Sharpe Thoughts – May 2019

Welcome to Sharpe Thoughts, a monthly newsletter produced by MJ Hudson’s Hedge Fund Team.

Key points on key people

Your investors have accounted for the risk, but have you?

A successful hedge fund depends heavily upon the fund manager’s key decision makers, not just in terms of investment returns (although that is arguably their single most important function) but also the ongoing financial and business management of the fund manager. Without the fund manager, there is, of course, no hedge fund. There lies the conundrum: buying the fund also means buying the key personnel of the fund manager. Should it also mean taking a view on the infrastructure supporting those key personnel? Institutional investors increasingly need to see a reliable set of systems and processes which offer some protection against the fund manager losing key people.

This is particularly relevant in the emerging manager space, where, arguably, almost all of the principals and senior staff of the fund manager will be key persons and where, as a result, investors (whether in the fund or into the emerging manager itself) will be exposed to the considerable risk associated with the loss of one of those individuals, to the extent to which this disrupts operations. Investors in the fund may seek to mitigate these risks by negotiating favourable exit terms or a greater say in the ensuing change management. The precise mechanic is dependent on the fund, but often means that investors can take some (or all) of their money off the table upon the departure, death or incapacitation of a key person. In extreme cases, the fund may even be terminated and money returned. Although such mechanisms will help to arrest potential losses, exiting an investment sooner than expected on account of operational failure of the fund manager will be a less than desirable outcome for all concerned.

But what for the fund manager themselves? It’s not only the investors in the fund that bear the risk of a key-person event; it can have an equally significant impact upon the financial viability of the fund manager, in turn.

If investors are structuring themselves to protect against these risks, then it should be of equal concern to the fund manager. It is, however, all too easily overlooked. It stands to reason that an emerging manager will be heavily dependent on a small number of highly skilled, important people and, while the discussion often focusses solely on those making the important investment management decisions, the importance of (and reliance on) key decision makers in other areas (for example, operations and IT) should also be carefully considered, from a risk perspective.

As the business grows and develops, the importance and talents of these key people become further embedded and integrated into the systems and procedures of the fund manager (and by extension the investment process for the funds or accounts they manage). Fund managers may think their level of key person risk decreases once they move beyond the “emerging” phase, but without adequate business and succession planning to lessen the importance of key persons to the ongoing success of the business, the fund manager may find that investors may not perceive this to be the case.

Investors will (or should) expect to find that the fund manager operates according to a system of rules, practices and processes by which the business of the fund manager is directed and controlled. They also may (or should) expect these rules, practices and processes to operate independently of key persons. Certainly, producing alpha depends on the skill and acumen of the key investment decision makers, but positive investment performance over time results from a disciplined and controlled process, which is explainable, consistently repeatable and testable. So it should be for all mission critical operations of the fund manager.

Investors will want to feel that the business of the fund manager is capable of organisational stability conducive to consistent performance.

It is often the case that emerging managers are captive to the personality of their founders, those who take the enterprise risk of establishing a business based on what is often an intuitive idea. It’s also often the case that those personalities continue to be the loudest voices in the room, driving the direction of the business, long after the initial stages. There is certainly something organic and quite natural about that, but just as any parent will know all too well, the formative process of finding a separate identity and way of doing things is no easy process and doesn’t happen overnight. But it will happen, whether by design or otherwise. The same is also true of succession and business planning in any business. Fund managers are no exception. So it is that, over time, the business of the fund manager should (albeit with the continued guidance of its founders) aim to stand on its own two feet.

Fund managers are facing increasing scrutiny from investors about the way their businesses operate; investors at all levels have increasingly sophisticated expectations about how best to protect their capital. In an environment where profit margins are under pressure, due to increasing regulatory and compliance burdens, investors are more focussed than ever on the ability of fund managers to build efficient, well managed businesses, which will continue to preserve and control internal expertise.

If you would like further advice, or need to review existing or proposed arrangements, please contact your usual MJ Hudson contact or Sean Scott at sean.scott@mjhudson.com.