The material in this report is obtained from public and non-confidential sources which we believe to be reliable; however we do not guarantee its accuracy of completeness. This report is intended to serve as a guide only. It is not a substitute for seeking professional advice at all stages.

© RR Capital Management Corp. 1998

TABLE OF CONTENTS

Author Biographies

Preface

Executive Summary

I. Background of Hedge Funds

I.(a) Characteristics of Hedge Funds
I.(b) Investment Styles of Hedge Funds
I.(c) Investment Performance of Hedge Funds
I.(d) Hedge Fund Investors

II. Historical Perspective on the Hedge Fund Industry

II.(a). Growth of the Hedge Fund Industry
II.(b). Hedge Fund Industry Structure

III. The Future Outlook for the Hedge Fund Industry

III.(a). Demand for Investment Management Services
III.(b). Hedge Fund Investor Segment Trends
III.(c). Future Growth Projections for Hedge Funds

IV.(a). Macro Structural Challenges
IV.(b). Other Structural Needs
IV.(c). The Family of Hedge Funds Structure
IV.(d). Benefits of FHF to Investors
IV.(e). Benefits of FHF to Fund Managers
IV.(f). Market Leadership to the Hedge Fund Industry

V.(a). Hedge Fund Industry in Growth Stage
V.(b). Lessons Learned from the Mutual Fund Industry
V.(c). Fragmented Industry Ripe for Consolidation
V.(d). Future Opportunities - The Evolution has Already

PREFACE

It is our view that the hedge fund Industry is at a strategic inflection point in its life. Strategic inflection points are about the fundamental changes in any business. Mathematically, the inflection point occurs when the rate of change of the slope of any curve changes. After a few decades of modest growth, the hedge fund industry, since 1990, is experiencing a dramatic acceleration in its growth of both assets and number of funds. During this period, the industry has not only attracted a lot of media attention but also some of the best people and the most elite groups from the money management industry. In 1996, six out of the top ten earners in Wall Street were hedge fund managers.

In this report, we have attempted to analyze the fundamental changes that the hedge fund industry is undergoing and how the balance of forces is shifting from the old structure and the old way of doing business to the new. It is our view that you can not stop or hide from the structural evolution of an industry that is at an inflection point in its development. Instead, we must understand and focus on preparing for change. In this report, we have presented the industry’s past, projected its future growth and predicted its structural evolution for the next decade. Our hope is that this report can serve as an important milestone in the evolution of the hedge fund industry.

We would like to thank various people for their help in the preparation of the report. Fred Schlosser and Wayne Weil were extremely helpful in identifying the research materials and assisting us with many ideas and views of the hedge fund industry. We are also grateful to Steve Crosby of KPMG for providing us the guidance and encouragement throughout the work and Howard Hirschman of RRCM for his invaluable help in critically reviewing and editing the report.

EXECUTIVE SUMMARY

It is our view that the hedge fund industry is at a defining point in its evolution. After a few decades of modest growth, the hedge fund industry has experienced a dramatic acceleration in growth starting in 1990. It is estimated that hedge fund assets grew from under $20 billion in 1990 to over $170 billion in 1996. The number of funds also grew dramatically from under 500 to over 2500 in little more than five years.

The driving forces behind the growth of the hedge fund industry are increasing acceptance of these "alternative investments" and the increase in the base of "sophisticated" investors, especially high net worth private investors. The search for greater returns has led sophisticated investors to ever more exotic asset classes, including hedge funds. As hedge funds can go short, use leverage and take very concentrated positions, they can significantly enhance the performance. Various studies indicate that hedge funds as a group provide superior returns on average compared to the S&P 500 and demonstrate a low correlation with traditional investments like stocks and bonds. Higher and superior returns bode well with private investors who are always looking for "market beating" returns while willing to bear the higher risks associated with those higher returns. Institutions are attracted to hedge funds more because of their non-correlation characteristics. According to Modern Portfolio Theory, including hedge funds in a balanced portfolio consisting of stocks and bonds, can significantly improve overall portfolio returns while simultaneously lowering volatility.

The affluent private investors represent more than 80% of the hedge fund assets; the balance of almost 20% is made up of institutional investors including pension funds, endowments, foundations and insurance companies. In recent years there has been extraordinary growth in the affluent population in the US. Affluent households, those with investable assets of more than $1 million, control about $5 trillion of financial assets. This affluent segment of the population is growing at 14% annually while the population as a whole is growing at 1%. Strong asset growth is also projected for institutional investors. The financial assets available for investment are expected to grow from $10 trillion in 1996 to over $16 trillion by the year 2001.

Based on the analysis of the underlying forces, the outlook for the future growth of the hedge fund industry is very promising. We project an annual growth rate of about 26% to over $500 billion of assets by 2001 and a ten fold increase to over $1.7 trillion in ten years.

A study of the MAR/HEDGE database reveals that the top 15% of the population of funds control in excess of 80% of all assets under management. The industry appears to be concentrated at the top and very fragmented at the bottom. The hedge fund industry, as it exists today, features two strategic segments. At one end, there is a small group of very large "superfunds" and on the other end a large number of small niche players. The superfunds are an outgrowth of the original global macro players, generally having more than $5 billion of assets with extremely high minimums and long lock-up requirements. Most of these ultra-exclusive funds are closed to new investors. The majority of other hedge funds (more than 80%) are niche players and are run by one or a small group of individuals, each with their own investment strategy, market identity and support structure. These niche players have assets of less than $100 million with more than half of them having assets under $20 million.

The net result of these two extreme groups is that a void exists. There are no real market leaders with national or global reach and efficient customer and operations support available to the average sophisticated investor. The industry is looking for market leadership and we see a clear opportunity for a market leader to emerge and lead the industry into the next century. We believe that the present structure of the hedge fund industry will change from a fragmented one with thousands of small niche players into one made up of a small group of branded large organizations providing leadership in the global marketplace.

I. Background of Hedge Funds

Hedge funds first came into existence on January 1, 1949 when Alfred W. Jones opened an equity fund that was organized as a private partnership to provide maximum latitude and flexibility in constructing a portfolio. He took both long and short positions in securities to increase returns while reducing net market exposure and used leverage to further enhance the performance. Today the term hedge fund takes on a much broader context, as many of the hedge funds control risk by hedging one or more methods, but many do not. Hedge funds are broadly defined by⁽¹⁾ their structural characteristics, rather than their "hedged" nature. There are several characteristics common to most hedge funds.

First, hedge funds are primarily private investment vehicles and therefore exempt from some of the SEC’s regulatory requirements. The legal structure of the fund provides hedge fund managers with broad discretion over investment styles and asset classes. Hedge funds can take both long and short positions, make concentrated investments, use leverage, use derivatives and invest in many markets. This is in sharp contrast to mutual funds which are highly regulated and do not have the same breadth of investment instruments at their disposal. A hedge fund need not employ all of the tools all of the time, it merely has them at its disposal to meet the objective of achieving absolute maximum returns.

Second, hedge funds utilize a performance based fee (allocation) structure. Hedge fund managers are rewarded primarily in proportion to the profitability of the funds investments (typically 20% of profits). Many times a hurdle rate of return must be achieved or any previous losses recouped before the performance fee is paid. The reward system tends to encourage the hedge fund managers to achieve maximum returns. Most hedge funds also include a management fee based on a percentage of assets under management (typically 1-2%). This fee structure is again in sharp contrast to the mutual fund industry, where fees are based solely on assets under management.

