Hedge Funds – Capital Ideas
The capital structure of hedge funds will see further evolution
Michael Hamer
A. Summary
In writing this paper, we hope to stimulate thought on ways that hedge funds may evolve in the coming years. Hedge funds have shown themselves to be agile adaptators as markets have grown and changed, and we do not believe the process is over. In particular, we believe that the capital structure of hedge funds will see further evolution, and better mechanisms will appear to unlock the economic value that has been created by hedge fund structures.
B. Background
a) Industry GrowthIn the last twenty five years, we have seen rapid growth in the number of hedge funds and the volume of funds invested in them. In our view, powerful reasons for this growth, apart from the relatively high returns that were generated, have been low barriers to entry, the presence of many supporting institutions, the efficiency of the hedge business model, and the supply of people from larger institutions looking to run their own operations. More recently, several years of low returns in other asset classes has led to a surge in institutional interest in the hedge fund sector.
Key to the industry's ability to grow has been the rapid development of markets in a wide variety of financial instruments with related liquidity and clearing mechanisms that means the ability to exploit market opportunities no longer depends purely on size or credit-worthiness but increasingly on trading skill, nimbleness and creativity. While it is true that some hedge funds have grown to be behemoths with billions of assets under management and staff in the hundreds, it continues to be possible to start up a new hedge fund with just a handful of people and small amounts of capital. The "atomization" of the trading markets has also been made possible by the growth in quality and sophistication of services supplied by prime brokers and third party administrators, which give hedge funds access to "working capital" and outsourced services at low cost. (This is not to say that there is no room for improvement in prime-broking and administration arrangements, which are not yet standardized, can be tedious to negotiate and can be a source of significant operating risk to the fund.) More recently, starting a hedge fund has been made even easier by hedge fund "incubators" – entitiesthat supply many of the operational services and funding required by hedge funds in their early start-up period.
This opportunity to set up hedge funds has coincided with a realization by publicly traded banks and other institutions that the markets did not reward them for the volatility that proprietary trading introduced into their earnings,and that institutionally they were often not capable of carrying out these activities is the most cost-efficient, flexible and controlled manner. Consequently, a large number of traders have moved from proprietary trading desks in large financial institutions to hedge funds. These large financial institutions have supported and even encouraged this by developing the prime-broking services mentioned above and by assisting with introductions to capital providers, or in some cases also supplying seed capital themselves. This process of enabling small operations has been enhanced by the efficiencies of the business model that hedge funds represent. Overheads are kept low and compensation is largely performance based. Decision-making is fast, and largely unencumbered by excess regulation or conflict of interest. As many mid- and back-office functions are outsourced, hedge funds have benefited from the related economies of scale and access to third party expertise.
b)Corporate StructureMost hedge funds have adopted a two-tier corporate structure consisting of a Management Company (typically owned by the principals, and often with a separate but related advisory company) and a Fund, which is most often either a partnership or a limited-liability company. The Fund raises money from third-party investors (and from the principals) and enters into an agreement with the Management Company in relation to trading the assets of the Fund. The Fund will also typically enter into other agreements with Prime Brokers and Administrators for various services in relation to trade settlements, accounting, valuation and shareholder relations.
Some hedge funds also manage separate pools of assets ("managed accounts") on behalf of particular investors. The assets in these pools remain owned by the investors, rather than the Fund, but are invested in parallel with the Fund's assets.
While the Fund and the Management Company will most likely have some shareholders in common (e.g. the principals), it is unusual for a third-party investor in the Fund to also have a stake in the Management Company, unless such an investor is a large supplier of funding or is regarded as "strategic".
c)Sources of CapitalThe main source of funding for the Management Company is equity from the principals, in some cases augmented by loans and/or equity from third-party "strategic" investors, including incubators.
