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| March 1998 | The Coming Evolution of the Hedge Fund Industry | ||||||||
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V. Strategic Drivers for Evolution |
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V.(a) Hedge Fund Industry in Growth Stage |
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In describing the state of the hedge fund industry above, a number of factors were highlighted that we feel will serve as strategic drivers for this next phase of evolution within the hedge fund industry. Some of these factors are evident in the evolutionary phases of other industries that experienced similar growth and characteristics. Still others have come to light through our survey of US hedge fund managers and investors. It may be instructive to look at the hedge fund industry in the context of the industry lifecycle and compare it to the structural changes that have taken place in another similar financial industry - mutual funds. The lifecycle concept asserts that products and industries go through an S-shaped growth curve based on Michael Porter’s classic "Lifecycle of an Industry" framework (20). The framework breaks the lifecycle of industry evolution into four stages; Introduction, Growth, Maturity, and Decline. In the introduction phase, an industry goes through an often extended trial period of introducing the new product and overcoming buyer inertia. Once the product is accepted and proven successful, the industry enters into the second phase of rapid growth. We believe the hedge fund industry is in this phase of its lifecycle. This stage is characterized by high revenue growth, many competitors, low barriers to entry and relatively high profitability. The third phase, maturity, is reached when penetration of the product into the market place reaches a saturation level causing the rapid growth to halt. We believe mutual funds are entering the maturity phase of their lifecycle; the market is becoming saturated, price competition is increasing and consolidation is taking place. Although there are some fundamental differences between the mutual fund and hedge fund industries, it is our view that one can learn a lot about the forthcoming structural evolution of the hedge fund industry by looking at the historical evolution of the mutual fund industry. In essence, one can look at the mutual fund industry as a leading indicator for the hedge fund industry. Exhibit
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Source: Porter
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| V.(b) Lessons Learned from the Mutual Fund Industry | |||||||||
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The recent growth in the hedge fund industry bears many similarities to the growth and evolution that occurred within the mutual fund industry. In the early 1980’s mutual funds began to attract significant investor attention. Very rapidly the industry advanced from relative obscurity to a multi-trillion dollar business (21). Exhibit
20 Source: ICI It appears that hedge funds and mutual funds are following very similar growth patterns in terms of both assets and number of funds. Exhibit
21 Source: Bekier, Cottier, ICI Looking at these curves, it appears that the rapid growth of mutual funds began some ten years prior to that of hedge funds; approximately 1980 for mutual funds and 1990 for hedge funds. The rapid growth stage for mutual funds has lasted more than 15 years (1980-1997). Granted that some of the underlying drivers of growth may be different for mutual funds than for hedge funds (e.g., the proliferation of mutual funds in 401 (k) plans). However, if one assumes that the growth cycles will parallel each other to some extent, then one can conclude that hedge funds are at the beginning of their journey and the growth cycle for hedge funds could last another ten years taking us to well into the next century. In fact, if one looks closely, it becomes evident that the hedge fund industry today bears a strong resemblance to the mutual fund industry of the early 1980’s. Since then, the mutual fund industry has gone through several phases of evolution; from stand-alone small funds to large families of funds and now a period of consolidation and globalization. It is our view that the hedge fund industry will take a similar course of evolution in the next decade. Just as we see today in hedge funds, mutual funds experienced a tremendous inflow of capital in the 1980s. Very rapidly the industry grew to a multi-trillion dollar industry, but with little structure. There were many stand-alone funds each presenting investors with different investing styles and fee structures. There was little way for the average investor to get comprehensive information about fund performance. For this reason, mutual funds at this time were mostly used by sophisticated investors who had the time, resources, and intellect necessary to evaluate and select funds. In response to the growing investor demand for mutual fund products, major financial publications began devoting more and more space to grouping, ranking, and explaining mutual funds. As this need for systematized information continued to evolve, there was an emergence of information providers like Lipper Analytic, Morningstar, Micopal, etc. dedicated solely to rating mutual funds. Today, their ratings serve as one of the primary determinants of success for a fund. In the hedge fund industry, similar to the rise of Lipper and Morningstar, there is an emergence of organizations like Managed Account Reports (MAR), Hedge Fund Research, Hennessee Group, Van Hedge Fund Advisors and TASS. Each of these groups track their own universe of hedge funds. Participation in the "league tables" that these research groups prepare is becoming an essential component in the successful marketing of hedge