Third, in addition to managing the fund as a general partner, the fund manager is generally an investor in the fund as a limited partner. The size of his investment can range anywhere from a 1% share up to a significant majority interest. Most hedge fund managers commit a large portion of their wealth to the funds in order to align their interest with that of other investors. Since managers tend to be significant investors in their own fund and keep a significant portion of their performance fees in the fund, they share in both the upside and downside of the fund returns. It appears that in hedge funds, the destination of managers and investors are the same and the nature of the relationship is one of true partnership.

There are many different investing styles and strategies of hedge funds, some of which are quite unique. A number of hedge fund industry groups, consultants and information providers attempt to aggregate hedge funds into specific styles. While each organization has its own categorization scheme, a review of several sources ⁽²⁾ yields the following list of styles most commonly included:

Exhibit 1
Investment Styles of Hedge Funds

Source: MAR/HEDGE

Investors decide to invest in hedge funds for a variety of reasons, but several studies reveal that the single most important reason for investing in hedge funds is to earn a superior return. Investors, both private and institutional, feel that hedge funds’ ability to pursue a variety of investing options (short, leverage, concentrated positions, etc.) provide greater possibility of outstanding returns. The ability of hedge funds to outperform mutual funds or the market is very much at the forefront of media attention. It is well documented that individual funds can indeed perform exceptionally well.

Various studies have been conducted to evaluate the performance of hedge funds⁽³⁾. Each of the different investment styles of hedge funds has its own risk and return profile. Generally speaking, the studies conclude that hedge funds as a group do provide higher and superior returns on average compared to the S&P 500 and mutual funds. However, there are some concerns regarding the validity of each study. A central question relates to the make-up of the sample, size of the funds, the survivorship effect, and the self-selection bias of the funds reporting results. Reporting of the data on hedge funds is voluntary and therefore, no one source is comprehensive. However, the differences between different studies also seem to get smaller over time which increases the significance of the results. Based on the studies available, the long-term average performance of hedge funds as a group can be estimated to be in the range of 17-20%, several percentage points higher than traditional equity returns ⁽⁴⁾ .

The volatility of hedge funds, as measured by standard deviation, varies greatly as a function of the strategy pursued. Some of the strategies, such as market neutral are designed to be low in volatility while others, such as short only or global macro funds, are highly volatile. However, the data indicates that a long-term standard deviation of a diversified pool of hedge funds as a group is very similar to the standard deviation of the stock market as measured by the S&P 500 index. The exhibit below compares the performance of hedge funds as a group against a variety of other instruments ⁽⁵⁾.

Exhibit 2
Risk & Reward Comparisons
Hedge Funds vs. Traditional Assets
(1986-1995)

Source: Cottier

Another motivation for private and institutional investors to include hedge funds as part of their investment portfolios is diversification benefit. In addition to their ability to generate higher returns, hedge funds show a low historic correlation to traditional investments. Because of their flexibility to use a full range of investment instruments and techniques, hedge fund returns are somewhat independent of the ups and downs of the market. The low correlation of hedge funds with traditional instruments has emerged as one of the key advantages for investors, especially institutional investors.

The correlation of hedge funds to the S&P 500 and Lehman bond indexes are shown in the Exhibit below. These results were obtained by Dr. Matthias Bekier and his group at the University of St. Gallen⁽⁴⁾. Again, there may be some reservation about the validity of these conclusions as only a limited set of data was used over a one year time horizon.

Exhibit 3
Correlation of Hedge Funds to Traditional Investments
(as measured by r²)

Source: Bekier

Correlation coefficients are usually measured in terms of r-squared. Bekier’s analysis shows that more than 70% of hedge funds have correlation coefficients with the S&P 500 and Lehman bond indexes below 0.3 which is considered to be a statistically insignificant correlation. An r-squared of 1.0 represents perfect correlation while a r-squared of 0.0 represents no correlation.

In summary, hedge funds as a group seem to offer higher returns with average volatility and have a low correlation with traditional investments. Based on Modern Portfolio Theory, it is possible for investors to boost returns while simultaneously lowering volatility by including hedge funds in their optimum portfolio versus a portfolio constructed exclusively with traditional instruments like stocks and bonds. It is our view that as investors become more and more sophisticated and become aware of these performance characteristics, they will allocate a larger portion of their investment assets to hedge funds.

While hedge funds are largely exempt from SEC regulation, there are some specific limits placed on the number and types of investors they may accept. Only "accredited" investors are eligible to invest in hedge funds. "Accredited" individuals must (1) be "sophisticated investors" capable of assessing the risks inherent in unregulated alternative investments and (2) have over $1 million in investable assets. For institutions to be considered "accredited" they must have over $5 million in investable assets. Furthermore, current hedge fund partnerships are limited to 99 partners (a new exemption to this rule allows partnerships of up to 499 investors). Of those 99 investors/partners, no more than 35 can be non-accredited investors.

Due to these restrictions, the universe of hedge fund investors is effectively limited to two specific groups: High Net Worth private individuals and institutional investors (including pension and benefit plans, endowments and foundations, insurance companies, banks and corporations) ^(4,5,6). The exhibit below illustrates the distribution of hedge fund assets by investor group.

Source: KPMG Survey, Bekier, Cottier

By far the largest group of hedge fund investors is affluent private individuals. It is estimated that this group represents more than 80% of hedge fund assets. In fact, through the 1980s, investors in hedge funds were almost exclusively high net worth private investors. In the 1990s, this circle began to expand and institutional investors started to participate in hedge funds.

Private investors dominate hedge funds because they are more willing to pursue higher absolute returns and to bear the higher risk associated with those higher returns. This group consists primarily of high net worth individuals (defined as those with annual income in excess of $100,000 and net worth in excess of $1,000,000). Family offices and trust departments of private banks are also included in this grouping as their primary role is to manage the fortunes of wealthy individuals and families.

While this group may be a rather small slice of the overall population, they control over one third of the estimated $15 trillion in household financial assets in the United States ⁽⁷⁾. During the 1990’s, the high net worth market has grown at almost twice the rate of the general population. The primary sources of wealth creation have been initial public offerings (IPOs), creation and sales of businesses, merger and acquisition activity and the expansion of stock options as compensation. In the US, there are now nearly 2 million "accredited" household investors with investable assets over $1 million. This group controls about $5.3 trillion of financial assets. The Exhibit below shows the high-net worth market size and share of household financial assets by different wealth groups ⁽⁸⁾ .

Source: Sanford C. Bernstein

It is estimated that institutional investors represent less than 20% of hedge fund assets. Institutional investors include pension and benefit plans, insurance companies, non-profit organizations such as foundations and endowments and other organizations such as corporations and banks. The strict fiduciary responsibilities of many institutional investors and their sometimes bureaucratic investment decision making process has made them slower to adopt hedge funds. Media attention to specific instances of high returns and high variability of returns has created an impression of high risk.

Pension plans are subject to ERISA and the legal doctrine of the "prudent man" rule. The combination of the perceived riskiness of hedge funds and their fiduciary requirements has caused pension plans to be very cautious in their allocation to hedge fund investments. Insurance companies are regulated by state insurance authorities and generally are limited in their investment allocations to limited partnerships. Foundations and endowments on the other hand, have more investment autonomy and were one of the first institutional investor groups to embrace hedge funds.

Although the participation of institutional investors in hedge funds is small, they represent an important segment. Institutional investors as a group control almost twice the assets available for investment than high net worth investors. In the US, at the end of 1996, they had total investable assets of over $11.1 trillion ⁽⁹⁾ compared to the $5.3 trillion of "accredited" private investors. The largest group of institutional investors, by asset size, is pension and retirement plans. They are followed by insurance companies. Third place is occupied by non-profit organizations which include private foundations and endowments. Exhibit 6 below, shows the US institutional capital pool by major investor category along with their historical compounded annual growth rates ⁽⁹⁾ .