For the Fund itself, the principal sources of capital are investors' funds and leverage supplied by prime brokers. Although an investment in a hedge fund is usually called a share, it more closely resembles a debt obligation. There is usually no participation in the "enterprise" or "franchise" value of the Fund, which is captured by the owners of the Management Company.1 Indeed, hedge fund investments resemble short-term deposits as investors commonly have the right to withdraw their funds at short notice – often three months or even less. Increasingly, funds are looking to "lock up" this funding for longer terms, up to three and five years, but many investors, particularly non-institutional ones, still want liquidity which currently is only really available through redemption.2
If we were to draw up a notional balance sheet for a typical Fund, we would see that the liability side of the balance sheet is composed almost entirely of debt, either provided by prime brokers or investors, with little or no real equity. The investment by the principals in the Fund can represent a significant part of the total funds under management, but this is usually still in the form of "debt" even if management controls the timing of redemption.
C. Reasons For Changes In Capital Structure
We believe that there is considerable scope for innovation in the structure of the liability side of the balance sheet for both the Fund and the Management Company. There are already forces in the industry that may provide impetus to such innovation. These include
1. Limits on trading flexibility and horizon.While the duration of many or indeed most of the trades put on by a Fund is likely to be less than the redemption notice on its funding, the duration of its trading strategy may be much longer. In some strategies such as mortgaged backed, excellent opportunities occur just after significant disruptive events. This is often a reflection, we believe, of the herd instinct that grips investors and may lead them to choose their hedge fund exposures based on past history instead of future prospects. We believe a Fund should find ways to ensure it is in a position to take advantage of market disruptions, and a volatile funding base is a handicap.
Certainly, most hedge fund managers are aware of the attraction of getting longer-term investment in their Fund(s), and we are seeing many Funds lengthening the overall term of their funding base. Investment money has been raised with extended lock-ups for two to three and even five years with either lower fees or penalties for early withdrawal, and some Funds have imposed lock-ups on existing investors.
Lock-ups may have the effect of differentiating the liability base, with investors having different liquidity horizons, depending on when or on what terms they invested.
2. Valuation at the management company level.Potential investors in the Management Company should be willing to pay a price that reflects the value of expected future earnings. These future earnings become more volatile and harder to predict if the funding base can disappear within a short period of time. Actions to strengthen a Fund's ability to retain funding are likely to have a positive effect on the valuation of the management company.
Improving this valuation can be important to owners if they are seeking purchasers for some or all of their business, or seeking to raise additional long-term capital or find partners for some of the aspects of their business. There is considerable interest amongst traditional asset management firms and other financial institutions to take stakes in Management Companies to participate in this rapidly growing business. Existing hedge fund managers are also seeking to increase the range of trading strategies that they can offer which might be achieved through acquisition, and hedge fund managers may find it attractive to form joint ventures with firms that can offer them branding, distribution and/or infrastructure support. All these activities require a value to be placed on Management Company equity, and maximizing this value is clearly a good thing.
3. Switching Between Strategies.The market conditions and opportunities for each hedge fund strategy change over times, and we at Albourne believe it is possible to observe, either directly or indirectly, the immediate outlook for most strategies. However, the great majority of hedge funds focus on one particular strategy. Even with relatively short redemption notice periods, it is an inefficient and drawn out process to redeem funds, both for the Fund and for the investor. Investors are naturally cautious about hedge fund managers diversifying into strategies that they are less familiar with, but a well-managed multi-strategy approach can represent a much more efficient way of internally reallocating capital as market conditions change. This would argue for a longer-term capital base with capital allocation decisions occurring within the Fund, lessening the need for investor liquidity.