funds. As the mutual fund industry became systematized and fund information became widely available, investors began managing their funds more actively and began switching between different funds as their preferences changed. The mutual fund industry went through a further evolution joining a variety of fund styles together under a common umbrella to provide customers with a menu of choices. In addition to providing greater choice and service for customers, the "families" of mutual funds were able to retain assets even if customers were switching to other styles of funds. These families of mutual funds (FMF) quickly became household names and rose to the top of the industry. As these large families of mutual funds gained prominence, they began to exert significant pressure on small niche players. Using their size and diversity, these FMF could attract and retain more customers through larger product offerings, better technological infrastructure and superior "marketing machines" that thrust their brands into the public consciousness. The results are evident today by the fact that the top 10% of the mutual fund companies control over 80% of the total assets under management. The clear advantage of large families of funds has led to the current industry evolution, that of industry consolidation and globalization. While internal growth and expansion initially spawned the development of FMF, merger and acquisition activity is now playing a key strategic role in building broad and global fund families to achieve competitiveness and economies of scale. It is our view that a similar evolution will take place in the hedge fund industry. A Family of Hedge Funds (FHF) bringing together a variety of different funds under a single unified operating organization will have a similar opportunity for market domination. The present structure of the hedge fund industry will change from a fragmented one with thousands of small niche players into one made up of a smaller group of large organizations providing market leadership in the global marketplace. However, the motivation and drivers for consolidation in the hedge fund industry may not be the same as for the mutual fund industry.
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| V.(c) Fragmented Industry Ripe for Consolidation | |||||||||
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As discussed earlier, the hedge fund industry is highly fragmented with approximately half of the current funds under $20 million. An analysis of the MAR/HEDGE database indicates that the number of newly listed hedge funds in their directory, rose from 73 in 1990 to 661 in 1996, an annual compound growth rate of 44%. Most of these new funds are small, with assets under management much less than $100 million. However, with average investment performance, a small fund can generate significant revenues. Most of these smaller funds are managed and operated by one or a few individuals. Therefore, even a smaller fund with average performance could provide a good cash flow to its managers. Historically, this combination of fragmentation and high profitability has presented significant opportunity for evolution or consolidation. The profitability makes the industry attractive and the lack of dominant players creates an opportunity for a motivated, well-funded consolidator to create an organization that represents the next evolutionary step. However, there is little economic pressure toward consolidation in the hedge fund industry today, due to the large inflows of new money and the recent bull market. As these remarkable market conditions inevitably change, however, there may be far more significant pressure on small or under-performing hedge funds. At the same time, hedge fund managers will have to compete, for the first time, on a global basis as the battle to manage the world’s assets is evolving into a single market. We believe that these conditions will drive structural change from a fragmented industry with thousands of competitors into one made up a smaller group of larger organizations. This kind of consolidation is a part of natural evolution of any maturing global business. For example, the automobile industry and personal computer businesses were both extremely fragmented at different points in time. As the business matured and globalized, the participants either lost their market share or were being acquired by larger, well known groups. It is our view that the hedge fund industry will follow the same pattern in its journey of growth. We believe that the strategic benefits of expanded product lines, focused marketing and sales and improved operational support and the potential for high financial rewards will be the primary motives for consolidation. Those organizations that take a pro-active approach are most likely to complete timely acquisition with the most attractive funds. There are a number of profiles of potential merger and acquisition candidates. One group of potential candidates will be those hedge fund managers looking for liquidity and succession. Another group will be those who are looking to grow their asset base through the benefits a larger organization could bring such as distribution and global exposure. Another group of potential candidates may be corporate parents that feel a hedge fund managementr subsidiary no longer fits with its core business. Valuations of investment management companies is more of an art than a science. Like hedge fund managers, the majority of investment management companies are run by one or a small group of owner/managers. The success of the firms are highly dependent on the investment management expertise and the client relationships of the owner/managers. While there is a relatively active merger and acquisition market for more traditional high net worth and institutional managers, the personal nature of the business leads to a wide variety of transaction structures and valuations. However, there are some "rule-of-thumb" benchmarks for more traditional asset management company valuations. There are three commonly used benchmarks for comparing money management firm valuations; (i) percentage of assets under management, (ii) multiples of revenue, and (iii) multiples of pre-tax earnings or cash flow. The first two are connected via management fees, while the later two are connected via gross margins and operating expenses. All three schemes should ultimately lead to a similar valuation . Exhibit