Source: Putman, Lovell & Thornton

Although hedge funds are offered globally, the US market is the single most significant one measured by the assets contributed. US managers control almost three quarters of the global assets. We estimate that at the end of 1996, the global assets of hedge funds were approximately $170 billion. The table below estimates the total amount invested by various groups and the corresponding allocation rates for hedge funds for these segments of investors.

Source: RRCM & KPMG

II. Historical Perspective on the Hedge Fund Industry

Because of the private nature of hedge funds and regulatory disclosure requirements, definitive data on the size of the market and number of hedge funds is not readily available. Many estimates place the total number of funds in operation worldwide at over 2,300 with some estimates approaching 5000^(3,5,10). The total assets under management of the industry range between $140 and $250 billion ^(5,11).

Although the US equity market with a total capitalization of over $6.8 trillion ⁽¹²⁾ dwarfs the hedge fund market in size, hedge funds have far surpassed the equity markets in recent growth. In the US, total equity capitalization from the beginning of the 1980’s through today has grown at less than 13% ⁽⁹⁾. Hedge funds on the other hand, have experienced 24% growth over the same period ^(4,5).

According to extensive research conducted by Dr. Philip Cottier and his group at the University of St. Gallen ⁽⁽⁵⁾ , hedge funds entered a period of accelerated growth in the early 1990’s after a few decades of relatively modest growth. The number of funds grew tremendously from under 500 in 1990 to over 2500 in little more than five years.

The growth in hedge fund assets has paralleled the growth in number of funds. The decade of the 1990’s has seen a phenomenal acceleration of growth in the hedge fund industry with new funds being formed at the rate of some 42% per year while assets have increased at the rate of 37% annually.

Source: Cottier

The asset growth has come from new money invested in this class of investments as well as internal growth from the reinvestment of returns. Asset growth dipped slightly in 1994 due to relatively poor performance of hedge funds and the market overall, as well as the high profile failure of some large hedge funds such as David Askin’s Granite Fund.

The hedge fund industry today is very fragmented and made up primarily of individual funds, each with their own investment strategy, market identity and support infrastructure. As discussed above, the number of new funds being formed has skyrocketed in the 1990’s. While the biggest funds control a large portion of total hedge fund assets, there are a large number of relatively small funds. For example, more than one third of the estimated 2,500 hedge funds have less than $10 million of assets under management. The industry appears to be concentrated at the top and very fragmented at the bottom. The largest 15% of hedge funds control over 80% of total assets ⁽¹³⁾.

III. The Future Outlook for the Hedge Fund Industry

Even given the significant growth over the past few years in the hedge fund industry, there appears to be strong evidence that this growth will continue. A combination of factors point to this conclusion.

There continues to be an increase in demand for investment management products and services across the board. Over the next five years, this demand is expected to continue growing. According to Putnam, Lovell & Thornton, total financial assets, including both US household and institutional, are expected to increase from $27.3 trillion in 1996 to $42.4 trillion by 2001. In 1996, approximately 42% or $11.6 trillion of the these assets were professionally managed. This percentage is expected to increase to over 48% or $20 trillion of assets by 2001. Concurrently, there will be a slight shift in the composition of that demand from institutions to households, the largest investor segment for hedge funds. In 1996, 30% of the demand for money management came from households and nearly 70% from institutions. By 2001, 33% of the demand is expected to come from households and 64% from institutions ⁽⁹⁾.

Hedge funds stand to benefit disproportionately from the growth in demand for investment management due to their better return and non-correlation characteristics. As demand for traditional investments has grown, the market has become saturated. Innovative mutual fund managers have seen their returns fade as their styles are copied and the inevitable regression to the mean takes hold. Many successful mutual funds are now so large that they are no longer nimble enough to achieve superior returns. It is a well documented fact that a majority of mutual funds under perform the S&P 500 index. As a result, sophisticated investors are looking for other investment alternatives that can produce "market beating" returns. Hedge funds represent the next logical choice for their investment.

Trends in the size and investment philosophies of the different segments of hedge fund investors also bode well for the growth of the industry. The growth of potential hedge fund investor segments and their increasing acceptance of alternative investments should produce superior growth for the industry.

As mentioned previously, the most important investor segment for the majority of hedge funds is the high net worth individual. There has been an extraordinary growth in the affluent population in the United States in recent years. Affluent households control over $7 trillion of financial assets. The affluent segment (over $100,000 of income or $500,000 of net worth excluding primary residence) is growing at an annual rate of 5% while the wealthy segment (over $1 million of investable assets) of the population is growing at approximately 14%. This compares with the population as a whole which is only growing at around 1% ⁽¹⁴⁾. This growth of affluent households and the shift within the affluent market from the $500,000 - $1 million net worth segment to the $1 million-plus net worth segment is driving demand for financial services across the board.

Source: PSI

In addition to the net increase in wealthy individuals and the shift to greater concentration of wealth, there will also be an unprecedented transfer of wealth through inheritance in the near future. Estimates of the coming "inheritance boom" point to over $10 trillion dollars passing from one generation to the next over the next fifty years ⁽¹⁵⁾. This generational shift of wealth from the parents of baby boomers to their children presents both an opportunity and a challenge for hedge funds. These young investors are more sophisticated and have a higher tolerance for risk, but also are more demanding in terms of investment performance which bodes well for hedge funds which generally have higher absolute returns.

 
Source: Merrill Lynch

Strong asset growth is also projected for the next ten years among the institutional segments of hedge fund investors. The assets available for investment are expected to grow from $10 trillion in 1996 to over $16 trillion by the year 2001⁽⁹⁾.

Among institutional investors, pension funds control the largest pool of investment capital. The overall pension market is estimated at $5.5 trillion dollars in the US alone and expected to grow at over 10% annually over the next five years ⁽⁹⁾. However, pension plan sponsors are subject to strict fiduciary requirements under ERISA and, as a result, have been less enthusiastic about hedge fund investments. This view, however, is changing. Recent court rulings have expanded the "prudent investor rule" to include Modern Portfolio Theory (MPT), thereby providing more leeway to ERISA managers in applying MPT to their funds. These changes open the door to higher allocations to alternative investments including hedge funds.

Source: Greenwich Associates

Nonprofit organizations are an important segment of institutional investors for hedge funds. In the US, they hold approximately $1 trillion in financial assets and are expected to grow at 10% annually over the next five years. Among institutional investors, foundations and endowments have the largest percentage of their assets allocated to hedge funds. There is also evidence that this allocation will continue to grow. One recent study revealed that the average dollar weighted endowment allocation to hedge fund investments increased by almost 4% in the period 1995-1996 alone⁽¹⁶⁾. As more and more non-profit institutions look to their endowments to cover shortfalls in operating cash flow, the superior returns of hedge fund investments should generate even greater interest.

One other segment of the institutional investor community that deserves mention as a potential source of growth is the insurance industry. US insurance companies currently control approximately $3 trillion of assets with expected growth at 9% per annum ⁽⁹⁾. These organizations are constantly looking for new ways to diversify their holdings and to generate future cash flows needed to fund future policy claims. However, current regulations limit the total allocation that insurance companies can make. Many insurers are currently prohibited from investing over 5% of their capital in limited partnership vehicles. These rulings limit insurers’ participation in a number of alternative investments (venture capital funds, oil & gas funds, real estate limited partnerships) in addition to hedge funds. The particular risk/reward structure of hedge funds does indicate, however, that hedge funds are well positioned among alternative investments to capture a greater share of the insurance market.

Many of the same demands on portfolio return will be placed on the investments of banks and corporations. These investor segments currently represent a small piece of the hedge fund pie, but they also hold the potential for growth. Since asset allocation decisions in these organizations are made by a variety of methods and for the benefit of varied constituencies, it is unclear how rapidly hedge funds will be able to penetrate these investor segments.