D. Type Of Innovation Possible
In order to get ideas of the types of innovation that might occur in the hedge fund industry, we have looked at other sectors of the financial industry to provide some guidance. Given the two-tier nature of hedge fund capital structure, we were attracted to a specialized part of the insurance markets – Lloyds of London – which until recently consisted mainly of entities that closely resembled hedge funds in capital structure, and which has undergone some quite significant restructuring in the recent past.
a) Lloyds Of London – BackgroundLloyds has for many years been home to the most entrepreneurial individuals in the insurance markets. Underwriting Management companies underwrote risks for Syndicates of capital providers. (Lloyds itself provided an umbrella of rating support through ultimate loss payment support, administration and licensing to the Syndicates.) These Underwriting Management companies closely resembled hedge fund Management Companies, being owned by the underwriters and underwriting risks onto capital provided by third parties. The capital for Syndicates traditionally came from individuals or "Names", who agreed to supply capital to Syndicates on a year-by-year basis (the "annual venture"). Just as for hedge fund investors, capital was subscribed for at par, and returned at par plus accumulated return. The main difference between the individual Names at Lloyds and hedge fund investors is that a Name has (in theory) unlimited liability for losses arising from underwriting/ by the Syndicate.
The number of individual Names at Lloyds grew rapidly in the late eighties. Reported profits were strong during this time and Names could use Letters of Credit ("LOC"s) secured on illiquid assets such as their homes as capital to support underwriting. There were also tax advantages to investing.
b) Problems and ReactionsLloyds was one of the main underwriters of US liability risk, and in particular coverage for pollution and asbestosis. Through loose policy wording and re-interpretation of contracts by US courts, Lloyds' losses from prior years' underwriting in these areas grew enormously in the late eighties and early nineties. These losses were exacerbated by poor underwriting results in property catastrophe risks and poor risk diversification. The effect on a number of the Names was catastrophic. Some lost their homes and most of their wealth. Lawsuits multiplied, and the market was in general disarray, although a number of the better Syndicates were able to trade on through this period.
Lloyds instigated major reforms, and other changes in the market occurred in terms of pricing and types of risk underwritten. In an effort to release existing Names from ongoing liability for claims, Lloyds formed a new reinsurer, Equitas, to take over much of the historical business. Reporting requirements for Syndicates were significantly increased, and much more central monitoring and administration was put in place. But perhaps the most relevant changes for our purposes occurred in the capital structures of Syndicates and the pools of capital that they managed.
As the number of Names continuing to underwrite dropped during the early 90's, Lloyds changed its constitution to allow limited liability corporations to supply capital to Syndicates, so as to maintain the market's capacity to underwrite and retain business. Names forced by their losses to pull out of successful Syndicates began to question the "ownership" of the rights to participate. Others questioned the entry process that they felt had prevented them from ever obtaining capacity in "good" Syndicates.
One of the first developments was the emergence of investment companies which raised money to support underwriting at Lloyds. These investment companies were usually publicly quoted, although the volume of trading in their shares was usually low. The companies took up capacity in a portfolio of syndicates, often supported by leveraged LOC arrangements with the backing of professional reinsurers. The management ofthese companies offered investors superior access to information and analysis of the performance of the Syndicates, something that had been difficult for the ordinary investor to obtain. These companies were able to obtain capacity directly from the syndicates, but in response to Names' pressure, Lloyds also began to auction capacity that became available in syndicates.
Syndicates also organized dedicated corporate vehicles that raised money to invest only in that Syndicate. In some cases, the ownership of the vehicle and of the Syndicate remained separate. But as sophisticated financial investors became involved, the vehicles took an increasing stake in the Syndicate as well as investors required this is return for the long-term commitment they were making. The conclusion of this process saw subsidiaries of existing reinsurance companies setting up as combined underwriting and corporate capital vehicles to underwrite within the Lloyds umbrella.
Corporate capacity now dominates the Lloyds market, although a much-reduced number of individual Names continue to participate. Corporate vehicles partially or wholly own many Syndicates, and Lloyds is looking increasingly like a collection of insurance companies operating under a central umbrella.
c) Lessons For The Hedge Fund Industry?Many of the catalysts for changes in Lloyds may have been particular to the insurance market and in part to Lloyds, but the "fault lines" along which change occurred are, we believe, also present in the hedge fund market. These were:
* Short-term financing base. The annual venture concept meant that Syndicates could only count on capacity one year at a time. In good times, this mattered little, but it became a major problem for Lloyds when results soured. Excessive redemptions at the wrong time are a potential problem for hedge funds.
