17/08/2011 Author: Will Wainewright

Passing the baton

The prominence of key individuals in a hedge fund’s success is something of a double-edged sword. As institutional investors gravitate towards managers that can demonstrate a sustainable business model, how can hedge funds ensure that performance and investor confidence is not concentrated on key players?

The recent decision by hedge fund luminary George Soros to effectively depart the industry and administer his funds through a family office was no surprise – his funds had been closed for 11 years to outside investors, who owned just a fraction of the $25bn total. However, while his exit from the sector was a logical choice, other funds considering how they can remain in the hedge fund game face tougher questions. Succession planning is difficult when the confidence of your investors is closely tied to the performance of a certain trader or the reputation of a founder.

So what steps can hedge funds take to reassure investors that their prospects don’t just depend on the fortunes of certain key players? Elliott Management Corp, the $17bn US hedge fund, took the unprecedented step recently of creating a formal succession plan that would install a four-person management committee in the event of founder Paul Singer’s departure. It was a rare move designed to indicate long-term stability, with the committee having the power to oversee the transition and select a CEO.  

Myron Kaplan, founding partner at Kleinberg, Kaplan, Wolff & Cohen, is an advisor to Elliott Management and an intended member of the firm’s planned committee.

“Investors want to know if they have invested in a money management organisation with stability or just put their chips down on one guy,” he says. “With the institutionalisation of the industry and increased due diligence demands, everyone is asking about succession planning.” He believes the structure Elliott has put in place sends a signal that the business is about more than its founder. But what if a fund’s returns are reliant on an individual’s performance, a ‘star trader’ for instance?

Can you convince investors that returns will continue when that person has gone? “That’s the $64,000 question,” continues Kaplan. “The capital in a hedge fund is not permanent and performance is crucial. But if a management company has developed an institutional process and has a talented and diverse investment team which it exposes to investors over time, that can be effective.”

Jeffrey Bronheim, Cheyne Capital Management’s general counsel, agrees on the importance of convincing investors that talent, together with responsibility for performance, runs through the trading team. “If a firm is looking to institutionalise, you want to think about more traders across all funds as well as a diversified set of funds,” he says. “Investors want strategies with more than one manager, and multiple strategies.” Key-man provisions, which allow investors and counter parties to pull out should certain individuals leave, deepen the headaches for hedge funds.
What is more, some think that plans such as Elliott’s – designed to show that a hedge fund has long-term stability
– depend on investors being convinced that continued performance will be assured.

Leading prime brokers told HFMWeek that more and more hedge funds are now thinking about succession planning, so it is clearly rising up the list of priorities. But is it something of a pointless debate? After all, hedge funds will only exist as long as investors choose to invest in them, which in turn depends on performance. “Much as succession planning may be the answer to some investor and investment manager staff wishes, others favour a regeneration model in which stars burn out and are replaced by new ones (including some that are born of the dying star),” says Robert Duggan, a partner at law firm Mourant Ozannes.

But as the institutionalisation of the hedge fund industry continues, it is clear that longer-term, ‘stickier’ investors, like pension funds, will demand more stability. This has led to a new generation of start-ups that employ an institutional approach, often utilising high-grade infrastructure from the beginning. Arrowgrass, which launched in 2007, and Avantium, a new fund due to launch later this year, are examples.

An alignment of interests between investor and management is as important as ever. “Investors often like to see that managers have ‘skin in the game’ but this must be is at the management company level, as well as the fund level,” notes Duggan. This is why Elliott’s plan was praised: Paul Singer will keep equity in the company even after he leaves, while key staff hold equity in both the fund and management company. Equally, for this reason Izzy Englander’s mooted recent plan to sell a stake of Millenium Management to a private equity firm was criticised by one observer: “It sends out the wrong signal. It suggests you plan to leave some time soon. More immediately, if the outside buyer has different ideas to the fund, it could cause practical problems.”

The move to more institutional structures, often accompanied by an increase in staff numbers and asset levels, aids succession planning by creating a more stable, resilient organisation. To hedge fund veteran Hans Hufschmid, who now runs service provider GlobeOp, it is the size of the organisation that brings him most reassurance: “The one thing I find very gratifying with GlobeOp is having built the business that feeds 1,900 people and their families,” he says. “We have built something that is really going to be here when I’m not.” However, he knows this is much more difficult in the hedge fund space: “There are plenty of stories about hedge funds that have tried to equitise their business unsuccessfully.”

Myron Kaplan traces the realisation by hedge funds that they themselves could be quite valuable as investment management companies before 2008, but, as Hufschmid notes, there is a markedly mixed record of hedge funds successfully changing owners. The purchase of Highbridge Capital Management by JP Morgan was a model example of how to integrate a hedge fund into a larger institution, while Morgan Stanley’s acquisition of FrontPoint Partners went the opposite way and has now been reversed.

Whether hedge funds choose to integrate into bigger institutions, attempt to institutionalise themselves or simply rise and fall in line with the talent of their traders, the question of succession is one that will face more and more hedge funds as the older generation of founders looks for ways to pass on the torch. Whether or not they can successfully do so will have an important bearing on the future shape of the industry.