Source: Putnam, Lovell & Thornton

Based on the analysis of the underlying forces described above, the outlook for the future growth of the hedge fund industry is very promising. We predict a period of extended rapid growth for the hedge fund industry. To estimate the future growth, we considered three variables: (i) financial asset growth of each major segment of hedge fund investors, (ii) asset allocation or penetration rates for hedge funds, and (iii) intrinsic growth or hedge fund investment rate of returns. The Exhibit below illustrates our estimation of projected growth over the period 1996-2006. The underlying assumptions are; (i) investor financial assets grow at rates ranging from 9% to 14%, (ii) allocation rates to hedge funds grow between 2% and 12%, and (iii) hedge fund returns average 17%.

Source: RRCM/KPMG

These assumptions result in over $500 billion of assets by 2001 and a ten fold increase to over $1.7 trillion in ten years. Though the assumption of increased allocation rates mayt appear somewhat aggressive, these growth projections equate to a compound growth rate of approximately 26%. If this estimate of future growth is compared to the historical growth trends, it is apparent that our projection yields growth rates below the recent accelerated growth rates and about in line with the ten year trend.

Source: Bekier, RRCM, KPMG

IV. Emergence of The Family of Hedge Funds (FHF)

While the prospects for growth in the industry appear good, some structural aspects of the industry will need to evolve to support the future asset growth. It is our view that the sustained growth and maturation of the industry will alter its structure or at least provoke a debate over the form the industry will eventually assume.

To continue growing assets at 25%, the hedge fund industry must be able to retain and reach-out for new customers. Considering the facts that the total capital pool available for investments; over $5 trillion from high net worth individuals and over $10 trillion from institutional investors, and the present allocation rates to hedge funds in these segments; less than 2% in high net worth market and less than 1% in the institutional market, one can conclude that the industry has a plenty of room to increase its market share.

In the initial growth stage of any industry, products are more easily accepted by a select set of customers, often sold without much marketing and sales activities or even without infrastructure for customer support and services. However, as the industry matures and becomes more competitive, the mode of competition switches from convincing customers to try a new product to explaining to them the product advantages, attracting new customers and even encouraging customers to switch away from competitors. One of the challenges in the future will be to expand the investor base of high net worth individuals while targeting the much larger institutional investor base. In the long run, institutional capital will be key for sustainable asset growth.

Another challenge facing the hedge fund industry is that the market is becoming increasingly global. Recently, we have seen how our stock market can be impacted by events in Asia. The development of a global economy and the emergence of multinational asset management companies are forcing investment managers to view their business on a global basis. It is our view that the competition to manage assets will evolve into a single global market. The battle for investment assets, especially from high net worth and institutional investors, will shift from one that is primarily fought among domestic funds to one involving global competitors.

In the very near future, hedge funds will need to be able to conduct a significant part of their business electronically, at least as far as the distribution of information is concerned. A new class of sophisticated investors, the "www.generation" is emerging. They share and access information anywhere, anyplace and anytime without concern for physical location. For the first time, on May 29, 1997, a no-action letter from the Securities & Exchange Commission was issued which has paved the way for delivery of hedge fund performance and related information over the Internet⁽¹⁷⁾. Today more than 70% of affluent households own a computer and are interested in on-line delivery of information. Investors would like to buy and sell financial products, monitor their returns and analyze the performance of their portfolios on a real time basis using their PC.

Another recent development addresses the number of investors hedge funds can accept. Under reforms enacted by the SEC in early 1997, hedge funds now have the option of reorganizing under a provision known as 3(c)(7) that permits them up to 499 investors⁽¹⁸⁾ that meet the standard of "qualified purchasers." "Qualified purchasers" are defined as individuals or family businesses with over $5 million of investable assets and institutions with over $25 million. Prior to this change, U.S. hedge funds were limited to 99 investors with a significant portion required to be "accredited". This regulatory change increases the potential number of investors for an individual fund by five-fold.

There are a number of other, more specific structural needs that came to light during a KPMG survey of hedge fund managers and investors. These needs center around the marketing of hedge funds and servicing of hedge fund customers which is at the heart of the major structural challenge of expanding the customer base. Essentially, hedge funds need to make it easier for investors to find, evaluate, obtain, and liquidate their investments. To a lesser extent there are operational needs that must be addressed to insure future growth.

Marketing is the one aspect of hedge fund management that was cited most frequently as a distraction from investment activities. Many fund managers expressed frustration at the time and effort required to grow their fund’s assets and how those activities prevented them from focusing on their core business: generating investment returns for their current investors.

Key to the marketing dilemma is the problem of access to information. Whether seeking data on specific funds or general industry information, there are relatively few good sources easily accessible by investors. This shortage primarily affects private investors and smaller institutions. Large institutions have more access to data and regularly employ outside data gatherers such as consultants. The rating agencies and league tables fill some of this void and their data is slowly creeping into the mainstream (Bloomberg terminals now have access to both Van Hedge Fund Advisors and Hennessee Group data).

Successful marketing of the hedge fund concept is also hampered by the financial terms of the investments. Most hedge funds have high minimum initial investments, often as high as $1 million. Compounding the limiting factor of the high initial minimum investments are the long "lock-up" periods common to many funds. Fund managers seek to build some stability into their asset base by requiring that investments remain "locked up" in the fund for a period of time, usually a minimum of one year and up to five years or longer. Even after that initial period, redemptions and liquidations of investments are permitted only at proscribed intervals, sometimes as seldom as once per year, and with significant lead times. Currently, there is a trend within the industry to lower the minimums, reduce the lock-up periods and permit more frequent redemptions. This trend is particularly evident in the newer, start-up funds. In practice however, many managers already exhibit some flexibility with regard to initial minimums and redemptions.

To a lesser extent than with marketing, operational issues may limit the future growth of hedge funds. The small size of today’s hedge fund partnerships (99 or fewer investors) mitigates somewhat the impact of operational issues. While some managers indicated that operational issues distracted them from their investment management duties, many felt that the small investor pool kept these issues at manageable levels. However, the five-fold increase in investors allowed under 3(c)(7) could create an attendant rise in customer account reporting and investor relations inquiries.

Another issue has to do with the lack of transparency. There are significant numbers of institutional investors whose willingness to place assets with hedge funds is contingent upon being able to "see into" the portfolio on a regular basis. As the hedge fund industry grows, the industry will become increasingly transparent. The increase in transparency will increase competition as it will be easier for investors to compare investment performance. The impact of these changes will be an increase in overall performance pressure for hedge fund managers. Hedge fund fees have not yet come under pressure except in the institutional market. Based on the experience in other segments of investment management, it can be assumed that fee pressure will increase in hedge funds, although this may impact performance fees (allocation) more than the management fees. It is our view that these forthcoming demands will cause managers to focus their activities on their core expertise, managing money.

It is our view that the entire hedge fund industry will move from a relatively local and private business to a more mature, globally operating and institutionalized industry. A new structure in the hedge fund industry will evolve to accommodate these changes. One structure that holds significant promises to address the industry’s challenges and needs is the Family of Hedge Funds (FHF). Modeled after the family of mutual funds concept, the Family of Hedge Funds brings together a variety of different hedge funds under a single unified organization. The management of this family of funds would be structured such that each participating fund would operate autonomous with regard to the investment decision making process. These funds would be supported by centralized marketing and operations functions such as international marketing and sales, customer support and services, partnership administration, account reporting, legal compliance, etc.