* Inadequate information flow between Syndicate Managers and Names. Syndicate managers have considerable discretion over the nature of the risks they can underwrite. (Like hedge funds, Syndicates can take risk in the same underlying line of business in a variety of ways). Names had little knowledge of the actions of Syndicate managers and their net exposures, and their interests were not necessarily aligned.
* Variable access to Syndicates, unclear balance of rights and control between Syndicates and capital providers, and uncertain ownership of economic values created. Getting into the better Syndicates was difficult and it was widely felt that this capacity was largely reserved for market insiders. Until the 90's, few Syndicates had considered reducing capacity, and so there was no consistent process for removing Names or for determining who really "owned" capacity. This came to the fore when Syndicates decided to replace Names with corporate capital.
The responses to pressures on these "fault lines" can be summarized as follows:
* Formation of companies to hold portfolios of Syndicate participations. Investors gained same liquidity and "franchise value" through trading in these company's shares, while the permanent equity capital of the company provided longer-term support to the syndicate.
* Provision of liquidity and access at the Syndicate level through an auction of capacity. Existing Names began to realize some of the value of their participations in sought-after syndicates, and capacity went to those who valued it most highly.
* Growth of specialist investment advisors, following and analyzing the performance and risks of the Syndicates on behalf of investors. Historically, this had been provided by various Names' agencies, but the changes in methods of allocating capacity, improvement in the quality of information and analysis, the increase in caliber of participants and the removal of some of the conflicts of interest meant that this was a great step forward for the market.
* Increased control of Syndicate managers ceded to sophisticated financial capital entering Lloyds through corporate vehicles, and in many cases the common ownership of the Syndicate Manager and the corporate vehicle.
E. Predicted Future Developments In Hedge Fund Capital Structure
Combining the Lloyds example with our crystal ball, we predict the following developments in the hedge fund industry:
* The development of longer-term funding sources for the Fund itself, including the use of LOC's and backstop lines of credit as types of funding commitments which can complement lockups.
* The ability of investors to buy and sell investments in a Fund, as an alternative to redemption in the face of longer lock-up requirements.
* The partial or full ownership of Management Companies by long-term capital providers to the Fund, reflecting greater long-term commitment to the hedge fund entity.
* The emergence of successful multi-strategy Management Companies offering investors in the Fund an efficient alternative to reallocation between single-strategy Funds, thus removing one need for liquidity. This combination of strategies within a single entity may happen organically or through acquisition.
* As a logical conclusion, the appearance of publicly-traded companies that own large, multi -strategy Management Companies and which provide long-term funding to the related Fund.
* The design of new securities to allow third parties to participate in the economics of the Management Company. Large amounts of Management Company equity capital are not required, except perhaps for developing proprietary trading systems. Nevertheless, the Management Company generates a large amount of "franchise" value, which such instruments can capture. The proceeds of the sale of such participations could, for example, be used to provide longer term funding to the Fund. These instruments are discussed further below.
Some of these developments have already appeared, particularly the formation of multistrategy managers. The timing of others and the spread of these developments will depend in large part on the emergence of conditions for change, some of which will be from the trading environment and some from the motivations and needs of participants. As previously discussed, catalysts for change may include the desire for stability of capital and related stability of earnings, and the desire for succession planning.
F. Parallels Revisited
In Table 1 below, we list some of the possible features we see coming or which have already appeared in the Hedge Fund industry, and identify some similar features that have occurred in the Insurance and Finance sectors. We consider Table 1 gives good support to our predictions, as it shows that business combinations and structural ideas cross industry lines.
