There is no evidence that the middle ground is a happy place to be.
Just taking professional services firms as an example, the fourth largest of the Big Four firms has revenues of over £1 billion per year, while the fifth largest has slightly more than £250 million. The same sort of effect can be seen in the general asset gathering space and could well develop in the hedge fund industry.
There is a transition underway among hedge fund firms from being lifestyle businesses to businesses of scale. It is gathering momentum as firms compete to secure institutional investment, and at the same time, it requires cultural change. According to David Barker, who leads the Financial Services Transaction Advisory Services group at Ernst & Young in the UK, managers of firms undergoing such a transition have to want to change. “We’re talking about turning an individual dividend stream into a business of sustainable, realisable value, independent of the individuals that established it,” he says.
How do you achieve scale? Where does the law of large numbers kick in? Will it impact a firm’s ability to deliver alpha? “You need scale and critical mass to attract institutional money but, equally, without that institutional money, can you ever get there?” Barker asks. “We think that with rigorous process and transparency, [firms] will grow, but again, this stifles the reason many [owners] came into the business in the first place, which was perhaps to get out of big bureaucracies, large investment banks and process-driven organisations.”
The hedge fund industry has to get used to being on the front page of the FT, just as the private equity industry did a few years ago. Returns from private equity as an asset class have generally been good, and have consistently outperformed stock indices (although public performance figures are not available as they are for hedge funds), but a significant percentage of all funds fail to pay carry to general partners. There is incontrovertible evidence that larger deals, or larger funds, consistently outperform smaller deals, or smaller funds. According to Barker, the quantum of outperformance can be very marked. “It is effectively double,” he asserts.
Part of this outperformance stems from the fewer bidders, and the better leverage available for larger deals. “There’s excess liquidity there,” Barker says. “The standard deviation of return from large investments is clearly lower. And I think momentum investing also works.” He compares it to buying a supertanker once the engines have been turned off – it still keeps moving through the water for a while. This has been of benefit to the bigger players in private equity, where ‘mega funds’ are thought to start making serious returns once they exceed around $4 billion to $5 billion in assets.
Private equity funds can be extremely profitable: a typical house might have €5 billion of investments, and be charging fees of 1.75%, which is €87 million. Even with 20 partners, the firm would be making €4 million per partner. Overheads are relatively small: an office, some secretaries, some infrastructure. Many of the expenses of transacting would be charged back to the fund.
But big funds come with big deals and big deals mean coverage in the national newspapers, especially when firms are buying into high street names, as private equity businesses have been doing. Now it is hedge funds that are also making the headlines in this respect, as well as drawing more regulatory scrutiny of their activities.
The growth of private equity has been enormous – up to $1.75 trillion raised by 2004 from inception 30 years ago, with the expectation of a further $1 trillion to be raised in the following three years. In 2002, 60% of leveraged buy-outs used equity and one class of senior debt, and nothing else. Today, it is commonplace to have multiple classes of structuring. EBITDA has increased as well: in 2003 leverage of just over five times was common, today it is averaging in the order of 7.75 times, although there have been cases of 11-12 multiples of EBITDA. In December 2005, Carlyle raised $4.4 billion from 42 different funds, while it is currently raising for two different funds: a $15 billion US fund and a $5 billion European vehicle. The pace of growth in private equity looks set to continue: Blackstone raised a $15.6 billion fund eight weeks ago, and is now raising for a $5 billion sidecar fund.
As for convergence between hedge funds and private equity – this has much to do with private equity firms trying to reduce leverage dependency and fee loss to hedge funds and other parties. Firms are busy setting up mezzanine funds, CDO funds, CLO funds and other structured vehicles, forcing them to become more rigorous in the way they are managed operationally, and more institutionalised, particularly at the so-called mega fund level. Inevitably this means their cost bases soar.
“We believe there is an inflexion going on in the whole industry,” says John Cole, a Partner in the Financial Services Transaction Support team at Ernst & Young. “If you look at the private equity market 5 or 10 years ago, they too had to go through an evolutionary phase, switching in some cases from being lifestyle businesses run around individuals who enjoyed what they did...to becoming far more institutionalised, changing the way they do things to survive and grow, to access larger pools of capital, to get into the larger deals and create the superior returns.”
It has served to change the whole way such firms have been run in terms of governance and the level of transparency they provide. Succession has also become an issue as private equity houses move from businesses based around an individual to ones that are seriously considering a future where the founding partners are taking a less active role and need a competent team to step into their shoes. Getting this formula right is easier said than done. The price of getting it wrong, however, is frustration and an exit of talent. Mission critical managers can leave a firm easily, taking their track record with them. They are able to start again from scratch, thanks to their existing track record. It is critical, therefore, that firms take a far-sighted approach, encouraging the next generation and seeking out a potential future leader amongst them, in order to avoid succession problems. It requires foresight to recognise change, and to actively manage that change.
Private equity firms, on the hunt for the scale they need to participate in the big deals, have invested much of their time and energy in targeting big institutional investors like CalPERS, which has over $214 billion under management, approximately 5% of which is allocated to alternative investments.