Exhibit 18
FAMILY OF HEDGE FUND ORGANIZATIONAL STRUCTURE

IV.(d) Benefits of FHF to Investors

The Family of Hedge Funds structure offers investors high quality integrated services and easier diversification for their hedge fund investments. This structure also increases the standardization within the industry. Currently, individual funds have very different pricing structures, minimum investments, lock-ups, redemption terms and reporting quality and frequency. Standardization could simplify the buying and servicing processes. This will be of great service, especially for international investors.

Under the FHF structure, with a single phone call investors would be able to complete the qualification process and get access to a variety of hedge fund investments: from market neutral to emerging markets to convertible arbitrage to short-only. The FHF structure will permit investors to study and evaluate the range of hedge fund options in a manner that could previously have taken a significant amount of research and possibly required specialized consultants.

Furthermore, by having the ability to easily allocate their hedge fund investment across a variety of styles within the same organization, investors would not only diversify their portfolios by adding hedge funds, but will be able to diversify within their hedge fund investment, taking advantage of the low correlation among the various styles. In contrast to the diversification benefit offered by the fund of funds, however, this portfolio of hedge funds can be tailored to the individual investor’s investment goals. Also, the FHF would only subject investors to one layer of fees, rather than the two layers associated with fund of funds.

Depending on the exact structure of the FHF, investors may enjoy increased liquidity. Having multiple funds under one umbrella raises the possibility that investors would be able to examine and adjust their allocations among the component funds at more frequent intervals and much easier than with stand alone funds. If the FHF were structured with a proprietary "liquidity pool" it could allow investors shorter lock-ups or more frequent redemptions by "cashing out" the investor but maintaining the investment in a specific fund for a period of time to allow the fund manager more flexibility in running the portfolio.

Finally, having the operations and customer service functions handled by dedicated groups within the FHF structure would enable investors to get quick answers to operational, administrative or tax questions. By providing a unified customer account reporting function, investors could track their hedge fund investments on one simple statement that would provide an attractive and convenient communication to investors with multiple hedge fund investments.

The FHF could also provide a wealth of economic and industry intelligence culled from the best offerings of the component managers. Conceivably, this information could also be available to FHF investors on-line through a private, password protected internet site. Such a site would provide 24 hour account access with updated information and allow a high degree of interactivity between investors, fund managers, support staff and other investors.

The FHF structure also offers significant benefits to the individual fund managers. One function strongly desired by hedge fund managers and provided by the FHF structure is a unified marketing and sales operation. The single activity that the majority of managers surveyed felt distracted them most from their ability to concentrate on investing, but was nonetheless critical to the success of their business, was marketing and sales. The FHF structure would employ dedicated financial services marketing professionals to present the full range of FHF and hedge fund benefits to the widest possible audience of qualified investors. This allows the fund managers to focus on their greatest strength, managing the money. Most managers, and investors alike, felt it was critical for the manager to communicate the details of the investment strategy directly. A dedicated and skilled sales staff could better leverage the manager’s time by developing and qualifying sales leads before the manager gets involved. This will be especially critical as hedge fund managers increase the promotion of their products in foreign markets.

In addition to the time saving aspect of centralizing these various functions, there would be opportunities for cost savings realized by the FHF structure. Economies of scale can be realized in every area of support: from pure physical space requirements to technology infrastructure to administrative personnel. The ability to deliver the highest quality service at a cost saving will provide a significant competitive advantage to the FHF organization. Moreover, the FHF structure will permit managers to enjoy the benefits of centralized operations while still maintaining independent investment operations.

It is our view that the FHF structure can be quite unique in providing this vertical integration of "product" and "distribution". This not only reduces the cost of operations but more importantly increases customer satisfaction, both in terms of returns and service. These attributes will be critical in the future as we believe hedge fund investors will increasingly have a preference for multi-product firms with global capabilities.

In the coming years, hedge fund managers will need to find a way to promote their products in foreign markets. Instead of developing their own sales force, technology and products, it may be more advisable to be part of a much larger organization like a FHF which can provide the necessary infrastructure, financial resources and, more importantly, name recognition. For example, Japanese institutions prefer dealing with investment management organizations of substantial scope and size.

One additional service that the FHF structure may be able to provide to an individual hedge fund manager is minimizing unnecessary fluctuations of its asset base. As mentioned before, by utilizing its financial resources, the FHF may provide liquidation to investors at their convenience, while holding the investment in the fund for a period of time to ease disruption of the portfolio positions.

The hedge fund industry as it exists today essentially features two strategic segments. At one end, there is a small group of "superfunds" and on the other end a large number of niche players. The superfunds are an outgrowth of the original global macro players. These superfunds generally have over $5 billion of assets under management and feature well known, often quoted managers, like George Soros, Julian Robertson, and Leon Cooperman. The funds are a manifestation of the personality and investment philosophy of their managers. These high profile personalities not only attract media attention but also undue interest of regulators. The number of these macro players should remain relatively small. These funds feature extremely high minimum investments with only a limited number of institutions or the very wealthiest investors able to participate. In fact, many of these ultra-exclusive funds are now closed to the new investors.

The majority of other hedge funds are niche players, each with their own investment strategy, market identity, and support structure. Most of these funds are run by one or a small group of individuals who perform much of the marketing and operations as well as manage the investments. Most of them have assets much less than $100 million. These small niche funds are unable to attract large capital pools due to their lack of resources, marketing expertise or credibility with large investors, especially institutional investors. Smaller hedge funds may not be able to handle large allocations from pension funds. Hedge funds also have some restrictions on accepting money subject to ERISA. If more than 25% of a hedge funds assets are subject to ERISA, then the fund itself would be subject to ERISA. This could be a much more significant constraint on smaller funds.

The net results of these two extreme groups is that a void exists. The industry is looking for market leadership. It is our view that for the hedge fund industry to be a trillion dollar industry in the next ten years, it needs more leadership. Whenever there is any degree of inefficiency in the marketplace in terms of information dissemination or customer focus, there is an opportunity for a brand name to emerge. Just as Fidelity’s name has become synonymous with mutual funds, we see a clear opportunity for a market leader to emerge and lead the industry into the next century.

IV. Emergence of The Family of Hedge Funds (FHF)

While the prospects for growth in the industry appear good, some structural aspects of the industry will need to evolve to support the future asset growth. It is our view that the sustained growth and maturation of the industry will alter its structure or at least provoke a debate over the form the industry will eventually assume.

To continue growing assets at 25%, the hedge fund industry must be able to retain and reach-out for new customers. Considering the facts that the total capital pool available for investments; over $5 trillion from high net worth individuals and over $10 trillion from institutional investors, and the present allocation rates to hedge funds in these segments; less than 2% in high net worth market and less than 1% in the institutional market, one can conclude that the industry has a plenty of room to increase its market share.

In the initial growth stage of any industry, products are more easily accepted by a select set of customers, often sold without much marketing and sales activities or even without infrastructure for customer support and services. However, as the industry matures and becomes more competitive, the mode of competition switches from convincing customers to try a new product to explaining to them the product advantages, attracting new customers and even encouraging customers to switch away from competitors. One of the challenges in the future will be to expand the investor base of high net worth individuals while targeting the much larger institutional investor base. In the long run, institutional capital will be key for sustainable asset growth.

Another challenge facing the hedge fund industry is that the market is becoming increasingly global. Recently, we have seen how our stock market can be impacted by events in Asia. The development of a global economy and the emergence of multinational asset management companies are forcing investment managers to view their business on a global basis. It is our view that the competition to manage assets will evolve into a single global market. The battle for investment assets, especially from high net worth and institutional investors, will shift from one that is primarily fought among domestic funds to one involving global competitors.

