The Business of Running a Hedge Fund: Best Practices For Getting To The ‘Green Zone’

Feb 22 2011 | 10:25am ET

By Aaron Vermut, Ron Suber, Patrick McCurdy, Merlin Securities -- 2010 was transformative for the hedge fund industry and served as a strong reminder that managing money is not the same as managing a business. The significant number of small, mid-size and large fund closures already in 2011 provides continuing evidence of the material, multifaceted challenges facing operators of hedge fund businesses. The past few years have tested the industry in unprecedented ways, and by and large the industry has passed that test.

In Merlin’s latest white paper, we examine the hedge fund business model based on our observations and numerous conversations with managers, investors and industry experts. Our goal with the paper is to share the best practices we have witnessed among hedge funds that are well positioned for sustainability across a variety of economic and market conditions.

The diagram below highlights the basic revenue and expense scenarios that describe three types of hedge fund operating models: red zone, yellow zone and green zone. A fund operating in the red zone is dependent on outsized performance to cover its expenses; a fund in the yellow zone requires minimal performance; and a green zone fund can sustain itself when its performance is lower than expected, nonexistent or even negative. Funds that structure their business model to operate in the green zone are better positioned to navigate through downturns and therefore have higher survival rates over the long term.

The Hedge Fund Revenue Mix

Starting with the basics, hedge funds have two revenue inputs: performance fees and management fees. Performance fees offer tremendous upside and are what lure the most talented financial professionals to join the hedge fund industry. Management fees, however, are what keep people alive in this industry. While tempting, it is risky to build a business around the hope of large incentive fees rather than the guarantee of management fees.

To better understand the relationship of the two fees, consider some basic scenarios. Based on a 1.5% management fee and 20% incentive fee, a fund with no returns is 100% dependant on its management fee. A fund with gross returns of 5% gets 60% of its revenue from management fees. In order to derive more than 50% of its revenues from performance fees, a fund needs to generate returns of at least 7.5%. The following chart provides a map of hedge fund revenues based on a variety of asset and performance levels.

 

Looking more closely at the revenue inputs, two clear concepts emerge about the hedge fund business model. First, both the manager and investor stand to benefit tremendously when the manager performs well. Second, there is only one consistently reliable revenue input for funds: the management fee. Not surprisingly, the managers we work with who are most sustainability-minded think of their revenues in terms of their management fee alone.

For a $200 million AUM fund, that would mean setting its expense target at $3 million, equal to its 1.5% management fee. A start-up fund can apply the same principal based on realistic AUM assumptions. (For most funds, “realistic” start-up capital consists of investments by partners, friends and family.) A fund with $20 million in start-up capital and a 1.5 and 20 arrangement could base its expense considerations on $300,000 of annual fixed revenue – a considerably lower amount than in the previous example.

For start-up funds it’s also important to understand the numerous expenses they will incur. Many start-ups, for instance, cannot afford a non-bundled third-party vendor’s order management system (OMS), risk management product, aggregation service, trade allocation module and attribution tools. For these funds, analyzing the breakeven point (which we discuss in greater detail in the full paper) will help determine whether the business plan is realistic or needs refinement.

Getting to the Green Zone
 
It’s important to understand why some funds target operating in the green zone, and why other funds may intentionally operate in the yellow or red zones. The green zone calculus is simple: when a fund maintains fixed expenses that are lower than its fixed revenues, it operates with less business risk and is positioned to ride out difficult periods of low or no performance.

Some managers choose to operate in the yellow or even red zone, relying on performance to cover their expenses. This is particularly true among start-up hedge funds, which – like other start-up companies – require initial investments and operate with a higher burn rate. We advocate that both new and established funds constantly work toward getting to the green zone. This is key to managing a sustainable fund, and it starts with expense management.

Distinct from raising AUM, delivering strong performance or changing the management fee structure, the only lever that managers have complete control over is fixed expenses. Reducing fixed expenses has a multiplier effect on the level of assets required for a fund to break even. For instance, based on the pure management fee model described above, a fund with a 1.5% management fee and fixed expenses of $600,000 would break even at $40 million in AUM. By decreasing fixed expenses by $60,000, or 10%, the fund’s breakeven AUM drops by $4 million to $36 million. Stated differently, each $1 million in AUM will support $15,000 in fixed expenses.

In some cases, reducing fixed expenses may mean cutting excess and non-core spending across the board – including measures such as reducing headcount, taking smaller space and cutting budgets by a prescribed percentage in each area. Sometimes such draconian measures are necessary – e.g., for a prospective start-up fund which is budgeting $25,000 in expenses per million dollars of AUM, or for a fund whose AUM has decreased significantly. Very often, however, funds can get closer to the green zone by shifting some of their expenses from fixed to variable and by moving the burden of expenses to the shoulders of a third-party service provider.

Like many businesses, hedge funds have to make difficult decisions about which tasks they should perform in-house and which they should outsource. Third-party service providers are available to do nearly all of a fund’s activities outside of making investment decisions. Our observation is that funds typically prefer to do as much of their work in-house as is possible. As a result, they tend to build up significant fixed costs.

By moving the burden of high-expense activities from their own P&L to a service provider, hedge funds can reduce their fixed expenses. The resulting model is leaner and more effective, and it can be scaled up or down with greater ease depending on the fund’s performance, assets and business needs. As a fund grows, for instance, it may require more back office support, but if the fund’s growth levels off, some of that support will no longer be necessary.

Conclusion

The hedge fund industry has literally reshaped the investment landscape for talented managers and for qualified investors – not only because hedge funds provide greater flexibility in investment decisions, but also because of the business model itself, which aligns managers and investors and provides excellent incentives for strong performance. In the post-crisis environment, top hedge fund managers are increasingly focused not only on generating performance alpha, but also on creating enterprise alpha.

All three authors are with Merlin Securities, a leading prime brokerage services and technology provider for hedge funds and managed account platforms. Aaron Vermut is senior partner and chief operating officer, Ron Suber is senior partner and head of global sales and marketing, and Patrick McCurdy is partner and head of capital development.


In Depth

Firm Focus: Sustainable Insight Capital Bullish On ESG

Aug 12 2014 | 9:18am ET

Bruce Kahn spent over 15 years as a research scientist/consultant on environmental...

Lifestyle

Viking Manager In Rent Dispute

Aug 11 2014 | 4:14am ET

A hedge fund manager is demanding most of his money back from his former landlord...

Guest Contributor

Majority Of Inflows Go To Brand Name Hedge Funds

Aug 12 2014 | 9:00am ET

Since the market correction of 2008, a vast majority of hedge fund net asset flows...

 

Editor's Note

 

Futures Magazine

PREVIEW July/August 2014 Cover

Inside Futures' 500th Issue

The July/August 2014 issue is our largest in years—filled with the best trading strategies and stories from 43 years of being the primary publication for commodity, stock, options and forex traders.

The Alpha Pages

TAP July/August 2014 Cover

Real talk on alternative investments, business & finance

The Alpha Pages Editor's Note