Acquiring scale has not been without its price. Much of the institutional money reaching hedge funds is sourced via funds of funds. The drawback of funds of funds, in the private equity field, has been the additional layer of fees. Private equity funds tend to source their investment from leading institutions, including US pension funds and financial institutions, however this has created what Cole calls “a baggage train of requirements.” Big institutional investors like CalPERS have very specific criteria regarding the timeliness, accuracy and standardisation of reporting from their underlying managers. “They look for behavioural compliance, best practice, segregation of duties and codes of ethics,” Cole says. “They look for detailed rules about how you behave in certain circumstances.”
Private equity funds have found themselves meeting progressively stricter reporting requirements in order to continue to access the much sought after institutional clients in the US. State regulators are also now putting pressure on institutional investors to disclose in detail where they are putting their money; a demand for transparent and regular reporting which is being passed onto the underlying funds. Many industry leaders are also expending much of their time liaising with this client base, getting the message across, in order to remain competitive.
With the standardisation of reporting comes a concurrent burden on the back office and the resources that need to be devoted to it. A more professional compliance and finance function also has to be built up, and becomes a bigger cost centre as a result. Some of the bigger funds report that 10% of their payroll is now spent on their back office, marking a substantial increase from the cottage industry levels which used to be seen in private equity.
Another problem has been the 10 year cycle which characterises private equity funds. This gives firms very narrow windows in terms of investing and realising, and has led to a search for permanent capital. KKR and Apollo recently returned to the market in the quest for permanent capital, revisiting a model which existed in the UK for many years, for example in Candover and 3i.
Permanent capital requires an even greater level of compliance: “You get into the issues of Sarbanes-Oxley or financial reporting procedures,” Cole says. “You get into the issue of transparency disclosure. If you ever pick up a set of company accounts, you notice that a large section in public company accounts is now dedicated to directors’ remuneration and interests, not just to the financial performance of the business”.
Like private equity firms, hedge funds do not court or enjoy publicity. However, the bigger they have become, the more scale they have acquired, the more attention they have attracted. “Not a day goes by without some reference to a PTP (Public To Private) of a FTSE 100 company and speculation as to who that might be,” Cole says. The Gate Gourmet dispute in the private equity world last year, and the involvement of hedge funds in NASDAQ’s bid for the London Stock Exchange, typify this kind of exposure.
Private equity has been forced, as a result, to manage its relationships with the outside world in a way it was not used to doing previously. It seems likely that hedge funds will be required to make the same adjustment.
Just taking professional services firms as an example, the fourth largest of the Big Four firms has revenues of over £1 billion per year, while the fifth largest has slightly more than £250 million. The same sort of effect can be seen in the general asset gathering space and could well develop in the hedge fund industry.
There is a transition underway among hedge fund firms from being lifestyle businesses to businesses of scale. It is gathering momentum as firms compete to secure institutional investment, and at the same time, it requires cultural change. According to David Barker, who leads the Financial Services Transaction Advisory Services group at Ernst & Young in the UK, managers of firms undergoing such a transition have to want to change. “We’re talking about turning an individual dividend stream into a business of sustainable, realisable value, independent of the individuals that established it,” he says.
How do you achieve scale? Where does the law of large numbers kick in? Will it impact a firm’s ability to deliver alpha? “You need scale and critical mass to attract institutional money but, equally, without that institutional money, can you ever get there?” Barker asks. “We think that with rigorous process and transparency, [firms] will grow, but again, this stifles the reason many [owners] came into the business in the first place, which was perhaps to get out of big bureaucracies, large investment banks and process-driven organisations.”
The hedge fund industry has to get used to being on the front page of the FT, just as the private equity industry did a few years ago. Returns from private equity as an asset class have generally been good, and have consistently outperformed stock indices (although public performance figures are not available as they are for hedge funds), but a significant percentage of all funds fail to pay carry to general partners. There is incontrovertible evidence that larger deals, or larger funds, consistently outperform smaller deals, or smaller funds. According to Barker, the quantum of outperformance can be very marked. “It is effectively double,” he asserts.
Part of this outperformance stems from the fewer bidders, and the better leverage available for larger deals. “There’s excess liquidity there,” Barker says. “The standard deviation of return from large investments is clearly lower. And I think momentum investing also works.” He compares it to buying a supertanker once the engines have been turned off – it still keeps moving through the water for a while. This has been of benefit to the bigger players in private equity, where ‘mega funds’ are thought to start making serious returns once they exceed around $4 billion to $5 billion in assets.
Private equity funds can be extremely profitable: a typical house might have €5 billion of investments, and be charging fees of 1.75%, which is €87 million. Even with 20 partners, the firm would be making €4 million per partner. Overheads are relatively small: an office, some secretaries, some infrastructure. Many of the expenses of transacting would be charged back to the fund.
But big funds come with big deals and big deals mean coverage in the national newspapers, especially when firms are buying into high street names, as private equity businesses have been doing. Now it is hedge funds that are also making the headlines in this respect, as well as drawing more regulatory scrutiny of their activities.