In the very near future, hedge funds will need to be able to conduct a significant part of their business electronically, at least as far as the distribution of information is concerned. A new class of sophisticated investors, the "www.generation" is emerging. They share and access information anywhere, anyplace and anytime without concern for physical location. For the first time, on May 29, 1997, a no-action letter from the Securities & Exchange Commission was issued which has paved the way for delivery of hedge fund performance and related information over the Internet⁽¹⁷⁾. Today more than 70% of affluent households own a computer and are interested in on-line delivery of information. Investors would like to buy and sell financial products, monitor their returns and analyze the performance of their portfolios on a real time basis using their PC.

Another recent development addresses the number of investors hedge funds can accept. Under reforms enacted by the SEC in early 1997, hedge funds now have the option of reorganizing under a provision known as 3(c)(7) that permits them up to 499 investors⁽¹⁸⁾ that meet the standard of "qualified purchasers." "Qualified purchasers" are defined as individuals or family businesses with over $5 million of investable assets and institutions with over $25 million. Prior to this change, U.S. hedge funds were limited to 99 investors with a significant portion required to be "accredited". This regulatory change increases the potential number of investors for an individual fund by five-fold.

There are a number of other, more specific structural needs that came to light during a KPMG survey of hedge fund managers and investors. These needs center around the marketing of hedge funds and servicing of hedge fund customers which is at the heart of the major structural challenge of expanding the customer base. Essentially, hedge funds need to make it easier for investors to find, evaluate, obtain, and liquidate their investments. To a lesser extent there are operational needs that must be addressed to insure future growth.

Marketing is the one aspect of hedge fund management that was cited most frequently as a distraction from investment activities. Many fund managers expressed frustration at the time and effort required to grow their fund’s assets and how those activities prevented them from focusing on their core business: generating investment returns for their current investors.

Key to the marketing dilemma is the problem of access to information. Whether seeking data on specific funds or general industry information, there are relatively few good sources easily accessible by investors. This shortage primarily affects private investors and smaller institutions. Large institutions have more access to data and regularly employ outside data gatherers such as consultants. The rating agencies and league tables fill some of this void and their data is slowly creeping into the mainstream (Bloomberg terminals now have access to both Van Hedge Fund Advisors and Hennessee Group data).

Successful marketing of the hedge fund concept is also hampered by the financial terms of the investments. Most hedge funds have high minimum initial investments, often as high as $1 million. Compounding the limiting factor of the high initial minimum investments are the long "lock-up" periods common to many funds. Fund managers seek to build some stability into their asset base by requiring that investments remain "locked up" in the fund for a period of time, usually a minimum of one year and up to five years or longer. Even after that initial period, redemptions and liquidations of investments are permitted only at proscribed intervals, sometimes as seldom as once per year, and with significant lead times. Currently, there is a trend within the industry to lower the minimums, reduce the lock-up periods and permit more frequent redemptions. This trend is particularly evident in the newer, start-up funds. In practice however, many managers already exhibit some flexibility with regard to initial minimums and redemptions.

To a lesser extent than with marketing, operational issues may limit the future growth of hedge funds. The small size of today’s hedge fund partnerships (99 or fewer investors) mitigates somewhat the impact of operational issues. While some managers indicated that operational issues distracted them from their investment management duties, many felt that the small investor pool kept these issues at manageable levels. However, the five-fold increase in investors allowed under 3(c)(7) could create an attendant rise in customer account reporting and investor relations inquiries.

Another issue has to do with the lack of transparency. There are significant numbers of institutional investors whose willingness to place assets with hedge funds is contingent upon being able to "see into" the portfolio on a regular basis. As the hedge fund industry grows, the industry will become increasingly transparent. The increase in transparency will increase competition as it will be easier for investors to compare investment performance. The impact of these changes will be an increase in overall performance pressure for hedge fund managers. Hedge fund fees have not yet come under pressure except in the institutional market. Based on the experience in other segments of investment management, it can be assumed that fee pressure will increase in hedge funds, although this may impact performance fees (allocation) more than the management fees. It is our view that these forthcoming demands will cause managers to focus their activities on their core expertise, managing money.

It is our view that the entire hedge fund industry will move from a relatively local and private business to a more mature, globally operating and institutionalized industry. A new structure in the hedge fund industry will evolve to accommodate these changes. One structure that holds significant promises to address the industry’s challenges and needs is the Family of Hedge Funds (FHF). Modeled after the family of mutual funds concept, the Family of Hedge Funds brings together a variety of different hedge funds under a single unified organization. The management of this family of funds would be structured such that each participating fund would operate autonomous with regard to the investment decision making process. These funds would be supported by centralized marketing and operations functions such as international marketing and sales, customer support and services, partnership administration, account reporting, legal compliance, etc.

Exhibit 18
FAMILY OF HEDGE FUND ORGANIZATIONAL STRUCTURE

IV.(d) Benefits of FHF to Investors

The Family of Hedge Funds structure offers investors high quality integrated services and easier diversification for their hedge fund investments. This structure also increases the standardization within the industry. Currently, individual funds have very different pricing structures, minimum investments, lock-ups, redemption terms and reporting quality and frequency. Standardization could simplify the buying and servicing processes. This will be of great service, especially for international investors.

Under the FHF structure, with a single phone call investors would be able to complete the qualification process and get access to a variety of hedge fund investments: from market neutral to emerging markets to convertible arbitrage to short-only. The FHF structure will permit investors to study and evaluate the range of hedge fund options in a manner that could previously have taken a significant amount of research and possibly required specialized consultants.

Furthermore, by having the ability to easily allocate their hedge fund investment across a variety of styles within the same organization, investors would not only diversify their portfolios by adding hedge funds, but will be able to diversify within their hedge fund investment, taking advantage of the low correlation among the various styles. In contrast to the diversification benefit offered by the fund of funds, however, this portfolio of hedge funds can be tailored to the individual investor’s investment goals. Also, the FHF would only subject investors to one layer of fees, rather than the two layers associated with fund of funds.

Depending on the exact structure of the FHF, investors may enjoy increased liquidity. Having multiple funds under one umbrella raises the possibility that investors would be able to examine and adjust their allocations among the component funds at more frequent intervals and much easier than with stand alone funds. If the FHF were structured with a proprietary "liquidity pool" it could allow investors shorter lock-ups or more frequent redemptions by "cashing out" the investor but maintaining the investment in a specific fund for a period of time to allow the fund manager more flexibility in running the portfolio.

Finally, having the operations and customer service functions handled by dedicated groups within the FHF structure would enable investors to get quick answers to operational, administrative or tax questions. By providing a unified customer account reporting function, investors could track their hedge fund investments on one simple statement that would provide an attractive and convenient communication to investors with multiple hedge fund investments.

The FHF could also provide a wealth of economic and industry intelligence culled from the best offerings of the component managers. Conceivably, this information could also be available to FHF investors on-line through a private, password protected internet site. Such a site would provide 24 hour account access with updated information and allow a high degree of interactivity between investors, fund managers, support staff and other investors.

The FHF structure also offers significant benefits to the individual fund managers. One function strongly desired by hedge fund managers and provided by the FHF structure is a unified marketing and sales operation. The single activity that the majority of managers surveyed felt distracted them most from their ability to concentrate on investing, but was nonetheless critical to the success of their business, was marketing and sales. The FHF structure would employ dedicated financial services marketing professionals to present the full range of FHF and hedge fund benefits to the widest possible audience of qualified investors. This allows the fund managers to focus on their greatest strength, managing the money. Most managers, and investors alike, felt it was critical for the manager to communicate the details of the investment strategy directly. A dedicated and skilled sales staff could better leverage the manager’s time by developing and qualifying sales leads before the manager gets involved. This will be especially critical as hedge fund managers increase the promotion of their products in foreign markets.

