 11, 2013

So You Wanna Start a Hedge Fund?

Tommy Wilkes of Reuters reports, New hedge funds need $300 million in assets just to break even:
Traders launching a hedge fund need to raise at least $300 million in assets to pay for rising regulatory costs and to offset lower fees, a survey showed, a far cry from the pre-crisis days when managers could start with tens of millions.

According to the survey by Citi, hedge funds now charge annual management fees of as low as 1.58 percent of assets, down from the traditional 2 percent that larger funds still command.

Added to this, compliance and regulatory costs have risen because of new rules such as the Alternative Investment Fund Managers Directive in Europe and Dodd-Frank legislation in the United States.

"Fee compression continues to reshape the business of hedge funds, lowering fees even as expenses rise, all but eliminating fee-only operating margins, and raising the level of assets needed for a hedge fund business to succeed," said Alan Pace, Global Head of Prime Brokerage and Client Experience at Citi.

The findings underline the diverging fortunes of hedge funds today. While larger firms have sucked in the bulk of new cash flooding into the industry from institutional investors, smaller funds have struggled to raise assets.

The structure of hedge fund fees - typically an annual 2 percent management charge and a 20 percent performance fee - also means bigger firms can enjoy huge revenues and absorb increased regulatory costs even without generating positive returns for their clients.

By contrast, until smaller funds break the $1 billion in assets mark, they will struggle to cover expenses from management fees alone, the survey showed, meaning managers must increase assets and produce a positive performance or subsidize a loss-making business.

The situation is worse in Europe, Citi said, where company expenses were at least 20 percent higher than for U.S. firms and managers are worrying more about upcoming regulations.

The study surveyed 124 hedge fund firms representing $465 billion, or 18 percent plus of total industry assets.
Linette Lopez of Business Insider also reports, Starting A Hedge Fund Is Getting Next To Impossible:
The days of calling your rich relatives to raise $3 million to start a hedge fund a la Dan Loeb are over.

Citi just released a 45-page report on the hedge fund industry in the United States (where there are more hedge funds than Taco Bells), and it looks like barriers to entry are higher than ever before.

Citi determined that, with costs as they are, it takes an emerging hedge fund manager at least $300 million AUM just to break even. Basically, if you have less than $1 billion, you shouldn't even get out of bed.

The biggest cost of all the monster costs is compensation for the compliance personnel that keep you straight with the Feds. Size is a huge advantage there too.

From Citi:
For small hedge funds with only $100 million AUM, compensation accounted for 8.7 basis points ($87,000) out of total expenses of 17.7 basis points ($177,000)—49% of total compliance expense...

Overall dollar-based costs of compliance rise only modestly, from $177,000 to $210,000 as hedge funds move from $100 million to $500 million AUM, but the composition of those costs is quite different. Expenditures on software and other third-party services shrinks from 51% to only 23% of compliance spend. This share continues to decline at every progressive AUM level within the institutional category, falling to only 6% for firms with $10.0 billion AUM.
All that's not even the worst part. What really might get kids to go back to dreaming of being astronauts instead of hedge fund managers is that management fees are collapsing.

Unless you're a rock star hedge fund manager, clients will not pay you the infamous "2% and 20%" hedge fund compensation scheme. Here's what Citi has to say about compensation for hedge funds with $5 billion AUM or less:
Average management fees continue well below the historical 2.0% level, ranging from 1.58% to highs of only 1.76% for the largest firms in this band. Management company expenses dip and stabilize, ranging from 63 to 68 basis points. No appreciable economies of scale are realized by firms in the institutional category, as this is a period of ongoing investment into upgrading the firms’ capabilities and expanding their teams. During this phase of growth, headcount grows by ~2.0x for every ~3.0xincrease in AUM.
So what's the solution if you still want to be an investor? Franchising. Big shops with hedge funds within them. Citi found that firms that fit this description have an average AUM of $36.4 billion, and that only about 53% of their business is focused on the hedge fund.

Or you could just be David Tepper from day one. That's the other solution.
But all is not lost for small hedge funds. To her credit, Tabinda Hussain of ValueWalk dug a little deeper reporting, It’s A Tough World For Small Hedge Funds: Citi (But Not Really):
If it was for management fees only, hedge funds would barely make ends meet, according to the latest survey from Citi Prime Finance. Unsurprisingly, the bigger the asset base of the hedge fund, the easier it is for it to get by. It appears that hedge funds with $300 million under management, or emerging managers, just break even on their expenses, meaning that it would be the minimum AuM needed to survive. To breathe comfortably, they would at least need $1 billion, says the report.

The survey took responses from 124 hedge funds with over $465 billion under management.