The growth of private equity has been enormous – up to $1.75 trillion raised by 2004 from inception 30 years ago, with the expectation of a further $1 trillion to be raised in the following three years. In 2002, 60% of leveraged buy-outs used equity and one class of senior debt, and nothing else. Today, it is commonplace to have multiple classes of structuring. EBITDA has increased as well: in 2003 leverage of just over five times was common, today it is averaging in the order of 7.75 times, although there have been cases of 11-12 multiples of EBITDA. In December 2005, Carlyle raised $4.4 billion from 42 different funds, while it is currently raising for two different funds: a $15 billion US fund and a $5 billion European vehicle. The pace of growth in private equity looks set to continue: Blackstone raised a $15.6 billion fund eight weeks ago, and is now raising for a $5 billion sidecar fund.
As for convergence between hedge funds and private equity – this has much to do with private equity firms trying to reduce leverage dependency and fee loss to hedge funds and other parties. Firms are busy setting up mezzanine funds, CDO funds, CLO funds and other structured vehicles, forcing them to become more rigorous in the way they are managed operationally, and more institutionalised, particularly at the so-called mega fund level. Inevitably this means their cost bases soar.
“We believe there is an inflexion going on in the whole industry,” says John Cole, a Partner in the Financial Services Transaction Support team at Ernst & Young. “If you look at the private equity market 5 or 10 years ago, they too had to go through an evolutionary phase, switching in some cases from being lifestyle businesses run around individuals who enjoyed what they did...to becoming far more institutionalised, changing the way they do things to survive and grow, to access larger pools of capital, to get into the larger deals and create the superior returns.”
It has served to change the whole way such firms have been run in terms of governance and the level of transparency they provide. Succession has also become an issue as private equity houses move from businesses based around an individual to ones that are seriously considering a future where the founding partners are taking a less active role and need a competent team to step into their shoes. Getting this formula right is easier said than done. The price of getting it wrong, however, is frustration and an exit of talent. Mission critical managers can leave a firm easily, taking their track record with them. They are able to start again from scratch, thanks to their existing track record. It is critical, therefore, that firms take a far-sighted approach, encouraging the next generation and seeking out a potential future leader amongst them, in order to avoid succession problems. It requires foresight to recognise change, and to actively manage that change.
Private equity firms, on the hunt for the scale they need to participate in the big deals, have invested much of their time and energy in targeting big institutional investors like CalPERS, which has over $214 billion under management, approximately 5% of which is allocated to alternative investments.
Acquiring scale has not been without its price. Much of the institutional money reaching hedge funds is sourced via funds of funds. The drawback of funds of funds, in the private equity field, has been the additional layer of fees. Private equity funds tend to source their investment from leading institutions, including US pension funds and financial institutions, however this has created what Cole calls “a baggage train of requirements.” Big institutional investors like CalPERS have very specific criteria regarding the timeliness, accuracy and standardisation of reporting from their underlying managers. “They look for behavioural compliance, best practice, segregation of duties and codes of ethics,” Cole says. “They look for detailed rules about how you behave in certain circumstances.”
Private equity funds have found themselves meeting progressively stricter reporting requirements in order to continue to access the much sought after institutional clients in the US. State regulators are also now putting pressure on institutional investors to disclose in detail where they are putting their money; a demand for transparent and regular reporting which is being passed onto the underlying funds. Many industry leaders are also expending much of their time liaising with this client base, getting the message across, in order to remain competitive.
With the standardisation of reporting comes a concurrent burden on the back office and the resources that need to be devoted to it. A more professional compliance and finance function also has to be built up, and becomes a bigger cost centre as a result. Some of the bigger funds report that 10% of their payroll is now spent on their back office, marking a substantial increase from the cottage industry levels which used to be seen in private equity.
Another problem has been the 10 year cycle which characterises private equity funds. This gives firms very narrow windows in terms of investing and realising, and has led to a search for permanent capital. KKR and Apollo recently returned to the market in the quest for permanent capital, revisiting a model which existed in the UK for many years, for example in Candover and 3i.
Permanent capital requires an even greater level of compliance: “You get into the issues of Sarbanes-Oxley or financial reporting procedures,” Cole says. “You get into the issue of transparency disclosure. If you ever pick up a set of company accounts, you notice that a large section in public company accounts is now dedicated to directors’ remuneration and interests, not just to the financial performance of the business”.
Like private equity firms, hedge funds do not court or enjoy publicity. However, the bigger they have become, the more scale they have acquired, the more attention they have attracted. “Not a day goes by without some reference to a PTP (Public To Private) of a FTSE 100 company and speculation as to who that might be,” Cole says. The Gate Gourmet dispute in the private equity world last year, and the involvement of hedge funds in NASDAQ’s bid for the London Stock Exchange, typify this kind of exposure.
Private equity has been forced, as a result, to manage its relationships with the outside world in a way it was not used to doing previously. It seems likely that hedge funds will be required to make the same adjustment.