In addition to the time saving aspect of centralizing these various functions, there would be opportunities for cost savings realized by the FHF structure. Economies of scale can be realized in every area of support: from pure physical space requirements to technology infrastructure to administrative personnel. The ability to deliver the highest quality service at a cost saving will provide a significant competitive advantage to the FHF organization. Moreover, the FHF structure will permit managers to enjoy the benefits of centralized operations while still maintaining independent investment operations.

It is our view that the FHF structure can be quite unique in providing this vertical integration of "product" and "distribution". This not only reduces the cost of operations but more importantly increases customer satisfaction, both in terms of returns and service. These attributes will be critical in the future as we believe hedge fund investors will increasingly have a preference for multi-product firms with global capabilities.

In the coming years, hedge fund managers will need to find a way to promote their products in foreign markets. Instead of developing their own sales force, technology and products, it may be more advisable to be part of a much larger organization like a FHF which can provide the necessary infrastructure, financial resources and, more importantly, name recognition. For example, Japanese institutions prefer dealing with investment management organizations of substantial scope and size.

One additional service that the FHF structure may be able to provide to an individual hedge fund manager is minimizing unnecessary fluctuations of its asset base. As mentioned before, by utilizing its financial resources, the FHF may provide liquidation to investors at their convenience, while holding the investment in the fund for a period of time to ease disruption of the portfolio positions.

The hedge fund industry as it exists today essentially features two strategic segments. At one end, there is a small group of "superfunds" and on the other end a large number of niche players. The superfunds are an outgrowth of the original global macro players. These superfunds generally have over $5 billion of assets under management and feature well known, often quoted managers, like George Soros, Julian Robertson, and Leon Cooperman. The funds are a manifestation of the personality and investment philosophy of their managers. These high profile personalities not only attract media attention but also undue interest of regulators. The number of these macro players should remain relatively small. These funds feature extremely high minimum investments with only a limited number of institutions or the very wealthiest investors able to participate. In fact, many of these ultra-exclusive funds are now closed to the new investors.

The majority of other hedge funds are niche players, each with their own investment strategy, market identity, and support structure. Most of these funds are run by one or a small group of individuals who perform much of the marketing and operations as well as manage the investments. Most of them have assets much less than $100 million. These small niche funds are unable to attract large capital pools due to their lack of resources, marketing expertise or credibility with large investors, especially institutional investors. Smaller hedge funds may not be able to handle large allocations from pension funds. Hedge funds also have some restrictions on accepting money subject to ERISA. If more than 25% of a hedge funds assets are subject to ERISA, then the fund itself would be subject to ERISA. This could be a much more significant constraint on smaller funds.

The net results of these two extreme groups is that a void exists. The industry is looking for market leadership. It is our view that for the hedge fund industry to be a trillion dollar industry in the next ten years, it needs more leadership. Whenever there is any degree of inefficiency in the marketplace in terms of information dissemination or customer focus, there is an opportunity for a brand name to emerge. Just as Fidelity’s name has become synonymous with mutual funds, we see a clear opportunity for a market leader to emerge and lead the industry into the next century.

V. Strategic Drivers for Evolution

In describing the state of the hedge fund industry above, a number of factors were highlighted that we feel will serve as strategic drivers for this next phase of evolution within the hedge fund industry. Some of these factors are evident in the evolutionary phases of other industries that experienced similar growth and characteristics. Still others have come to light through our survey of US hedge fund managers and investors.

It may be instructive to look at the hedge fund industry in the context of the industry lifecycle and compare it to the structural changes that have taken place in another similar financial industry - mutual funds. The lifecycle concept asserts that products and industries go through an S-shaped growth curve based on Michael Porter’s classic "Lifecycle of an Industry" framework ⁽²⁰⁾. The framework breaks the lifecycle of industry evolution into four stages; Introduction, Growth, Maturity, and Decline. In the introduction phase, an industry goes through an often extended trial period of introducing the new product and overcoming buyer inertia. Once the product is accepted and proven successful, the industry enters into the second phase of rapid growth. We believe the hedge fund industry is in this phase of its lifecycle. This stage is characterized by high revenue growth, many competitors, low barriers to entry and relatively high profitability. The third phase, maturity, is reached when penetration of the product into the market place reaches a saturation level causing the rapid growth to halt. We believe mutual funds are entering the maturity phase of their lifecycle; the market is becoming saturated, price competition is increasing and consolidation is taking place.

Although there are some fundamental differences between the mutual fund and hedge fund industries, it is our view that one can learn a lot about the forthcoming structural evolution of the hedge fund industry by looking at the historical evolution of the mutual fund industry. In essence, one can look at the mutual fund industry as a leading indicator for the hedge fund industry.

Source: Porter

The recent growth in the hedge fund industry bears many similarities to the growth and evolution that occurred within the mutual fund industry. In the early 1980’s mutual funds began to attract significant investor attention. Very rapidly the industry advanced from relative obscurity to a multi-trillion dollar business ⁽²¹⁾.

Source: ICI

It appears that hedge funds and mutual funds are following very similar growth patterns in terms of both assets and number of funds.

Source: Bekier, Cottier, ICI

Looking at these curves, it appears that the rapid growth of mutual funds began some ten years prior to that of hedge funds; approximately 1980 for mutual funds and 1990 for hedge funds. The rapid growth stage for mutual funds has lasted more than 15 years (1980-1997). Granted that some of the underlying drivers of growth may be different for mutual funds than for hedge funds (e.g., the proliferation of mutual funds in 401 (k) plans). However, if one assumes that the growth cycles will parallel each other to some extent, then one can conclude that hedge funds are at the beginning of their journey and the growth cycle for hedge funds could last another ten years taking us to well into the next century.

In fact, if one looks closely, it becomes evident that the hedge fund industry today bears a strong resemblance to the mutual fund industry of the early 1980’s. Since then, the mutual fund industry has gone through several phases of evolution; from stand-alone small funds to large families of funds and now a period of consolidation and globalization. It is our view that the hedge fund industry will take a similar course of evolution in the next decade.

Just as we see today in hedge funds, mutual funds experienced a tremendous inflow of capital in the 1980s. Very rapidly the industry grew to a multi-trillion dollar industry, but with little structure. There were many stand-alone funds each presenting investors with different investing styles and fee structures. There was little way for the average investor to get comprehensive information about fund performance. For this reason, mutual funds at this time were mostly used by sophisticated investors who had the time, resources, and intellect necessary to evaluate and select funds.

In response to the growing investor demand for mutual fund products, major financial publications began devoting more and more space to grouping, ranking, and explaining mutual funds. As this need for systematized information continued to evolve, there was an emergence of information providers like Lipper Analytic, Morningstar, Micopal, etc. dedicated solely to rating mutual funds. Today, their ratings serve as one of the primary determinants of success for a fund. In the hedge fund industry, similar to the rise of Lipper and Morningstar, there is an emergence of organizations like Managed Account Reports (MAR), Hedge Fund Research, Hennessee Group, Van Hedge Fund Advisors and TASS. Each of these groups track their own universe of hedge funds. Participation in the "league tables" that these research groups prepare is becoming an essential component in the successful marketing of hedge funds.

As the mutual fund industry became systematized and fund information became widely available, investors began managing their funds more actively and began switching between different funds as their preferences changed. The mutual fund industry went through a further evolution joining a variety of fund styles together under a common umbrella to provide customers with a menu of choices. In addition to providing greater choice and service for customers, the "families" of mutual funds were able to retain assets even if customers were switching to other styles of funds. These families of mutual funds (FMF) quickly became household names and rose to the top of the industry.