22
Source: KPMG, Berkshire Some of the factors that go into the valuation equation relate to the stability of the customer base and the variability of revenues and cash flows. For example, mutual funds have a relatively large and stable customer base and relatively predictable revenues and profits. Therefore mutual funds tend to trade at the higher end of the valuation ranges (depending on the strategic drivers for the transaction). Hedge funds, on the other hand, have a customer base that is much more concentrated and revenues, and therefore profits, are more volatile due to their performance fee structure. The volatility of revenue could vary greatly among the different investment styles of hedge funds with market neutral strategies potentially exhibiting less volatility than traditional managers and short only or global macro funds with high volatility. As the assets and revenues of hedge funds tend to be more volatile and unpredictable, it is our opinion that a discount factor should be applied to valuations based on revenue. In addition, because of long "lock-up" periods, hedge funds become an illiquid investment and, therefore, as with any private equity partnership, they should carry a lower valuation multiple, approximately half that of publicly traded mutual funds (23). Even with a discounted multiple to revenue, however, hedge funds would have a higher purchase price based on a percentage of assets due to the performance fee structure. For example, a traditional investment manager with $100 million in assets under management and a 1% management fee might sell for three times revenue or $3.0 million. This equates to 3% of assets under management. A $100 million hedge fund with a 1% management fee and 20% performance fee could be valued at 2 times revenue. Assuming an average rate of return (ROR) of 20% results in revenue of $5.0 million and a valuation of $10.0 million or approximately 10% of assets under management. On the basis of 2 times revenues, the chart below estimates an approximate valuation of a hedge fund in terms of a percentage of assets under management (AUM) for various rates of return and performance fees. Exhibit
23
Source: RRCM One final note on this subject is that the financial structure of these transactions can only be determined by a detailed analysis of the assets, revenues, and operational expense characteristics of the hedge funds under consideration and how the target fits strategically with the acquiring organization’s business.
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| V.(d) Future Opportunities - The Evolution has Already Started | |||||||||
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There is ample evidence that an evolution like the one described in this paper will happen and that it will happen successfully. Other segments of the financial services industry with similar characteristics have evolved in this manner. We looked previously at the mutual fund industry, but other examples exist. Within the institutional money management industry there has also been significant consolidation of late. The most interesting examples of this consolidation come from United Asset Management (UAM) and the Affiliated Managers Group (AMG). Both of these firms are executing a form of industry consolidation, each with a different approach. Whereas UAM buys whole money management firms and incorporates them as part of the UAM organization, AMG takes less than 100% positions and links the various independent organizations into a confederation of smaller firms. Within the last six months we have also seen examples (24) of at least two rudimentary attempts at consolidation within the hedge fund industry. Both Consolidated Advisors Ltd. (a company sponsored by CIBC Wood Gundy) and Asset Alliance Corp. of New York have made some preliminary hedge fund acquisitions. Like UAM and AMG, they each take different approaches. Neither group, however, has yet emerged as a fully-formed Family of Hedge Funds. There is no clear brand identity established nor is there an established central sales, marketing or operations function. It is our view that there is a significant opportunity for the creation of the Family of Hedge Funds complex through acquisition. It is our view that FHF has the unique opportunity to combine the drive and creativity of entrepreneurial firms with the breadth and financial strength of a larger organization. It is the unique combination of strengths - both individual and collective - which makes FHF particularly well matched to the changing needs of the hedge fund industry. It is also our belief that FHF should not be a holding company but rather an operating partner that use its size and strength to help individual firms unlock new opportunities on a global basis. Our analysis indicates that there remains a void to be filled and opportunity to be seized. There is a significant opportunity for a motivated, well funded consolidator to create an organization that represents the next evolutionary step. Our research indicates that the market is looking for a leader. The question remains who will emerge as the industry leader? Who will play the role of the Fidelity of Hedge Funds ? |
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rrao@ramarao.com