These emerging hedge funds also see a tough time as they are forced to charge lower fees than the standard 2%. The “Business Expense Benchmark Survey” finds that hedge funds with less than $1 billion charge fee between 1.58% and 1.63%. These funds struggle with operating margins and barely match expenses with what they generate from management fees.
Small Hedge Funds: The chunky performance fee

It would seem that it is a tough world for small hedge funds, but all is not lost if these emerging managers net big returns and then charge the much juicer incentive/performance fee, where the industry standard is 18-20%. It is important to mention here that smaller funds average a much higher return and therefore it is more likely that they will charge an incentive fee, however Citi’s survey does not elaborate on this aspect of hedge fund economics.
The larger the hedge fund, the better

The survey also sheds light on the fee structure of larger firms which it categorizes as institutional hedge funds. Citi finds that the average hedge fund charges less than a 2% management fee even in case of larger firms managing between $1.5 billion to $5 billion. Operating margins based entirely on management fees come around 1% for these funds.

Hedge funds with more than $10 billion, or franchise sized firms as Citi puts it, are more profitable based on management fees alone. The report says that the average fees charged by these fund was 1.53%. In Citi’s survey, the average size for the large hedge fund was $36.4 billion. In this data set, only 53% of assets were invested in hedge fund strategies, whereas the rest was dedicated to regulated offerings and private and/or public long-only funds. Citi’s finding is consistent with what Deutsche Bank pointed out in its own survey that larger hedge funds (AUM over $5 billion) tend to focus more on non-traditional approaches than on conventional hedging wisdom.

The report further said that 95% of assets of emerging managers and 90% of assets of institutional fund managers were focused solely on offering hedge fund product, which is in stark contrast to the allocation of franchise-sized firms.
Let me give you my thoughts on all this. First, you really need to take the time to read all my hedge fund comments. You will quickly learn these are treacherous times for hedge funds, especially smaller ones that are withering away.

What's the main culprit? Dumb money, or to be more specific, dumb pension and sovereign wealth funds taking advice from useless investment consultants recommending the same large brand name hedge funds, many of which, like Eddie Lampert's ESL, are underperforming the broader market.

I know, skeptics will scoff that big hedge funds are "bigger because they're better." They have more money than God, can attract the best and brightest and charge 2 & 20. While there is definitely some truth to this, I submit there are plenty of large, lazy asset gatherers in Hedgeland perfectly content to collect that 2% management fee and the only reason they continue to thrive is because dumb money keeps plowing into them (there are some excellent large funds chopping fees in half  but they're the exception, not the rule, which is why most hedge funds underperform).

Also, take this Citi report with a grain of salt. Keep in mind, Citi's private wealth group made the bonehead decision to remove Paulson from their internal platform at the worst possible time. In fact, I wrote about the Paulson Disadvantage Minus Fund last October, and didn't mince my words:
As far as investors who are increasingly frustrated and looking to redeem from Paulson now, it's very late in the game. The time to have redeemed from Paulson was after his "stellar year," less so now. These funds of funds managing high net worth money are ridiculous, covering their asses because they were unable to determine the return drivers in Paulson's fund beforehand and protect their clients' gains. 
And who is the top large hedge fund this year? Oh shocker, Paulson! Bloomberg reports that Paulson’s event-driven Advantage fund surged 13 percent in November and 30 percent this year, betting on the global recovery. In fact, amid an awful year, Paulson is an exception. (There is a small Greek focused hedge fund that is up 107 percent in its first year. OPA! Talk about my Big Fat Greek Feta, umm, Beta!! LOL!)

No wonder funds of hedge funds are dying. On top of charging heaps of fees, most of them are just plain incompetent and can't figure out return drivers of the hedge fund strategies they invest in. They too rely on useless investment consultants regurgitating the same mindless advice (how many of you redeemed from the world's biggest hedge fund after Texas Teachers lost its Bridgewater mind?).

So what is the solution for smaller hedge fund managers who think they're the next Soros? Unfortunately, it looks grim out there and unless dumb money finally wakes up and starts seeding smaller funds on a much larger scale using top fund of funds, I see the bifurcation of the hedge fund industry getting worse. The big funds will become even bigger asset gatherers and small performance driven funds will continue withering away

But alas, don't fret my smaller hedge fund managers, there is plenty of dumb money looking for an alternatives miracle. I will give all you Soros wannabes some tongue-in-cheek advice on making it in the ultra competitive hedge fund industry. 

First, forget London and New York, set up your operation in Asia. The Citi report found that running a hedge fund in the Asia-Pacific region can be as much as 42 percent cheaper than in the U.S. and Europe, helped by lower-than-average compensation.

If Asia is too far, come set up shop in Montreal. The rent is cheap, the food is great and you can hire top finance students for next to nothing and have the Quebec government subsidies their salaries. The only drawbacks are the weather, Quebec politics, crummy infrastructure, and our bonehead regulators, all of which suck. But the women in Montreal are among the most beautiful in the world and they will warm up all you horny hedge fund managers during our freezing cold winter.

