Managing the Business of Asset Management
Contributed by Holly H. Miller, Partner, Stone House Consulting LLC
In the wake of plummeting revenue streams, particularly with client concerns over operational risk and managers’ needs to control costs, the lines between traditional investment managers and hedge funds have blurred and will continue to do so. Traditional investment managers and hedge funds alike need to focus on the business of managing money as well as the management of the assets. Though the industry’s historically high margins have allowed managers to pay scant attention to the decidedly unglamorous and hugely complex expense side of the business, they must do so now. The winners will be those who manage their firms as well as they manage their clients’ portfolios.
While buy-side revenues are driven by assets under management, costs and, ultimately, profit are driven primarily by the number of accounts and secondarily by the number of products or strategies the firm offers. Even with automation, more accounts or products equate to more people and salaries, typically the single biggest expense item. This disconnect between revenue and expense drivers frequently went unnoticed by many senior managers because of the industry’s incredible profitability. That clearly is no longer the case.
Now buy-side firms are stressed on both sides of the equation. Fee pressure has held back revenues relative to assets under management, while rising costs have further constrained the bottom line. To cope, effective managers must abandon past cursory approaches to accounting and detail their cost structures, examining profitability by product, strategy, vehicle, platform, client and account.
Such product or fund rationalization and justification will be entirely new to many firms. The effort will bring to prominence new product committees that will take on product evaluation responsibilities in a broader way than ever before. Comprised of representatives not just from sales, marketing and investment management, as in the past, but also from compliance, risk management, IT, and operations, these committees will need to develop ways to appropriately allocate expenses to products, platforms and clients. Ultimately, the approach will identify products, strategies and even clients that are not cost effective and should be discontinued.
Effective decisions will require new metrics across the industry. Successful buy-side management will tie these metrics to revenues and expenses, as well as compensation. Only in this way will managers understand their firms’ operations and cost drivers and leverage such knowledge when building new fee structures beyond the traditional assets-based model.
Complicating the process further, new demands from regulators, clients and prospects will increase costs in the areas of transparency, internal and external reporting, operational due diligence, insurance and risk management. While most traditional managers have already invested significantly in these areas, many hedge funds have not. Yet hedge funds have a terrific opportunity right now to lower staffing costs by hiring new staff from the traditional side of the business. Not only do those employees generally have greater overall industry experience, especially in a regulated environment, on average they cost significantly less than support staff from the alternatives side of the business.
Consideration of costs in all these ways should give pause to any hedge fund manager considering a move into separate account management or, as some call it, ‘hedge fund replication.’ Separate accounts will have a significant impact on profitability with more downstream implications for hedge fund managers than most firms realize. (Traditional managers: read on to see how this drives your costs!)
Separate accounts will cause hedge funds to establish trade allocation policies and document adherence to those policies. They will force managers to establish accounts with each trading counterparty for each separate account managed. Investment management agreements and investment guidelines will need to be negotiated and signed. Authorized signature lists will need to be created and maintained. Managers will need to communicate fully-allocated trades to what will be a growing number of custodians and prime brokers. Trade volumes will rise. Matching and affirming trades will also become the manager’s responsibility. Managers will need to build a capacity for shadow accounting for several reasons, including the use of different prime brokers or custodians. They will need reconcile each account with its custodian or prime broker and calculate fees on each portfolio, with invoices issued, tracked and followed up. Managers will need to send client reports on a monthly or quarterly basis. Over time, they will need to aggregate separate account track records across similar strategies to build performance composites, almost certainly under pressure to comply with the Global Investment Performance Standards (GIPS®).
All of the above will increase costs and require significant support infrastructure. Perhaps buy-side firms will begin to charge more for separate accounts and add surcharges for highly customized reporting or other non-standard offerings as a cost-offsetting tactic. But, however firms choose to cover the costs, those who cannot or do not develop the requisite infrastructure, either internally or through outsourcing, will find themselves acquired by others or out of business altogether.
Elsewhere on the revenue side, traditional managers will need increasingly to consider performance-based fees. Base management fees for hedge funds are not likely to remain at two percentage points, and will eventually trend into the same ranges as for traditional investment management. All managers should ensure they can ‘keep the lights on’ with what they earn in base fees. At the same time, as base fees fall, clients will pay increasingly for performance and, as a result, the performance-fee component could rise well above 20% for any kind of manager. This change, however, will not come free. Managers will need to reassure investors that the managers will contain risk and not walk away if the fund or strategy underperforms.
Improvement to the bottom line will come, in some cases, from significant infrastructure investment to enhance automation. Others will focus on increasing the average account size, either by exiting certain products, raising account minimums or even firing smaller clients. Traditional managers should take a page from the old hedge fund playbook and drive as many clients as possible into pooled vehicles.
Better management of buy-side firms will be a boon to the industry and will help managers get more out of their businesses.
Holly H. Miller is a partner at Stone House Consulting, LLC, providing strategic, operational and IT consulting services to investment managers and hedge funds. Prior to founding Stone House Consulting, she was Chief Operating Officer at M.D. Sass Investors Services, managing $15 billion in hedge funds, private equity funds, traditional separate accounts and SMA (‘wrap’) accounts across 18 investment strategies and 15 investment management firms. During her 30-year career, Ms. Miller was East Coast Region Manager for Citisoft, Inc., a business process and IT consulting firm, where her clients included Nuveen Investments, Dimensional Fund Advisors, Lord Abbett, T. Rowe Price and DuPont Capital Management. She has also managed operations teams for Bank Julius Baer, J.&W. Seligman and Citigroup.
