There’s a difference in hedge fund firms between big and small. And there’s a more subtle difference between merely big and really big, franchise big. If you’ve shopped recently for men’s shirts you’ll recognize that sticking a few Xes in front of the L describing the shirt size can make a grave difference. The principle here is the same.
Citi Prime has issued a report on hedge fund business expenses designed to provide benchmarks for both managers and investors, the 2012 Hedge Fund Business Expense Survey, conceived as the first of an annual series. It turns out that expense has a lot to do with size.
At the highest level of aggregation, the hedge fund industry will spend $14.1 billion, 65 basis points of the total industry assets under management on compensating support personnel (excluding pay to any individuals whose compensation is tied to investment performance) and on paying third party expenses related to their operations. Since the traditional management fee is 2 percent of AUM, this implies that business expenses eat up one-third of that management fee.
The Small Get Pinched
Tightening up the focus a bit, Citi divides the industry into four groups based on manager size. The “franchise” managers have more than $5 billion AUM. Large firms have between $1 and $5 billion. Medium sized hedge funds have between one-quarter and $1 billion. Thus, small firms have less than $250 million.
Dividing the industry that way, one encounters a striking fact: the small firms alone pay $2.7 billion out of the total $14.1 billion spent on business expenses, or roughly 19 percent of the whole “pie.”
This looks like a disproportion when we consider that small hedge funds control only 6.3 percent of the industry’s assets.
The franchise funds, which control 54.5 percent of those assets, or $1.2 trillion, pay $5.6 billion in expenses, which is a bit less that 40 percent of the whole.
The gist of it is that smaller managers, those with assets under management of less than $250 million, have a difficult time surviving on management fees alone. They need either regular infusions of new capital from partners or incentive fees. Since new entrants are likely to start small, these expenses seem to act as a barrier to entry, constructed by the increased institutionalization and regulation of the industry in recent years.
Much of the expense that is so daunting for the smaller funds consists of payments to third parties. Here, too, this is related to the life cycle of firms. The smaller firms tend to be the new entrants, and they have generally engaged “a broad range of professional service and infrastructure partners” as a condition of entry. As hedge funds grow they learn to internalize many of those third-party functions.
As the above graph indicates, small firms spend 126 basis points of their AUM on third-party relationships. This number drops drastically for medium-sized firms and drops again for the large ones. Large, it turns out, is the optimal size for keeping third-party costs down. Counter-intuitively, third party expenses increase slightly for the very large, the franchise firms. This is because quantitative change gives way to qualitative change: the franchise managers invest in illiquid strategies, and make regulated or PE-style investments that require greater operational complexity than the merely large, account for some rebound.
A related result of the structural distinctions between large firms and franchise firms is that the latter make data management infrastructure a priority. Forty percent of franchise participants in the survey reported “that they are planning either a new install or significant upgrade to their data management infrastructure.”
What happens when we break down expenses by function? Citi distinguishes three functions: business management (real estate, human resources, etc.); operations (middle office, accounting, and technology); and trading/research support (investing, marketing, IR, risk, compliance). As a firm increases in scale, its business management expenses in particular become a strikingly smaller part of the whole. They are 31 percent of the business expenses for the small firms, but less than half of that (15 percent) for the franchise firms.
Who exactly were the survey respondents? Sixty-two percent had a North American headquarters. The remainders were evenly spread across EMEA and APAC. Citi has also broken down survey respondents for us by vintage. Forty percent were founded before 2002, 30 percent between 2002 and 2008, the remaining 30 percent since 2008.