Speaking of attractive women, my second piece of advice is to stop hiring sexy bimbos to work for your investment relations department. All they do is bat their eyelashes and distract horny pension fund managers. If you're going to hire an attractive lady, make sure she's a sharp shark, like Tatiana over at MCM Capital Management.

Tatiana is doing great, flying all over the world, attending silly hedge fund conferences, wining and dining horny pension fund managers. She tells me business has never been better. Her cousins, Igor and Yuri, two Russian physicists, are also having fun going through my top funds activity, figuring out which stocks to go long and short. The only tedious part they hate is filling out long due diligence questionnaires but they're getting the hang of it, providing dumb money and dumber investment consultants a bunch of nonsense quantitative data, like their "unbelievably high Sharpe ratio" (insert roll eyes here).

My third piece of advice for emerging managers is if they can afford it, hire a real quant like Haim Bodek, the genius algorithmic trader who exposed the Wall Street code. The only problem is that guys like Haim are rare in finance because they're honest and ethical. You're better off finding a money hungry quant with a PhD from a top university who can find ways to frontrun clients, giving you profits and time to raise assets. Once assets mushroom to well over $1 billion, you can put your fund on cruise control, enjoying your new license to steal, charging 2 & 20 for sub-beta performance.

Fourth, you can subscribe to my blog ($500 or $1,000 a year option), and use my services to gain inroads with a few of Canada's top ten that invest in hedge funds. But before I send your pitch book to Ron Mock or anyone else, you will have the great pleasure of getting grilled by me. Ron is busy with his new job. He doesn't have time to listen to your rants on your "niche strategy" and "unbelievably high Sharpe ratio." Let me grill the hell out of you first and trust me, I'm a hopelessly cynical Greek prick who's seen it all. If you pass my mustard test, Ron Mock and his crew at Ontario Teachers will be a walk in the park (should start my own TV show, The Hedge Fund Shark Tank).

My last piece of advice for all you Soros wannabes is to follow the example of my favorite hedge fund manager of all time, Andrew Lahde who had the brains and foresight to say Goodbye and F---- You. He retired at the age of 37, right  after he made hundreds of millions in 2008 shorting the hell out of subprime crap 'idiot traders' with fancy degrees were recommending:
The boss of a successful US hedge fund has quit the industry with an extraordinary farewell letter dismissing his rivals as over-privileged "idiots" and thanking "stupid" traders for making him rich.

Andrew Lahde's $80m Los Angeles-based firm Lahde Capital Management made a huge return last year by betting against subprime mortgages.

Yesterday the 37-year-old told his clients that he had hated the business and had only been in it for the money. And after declaring he would no longer manage money for other people, because he had enough of his own, Lahde said that instead he intended to repair his stress-damaged health; he made it clear he would not miss the financial world.

"The low-hanging fruit, ie idiots whose parents paid for prep school, Yale and then the Harvard MBA, was there for the taking," he wrote. "These people who were (often) truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government," he said.

"All of this behaviour supporting the aristocracy only ended up making it easier for me to find people stupid enough to take the other side of my trades. God bless America."

Lahde became one of the biggest names in the investment industry when one of his funds produced a return of 866% last year, largely by forecasting the US home loans industry would collapse.

In his farewell letter, which concluded with an appeal for the legalisation of marijuana, Lahde said he was happy with his rewards and did not envy those who had made even more money.

"I will let others try to amass nine, 10 or 11 figure net worths. Meanwhile, their lives suck," he wrote, citing a life of back-to-back business appointments relieved only by a two-week annual holiday in which financiers are still "glued to their Blackberries".

Lahde's retirement came amid an implosion among the hedge fund industry - some 350 of the funds have liquidated this year, according to Hedge Fund Research.

His final words of advice? "Throw the Blackberry away and enjoy life."
That, ladies and gentlemen, is the best advice ever! I invite Andrew Lahde to Montreal so we can grab a nice dinner, gawk at beautiful ladies, and discuss how stupid the hedge fund industry has become as we smoke some good Québécois weed (lol).

Below, Jason Ader, chief executive officer at Ader Investment Management, Gregory Hall, senior managing director at Blackstone Alternative Asset Management, and Ted Seides, president of Protege Partners LLC, participate in a panel discussion about investing in hedge-fund startups. Katherine Burton moderates at the Bloomberg Link Hedge Funds Summit in New York

And Agecroft Partners Founder Don Steinbrugge discusses tracking hedge funds and dealing with public pensions. He speaks with Deirdre Bolton on Bloomberg Television's “Money Moves.”

If there are good funds of funds looking to seed top hedge fund talent, I have a few great emerging managers to recommend. Just contact me at LKolivakis@gmail.com but don't waste my time with ridiculous terms. Rest assured, I won't waste yours.