G. Further Thoughts On Management Company Participation Structures
a) Benefits In Relation To EquityA very simple example of a participation structure, which we shall call a revenue Participation Agreement ("RPA") is where an investor pays an upfront amount in return for a percentage of the revenues of a Management Company for a given number of years. Equity in a Management Company may in fact be thought of as a special kind of RPA, with perpetual maturity and the participation being at the net revenue level, after all Management Company expenses.
Valuing equity in a Management Company can be quite challenging. At a very simplified level, we might assume that fixed fees meet the running costs, so the value of the equity is the value of the performance fees. The value of equity can thus be viewed as a compound call option, since the quantum of performance fee depends not only on returns but also on assets under management, which in turn depends on performance. This option has to be valued taking into account lower bounds on acceptable drawdowns beyond which the Fund may have to close and upper bounds reflecting capacity of the strategy. Further, some decision has to be made in relation to the appropriate duration of the option for valuation purposes.
An RPA can be structured to alleviate a number of these issues. It can be set for fairly short periods, like three or five years, which reduces the uncertainty of future performance and makes it more likely that the buyer and seller can agree on price. They should give investors greater confidence in management prudence, since the economic interest will revert to the Management Company at the end of the RPA. The revenue sharing can also be constructed to be at the gross revenue level, or with fixed rather than actual expenses. Furthermore, the RPA looks and feels like a warrant, which is a leveraged play on the "underlying" (in this case, the performance of the Fund). Thus we think an RPA may be a more efficient way of realizing value at the Management Company level than selling equity.
b) Existing Forms Of RPAA related form of RPA is a share in the fees relating to a particular tranche of investment in the Fund. The "underlying" here is therefore just the Fund performance without the effects of that performance on assets under management.
This form of RPA exists today, and is created when a Management Company offers a reduction in management fees in return for a longer lockup of the investment in the Fund. An RPA is being given to the investor in exchange for decreased liquidity of the investment. In theory, knowledge of the price of liquidity should provide some insight into the values being ascribed to these RPAs. However, we suspect that there may not be a lot of "science" in the current trade-offs between fees and liquidity, and other factors, such as the competition to get into a Fund, will skew this negotiation. It is possible that in some cases the RPA's being created may be worth more to third parties than the investors to whom they are being granted, in which case the alternative would be to sell the RPA to a third parties and give the investors a discount on his initial investment in return for the lock-up.
Incubator companies investing in both Management Companies and their Funds often create more complex forms of RPA. An Incubator may agree to provide an amount of investment in the Fund, committed for several years, in return for a percentage ownership in the Management Company. At the same time, or perhaps as an alternative, the Incubator may provide a loan to a start-up company to cover initial expenses, to be repaid from future fee income. Again we believe that there is much room to get a better handle on the quantification of the trade-offs here.
c) Further Thoughts on Lockups.When considering the value of liquidity and the comparison with the value of RPA's being created, it becomes clearer that the costs and benefits of less liquid capital do not always fall to the same parties. All investors and the Management Company benefit from longerterm capital, but if there are several classes of investors with differing investment maturities, the shorter-term investors in the Fund may be benefitting without cost. If the lockup is being paid for by a reduction in management fees, it is not clear whether the division of the remaining benefit between the Management Company and the longer-term investors is appropriate when compared to the benefits received by the shorter-term investors. The introduction of an early redemption penalty as a way of producing longer-term funding would seem fair between investors if introduced across the board, but then some of this redemption penalty should go to the Management Company to compensate for the loss of its benefit in the event of early redemption.
H. Summary
We think the insurance industry and Lloyds in particular provides examples of capital and other developements that appear highly relevant to the hedge fund industry. Of these, perhaps the greatest change would be the development of more equity-like capitalfor Funds, and related to this, an increase in investment and control by Fund investors in the Management Company itself.
There are some exceptions to this. Some of the "shares" in funds run by George Soros could be bought or redeemed at prices set by the fund's management, and there is now a small but growing secondary market in "shares' of hedge funds.
PlusFunds announced but then postponed a project to trade shares in closed-end companies whose assets were invested in hedge funds.