AIMA: Smaller Firms Remain the Lifeblood of the Hedge Fund Industry

Jul 26 2017 | 5:55pm ET

Editor’s note: It is a hedge fund industry truism that the largest managers receive the most attention, but the 90% or so of hedge funds out there managing less than $1 billion are the lifeblood of the industry and the cradle of its industry’s innovation, according to AIMA CEO Jack Inglis. Moreover, new research suggests the breakeven point for these smaller managers is lower than traditionally thought. 

Smaller Firms Remain the Lifeblood of the Hedge Fund Industry

By Jack Inglis, CEO, Alternative Investment Management Association (AIMA)

The hedge fund industry comprises two branches. One includes firms managing $1bn or more in assets. This group’s star managers feature regularly in the pages of The Wall Street Journal and the Financial Times. It contains about 10% of the industry in terms of the number of firms, but manages about 90% of the assets.

Much attention focuses on this group - the “billion-dollar club”. Industry research and performance indices tend to be skewed to the larger firms. Consultants’ lists of approved hedge funds are dominated by the larger brands. Many of this group’s constituents are big institutionalised businesses whose clients include some of the largest institutional investors in the world, such as sovereign wealth funds and public sector pensions. 

The second branch contains firms that each run less than $1 billion in hedge fund assets. Their investors can include large institutions but family offices, funds of funds and private banking assets are more prevalent. These are small businesses led by entrepreneurs. They are often the cradle of the industry’s innovations, being able to invest in niche markets without capacity concerns. Frequently, they are among the industry’s best-performers. Yet the press, in general, tends to look elsewhere. The gaze of many investors, too, can be drawn to larger brand names. In some cases this is because they are unable to allocate to smaller funds due to size limitations. Other factors can include infrastructure demands, length of track record and other checklist items that can be difficult for some smaller managers to meet.

The bifurcation in the industry is nothing new, but the concentration of assets among the largest firms has become steadily more apparent since the financial crisis. Hedge fund firms with $5 billion or more now manage about two-thirds (69%) of total industry assets, according to HFR – up from about 60% in 2009. For firms managing over $1 billion in hedge fund assets, the proportion is 91% (up from 86% in 2009). 

Previous widely cited pieces of research suggested that hedge fund managers needed at least $300 million in assets to reach profitability. Taken at face value, the research in effect had written off hundreds, if not thousands, of fund managers as loss-making. This segment of the universe includes many firms that have been operating for years. Either we accept the premise that many of them are comfortable making losses year after year, or we assume that those research pieces may have been misleading. 

Industry averages, in a sector so diverse, can be imperfect. We know that this often impedes average performance analyses. In terms of break-even analysis, it of course stands to reason that a firm with hundreds of employees, a myriad array of funds and fund structures and institutional clients in numerous jurisdictions would cost more to run than, say, a five-person outfit managing a single fund for a small number of clients (as well as its own money).

As far as we were aware, no one had attempted to find the break-even average just for smaller firms. This is why we decided to take it upon ourselves, in partnership with the prime broker GPP, to ask this very question (and related others). The headline finding of the report we published in July, titled Alive and Kicking, was that the break-even point for firms managing less than $500 million is currently around $86 million in assets. And that was only the average; a significant minority of respondents said they reached profitability when running less than $50 million.

If those figures strike people as surprisingly low, then part of the explanation may depend on a factor that is difficult to quantify in a survey like this. Clearly, some founders will take a pay cut, or draw no salary at all, during the start-up phase. In that respect, hedge fund founders are no different to entrepreneurs everywhere, who accept that sacrifices may be necessary, particularly in those all-important first years of operating. Their motivations also may be different if they are primarily managing their own money and that of their friends and families. 

Easier to quantify is the degree to which smaller firms in recent years have embraced outsourcing in order to keep costs down. This effort undoubtedly has been helped by increased competition among all kinds of service provider businesses today, which has helped to raise standards and reduce fees. Our survey found that legal services, HR and technology are the functions most often obtained from external providers. 

Also clear from our research was how industry-wide trends such as fee pressures, rising compliance costs and investor demands for ever greater alignment of interests are applicable to smaller firms as well as larger ones. This underlines that while bifurcation has taken place, firms operating in both branches of the industry are experiencing many of the same issues, challenges and opportunities. 

Smaller hedge fund firms are the lifeblood of the industry and remain an essential constituency for AIMA. Sub-$500m firms comprise about two-thirds of our fund manager members. Some of them may break through to be the mega hedge fund firms of tomorrow. We wish them all success. 

Jack Inglis is the CEO of the Alternative Investment Management Association (AIMA). He has been in the financial services industry and closely involved with hedge funds for more than 30 years. He has held senior management positions at both Morgan Stanley, where he served for 16 years, and Barclays, where he was prior to joining AIMA.

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