Leadership Spotlight

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Scale versus Agility

Among the most powerful trends in the industry is a developing bifurcation, with the largest funds accumulating assets and the smaller ones becoming niche players. As the industry matures and the nature of its investors changes, some hedge funds are becoming at least as interested in size as in returns. Finerman at Metropolitan Capital says that, for some, “the business model has changed from the goal being superior returns to the goal being an asset-gathering machine.”

If anything, hedge fund data groups say, this has accelerated since last summer’s market turbulence, with bigger funds seen by some investors as better positioned to weather such periods.

The trend partly reflects the increasing significance of relatively risk-averse endowment and pension fund investors in hedge funds. With their own fiduciary responsibilities to worry about, they often demand scale, stability, comprehensive computer systems, increased transparency and other features that can be difficult for smaller funds to manage, or even afford.

It also owes something to the natural accumulation of assets by bigger funds, both through returns on investment and new money coming in. After all, they are large partly because of strong historical returns.

With many funds now managing billions after only a decade or so in business, there’s also the question of turning what in some cases began as a business based on one person’s reputation into an enduring institution—a process that also calls for giving the original principals a chance to partially cash out. Hence the public sale of shares in some hedge fund and private equity firms, including Fortress Investment Group LLC and Blackstone Group. At the time of writing, Och-Ziff Capital Management Group LLC, a big hedge fund manager, was readying an initial public offering. Reports have also surfaced in recent months suggesting that funds such as AQR and SAC have considered IPOs or sales of stakes to other, larger financial institutions. Neither fund would comment for this article.

This “institutionalization” can suit both the founders of funds and many of today’s investors. IPOs tend to open a window into the often-secretive world of hedge fund investing, another source of comfort to some investors and even to regulators. Another outward sign of this shift is the long-term debt some funds, including Chicago-based Citadel Investment Group, have put in place to reduce their dependence on collateral-based loans from Wall Street.

But where does this trend leave the smaller funds? Steinhardt says that when he ran his hedge fund, “there was a clear diseconomy of scale.” He says fund managers in the 1970s or 1980s would not have wanted to manage more than $100 million or $250 million, because the scale would make it harder to find opportunities with big enough return prospects.

Growing and more accessible global markets have made big bets easier to make, and large funds can and do make good returns. But Finerman, who manages about $500 million of investor money, still believes smaller funds have some advantages. “For us, the advantage of our size is our nimbleness and the ability to be in so many names that for us have adequate liquidity—we can be in and out without really moving the price,” she says. Larger funds need to put more money into trades and that may close some options to them, she adds.

Finerman says providing an adequate operational infrastructure for her fund is not a problem, but concedes that in the hunt for talented people it can be hard to win against big fund groups with deep pockets.

Gaine adds a personal concern about this trend. If you’re “the little guy in the garage with the dog and the neighbor” and a great investing idea, how do you get started when many investors want scale, carefully monitored processes and hefty disclosure from day one?

Tougher Talk about Regulation?

Regulators are increasingly keen on similarly institution-like behavior. The MFA and other hedge fund alliances recognize the need for consistent standards and practices. Generally, funds see this as helpful provided it is voluntary—although many funds are, in fact, regulated by the SEC in the U.S. or the Financial Services Authority in the UK, sometimes to a greater extent than is realized, in some cases under laws that are decades old. Even back in the early 1990s, former fund manager Steinhardt and others had a brush with U.S. regulators over Treasury bond trading.

Regulators tend to champion high levels of disclosure to protect investors, although this applies primarily in the retail arena, where most hedge funds don’t operate. “In general, as long as you can be sure it’s only big guys playing with big guys, there’s not an awful lot of reason to have the range of regulation we often see,” says Richard Herring, the Jacob Safra Professor of International Banking at Wharton. “It starts to get tricky when retail investors are involved.”

That’s not yet happening in the U.S. Indeed the MFA wants to raise the minimum net worth threshold for investment in hedge funds—but this is more of an issue in parts of Europe. Finerman thinks retail investors will eventually want to invest in U.S. hedge funds, too.

Meanwhile, Herring says hedge funds need to be alert to what he calls “back door retailization.”

“What do you do when a group of state policemen invest the life savings of the troop and the thing crashes?” He says managers need to think carefully about ensuring that investors are suitable for their funds, or they may find regulation “will be thrust upon them.”

Regulators also want hedge funds to be more transparent about what they do, especially over matters such as the valuation of illiquid securities—one of the issues at the root of last summer’s credit crunch.

Various industry groups have proposed ways to improve and standardize practices. But many managers agree with Herring’s view that it’s not clear what kind of prescriptive approach would actually be helpful to investors. For example, he says, “The intensity with which they trade means a balance sheet disclosure is temporarily meaningful at best.” He adds that some hedge fund strategies are proprietary and won’t work if they become publicly known.