As these large families of mutual funds gained prominence, they began to exert significant pressure on small niche players. Using their size and diversity, these FMF could attract and retain more customers through larger product offerings, better technological infrastructure and superior "marketing machines" that thrust their brands into the public consciousness. The results are evident today by the fact that the top 10% of the mutual fund companies control over 80% of the total assets under management. The clear advantage of large families of funds has led to the current industry evolution, that of industry consolidation and globalization. While internal growth and expansion initially spawned the development of FMF, merger and acquisition activity is now playing a key strategic role in building broad and global fund families to achieve competitiveness and economies of scale.

It is our view that a similar evolution will take place in the hedge fund industry. A Family of Hedge Funds (FHF) bringing together a variety of different funds under a single unified operating organization will have a similar opportunity for market domination. The present structure of the hedge fund industry will change from a fragmented one with thousands of small niche players into one made up of a smaller group of large organizations providing market leadership in the global marketplace. However, the motivation and drivers for consolidation in the hedge fund industry may not be the same as for the mutual fund industry.

As discussed earlier, the hedge fund industry is highly fragmented with approximately half of the current funds under $20 million. An analysis of the MAR/HEDGE database indicates that the number of newly listed hedge funds in their directory, rose from 73 in 1990 to 661 in 1996, an annual compound growth rate of 44%. Most of these new funds are small, with assets under management much less than $100 million. However, with average investment performance, a small fund can generate significant revenues. Most of these smaller funds are managed and operated by one or a few individuals. Therefore, even a smaller fund with average performance could provide a good cash flow to its managers.

Historically, this combination of fragmentation and high profitability has presented significant opportunity for evolution or consolidation. The profitability makes the industry attractive and the lack of dominant players creates an opportunity for a motivated, well-funded consolidator to create an organization that represents the next evolutionary step.

However, there is little economic pressure toward consolidation in the hedge fund industry today, due to the large inflows of new money and the recent bull market. As these remarkable market conditions inevitably change, however, there may be far more significant pressure on small or under-performing hedge funds. At the same time, hedge fund managers will have to compete, for the first time, on a global basis as the battle to manage the world’s assets is evolving into a single market. We believe that these conditions will drive structural change from a fragmented industry with thousands of competitors into one made up a smaller group of larger organizations.

This kind of consolidation is a part of natural evolution of any maturing global business. For example, the automobile industry and personal computer businesses were both extremely fragmented at different points in time. As the business matured and globalized, the participants either lost their market share or were being acquired by larger, well known groups. It is our view that the hedge fund industry will follow the same pattern in its journey of growth.

We believe that the strategic benefits of expanded product lines, focused marketing and sales and improved operational support and the potential for high financial rewards will be the primary motives for consolidation. Those organizations that take a pro-active approach are most likely to complete timely acquisition with the most attractive funds.

There are a number of profiles of potential merger and acquisition candidates. One group of potential candidates will be those hedge fund managers looking for liquidity and succession. Another group will be those who are looking to grow their asset base through the benefits a larger organization could bring such as distribution and global exposure. Another group of potential candidates may be corporate parents that feel a hedge fund managementr subsidiary no longer fits with its core business.

Valuations of investment management companies is more of an art than a science. Like hedge fund managers, the majority of investment management companies are run by one or a small group of owner/managers. The success of the firms are highly dependent on the investment management expertise and the client relationships of the owner/managers. While there is a relatively active merger and acquisition market for more traditional high net worth and institutional managers, the personal nature of the business leads to a wide variety of transaction structures and valuations. However, there are some "rule-of-thumb" benchmarks for more traditional asset management company valuations.

There are three commonly used benchmarks for comparing money management firm valuations; (i) percentage of assets under management, (ii) multiples of revenue, and (iii) multiples of pre-tax earnings or cash flow. The first two are connected via management fees, while the later two are connected via gross margins and operating expenses. All three schemes should ultimately lead to a similar valuation .

Source: KPMG, Berkshire

Some of the factors that go into the valuation equation relate to the stability of the customer base and the variability of revenues and cash flows. For example, mutual funds have a relatively large and stable customer base and relatively predictable revenues and profits. Therefore mutual funds tend to trade at the higher end of the valuation ranges (depending on the strategic drivers for the transaction). Hedge funds, on the other hand, have a customer base that is much more concentrated and revenues, and therefore profits, are more volatile due to their performance fee structure. The volatility of revenue could vary greatly among the different investment styles of hedge funds with market neutral strategies potentially exhibiting less volatility than traditional managers and short only or global macro funds with high volatility.

As the assets and revenues of hedge funds tend to be more volatile and unpredictable, it is our opinion that a discount factor should be applied to valuations based on revenue. In addition, because of long "lock-up" periods, hedge funds become an illiquid investment and, therefore, as with any private equity partnership, they should carry a lower valuation multiple, approximately half that of publicly traded mutual funds ⁽²³⁾. Even with a discounted multiple to revenue, however, hedge funds would have a higher purchase price based on a percentage of assets due to the performance fee structure. For example, a traditional investment manager with $100 million in assets under management and a 1% management fee might sell for three times revenue or $3.0 million. This equates to 3% of assets under management. A $100 million hedge fund with a 1% management fee and 20% performance fee could be valued at 2 times revenue. Assuming an average rate of return (ROR) of 20% results in revenue of $5.0 million and a valuation of $10.0 million or approximately 10% of assets under management. On the basis of 2 times revenues, the chart below estimates an approximate valuation of a hedge fund in terms of a percentage of assets under management (AUM) for various rates of return and performance fees.

Source: RRCM

One final note on this subject is that the financial structure of these transactions can only be determined by a detailed analysis of the assets, revenues, and operational expense characteristics of the hedge funds under consideration and how the target fits strategically with the acquiring organization’s business.

There is ample evidence that an evolution like the one described in this paper will happen and that it will happen successfully. Other segments of the financial services industry with similar characteristics have evolved in this manner. We looked previously at the mutual fund industry, but other examples exist.

Within the institutional money management industry there has also been significant consolidation of late. The most interesting examples of this consolidation come from United Asset Management (UAM) and the Affiliated Managers Group (AMG). Both of these firms are executing a form of industry consolidation, each with a different approach. Whereas UAM buys whole money management firms and incorporates them as part of the UAM organization, AMG takes less than 100% positions and links the various independent organizations into a confederation of smaller firms.

Within the last six months we have also seen examples ⁽²⁴⁾ of at least two rudimentary attempts at consolidation within the hedge fund industry. Both Consolidated Advisors Ltd. (a company sponsored by CIBC Wood Gundy) and Asset Alliance Corp. of New York have made some preliminary hedge fund acquisitions. Like UAM and AMG, they each take different approaches. Neither group, however, has yet emerged as a fully-formed Family of Hedge Funds. There is no clear brand identity established nor is there an established central sales, marketing or operations function.

It is our view that there is a significant opportunity for the creation of the Family of Hedge Funds complex through acquisition. It is our view that FHF has the unique opportunity to combine the drive and creativity of entrepreneurial firms with the breadth and financial strength of a larger organization. It is the unique combination of strengths - both individual and collective - which makes FHF particularly well matched to the changing needs of the hedge fund industry. It is also our belief that FHF should not be a holding company but rather an operating partner that use its size and strength to help individual firms unlock new opportunities on a global basis.

Our analysis indicates that there remains a void to be filled and opportunity to be seized. There is a significant opportunity for a motivated, well funded consolidator to create an organization that represents the next evolutionary step. Our research indicates that the market is looking for a leader. The question remains who will emerge as the industry leader? Who will play the role of the Fidelity of Hedge Funds ?

The Coming Evolution of the Hedge Fund Industry

References