HORIZONTAL INTEGRATION TO DRIVE HEDGE FUND INDUSTRY CONSOLIDATION
Over the past decade, the hedge fund industry has become increasingly fragmented and, to a certain degree, unbalanced — dominated by larger players who receive the vast majority of capital distribution and who are in need of additional diversified products to keep up with investor demand. Smaller-scale firms are struggling to raise capital in a progressively competitive environment, where fund performance that lags the S&P is no longer an isolated anomaly but instead has become the expected outcome. This polarized dynamic has had a direct impact on M&A deal activity as 2017 transactions in the hedge fund industry (both completed and announced) were significantly lower compared with prior years. Outside of a few larger marquee M&A deals and some minority stake deals, the majority of transactions this past year were smaller acquisitions.
Looking into the near future, many expect to see an uptick in deal activity as well as increased industry consolidation. Multiple factors are generating the momentum for potential increased activity, but the key drivers we see include:
We expect that these key drivers will help force consolidation in the hedge fund industry, and at the same time provide the impetus for a long-overdue rebalancing of capital allocation distribution.
HEDGE FUND INDUSTRY UPDATE
It is nearly 10 years to the day since the hedge fund industry emerged from the apex of the financial crisis. Over this period, hedge funds were forced to recalibrate both trading and operating platforms to adapt to a new era: one that is more regulated, less volatile, and tougher to raise new capital. The long-term effects of those changes created a dichotomous environment where certain industry levels reached both historic highs and lows. For example, aggregate hedge fund performance relative to the broad market benchmarks has never been worse — on track for a record eighth consecutive year lagging the S&P. Yet, allocations to the hedge industry continue to flow, resulting in industry AUM to be at an all-time high ($3.2 trillion — see Figure 1). Hedge fund management fees have fallen well below the once-gold-standard 200 basis point (bps) level, with some funds charging significantly below traditional, nonalternative mutual fund fees (i.e., <75 bps). At the same time, ongoing compliance and new regulatory requirements have increased the cost of doing business by as much as 30%, which, combined with the lower fees, has directly compressed profit margins.
Although the financial crisis disrupted the flow of allocations to funds, institutional investors have invested in the hedge fund asset class and have aggressively allocated to this sector as the need to diversify holdings is still a key return objective for most investment policies.
With this growth, the hedge fund industry has evolved and there has been increased segmentation in terms of both strategy, systems, and size. However, the benefits of increased allocations have not been shared proportionally with all firms in the industry. Bigger, more established asset managers continue to dominate the majority of large allocations derived from institutional investors. We see a few reasons driving this pattern:
Figure 1: Hedge Fund Industry Assets 2008-2017 ($US Billions)
Net asset flows continued to rise in Q4 2017 (see Figure 2), continuing the impressive run of positive flows in since the negative streak in the first half of 2016. On the surface, this signals incremental growth and bodes well for the industry. However, the overwhelming majority of the positive net flow can be attributed to the largest firms, and that is unlikely to change in the foreseeable future. According to Hedge Fund Research, Inc. (HFR), hedge fund firms with $5 billion or more manage about two-thirds (69%) of total industry assets — up from about 40% in 2007. For firms managing over $1 billion in hedge fund assets, the proportion is 91% (up from 75% in 2007).
In contrast, the largest firms represent only 10% of the 11,000- plus funds in the industry. This shapes the reality of how heavily dependent the industry is on the capital-raising capabilities of the bigger players.
Figure 2: Hedge Fund Industry Net Asset Flow ($US Billions)
Low Interest Rates, Volatility, and Volume
In addition to the industry concentration issues mentioned above, many smaller hedge funds must contend with sustained historically low interest rates, volatility, and trading volume. For some credit hedge funds, the low interest rate environment has made it harder to find deals where they can be competitive with banks and other financial institutions that have large balance sheets and access to cheap capital. For example, the ideal lending opportunities where asset-based lending funds historically were able to fund (at L+10) are currently being underwritten by business development companies and regional banks at lower than L+5. This promotes suboptimal tendencies for certain credit funds to underwrite higher-risk, lower-collateralized loans.
For certain long/short (L/S) equity funds, the historic low volatility levels seen in recent years has been detrimental to performance. Notwithstanding the recent spike in the volatility index in Q1 2018, overall low volatility in the equity markets has made it harder for managers to achieve higher risk-adjusted returns. Similarly, lower trading volumes have had a negative impact for nonalgorithmic trading strategies. Algorithms, quants, and rule-based systematic trading systems used to be less than 30% of the market, but now dominate, with only 10% of those influencing the supply and demand balance decisions being fundamental discretionary traders. Not surprisingly, L/S equity strategies have felt the biggest pushback regarding management fees, as institutional investors do not identify L/S equity strategies as a primary diversification option and would rather pay mutual fund-level fees versus 2 and 20.
Survival of the Fittest…
The challenging capital-raising and return environment for the previously mentioned 90% group has had a negative effect on M&A activity. Transactions in 2017 were down, consistent with the low activity levels in 2016. On one hand, there is clearly a need for consolidation in the industry, as smaller firms cannot rely on organic growth to meet the constantly rising investor demand for alternative products — let alone attempt to be competitive with the large players. However, the industry dynamics have evolved over the past 10 years and larger firms are getting stronger as the one-stop theme continues to grow. Going forward, expect to see megafirms building out longer-duration alternative strategies that are less liquid and more intellectually capital intensive. Conversely, low-performing managers struggling to attract new capital and stuck at financial crisis AUM levels will need to make tough decisions in the months to come. With rising costs of doing business, some may need to pivot and reposition themselves by leveraging technology or other resources, while others face the prospect of selling, transferring their book of business, or being forced to return capital outright.
KEY HEDGE FUND M&A DRIVERS
The hedge fund industry is complex, dysfunctional, and has shifted over time to where there are distinct subsectors within the industry group (see Figure 3). From a textbook definition, there are many characteristics of concentration where a few large players comprise over 75% of the market when it comes to asset allocation, fee revenue, and AUM. The megafirms, namely publicly traded one-stop shops and larger private firms that are widely considered “best in class,” are experiencing growth from economies of scale, advances in technologies, and, of course, large positive inflows. From an acquisition perspective, their focus is on acquiring either high-performing platforms or management teams (“rising stars”) that can help augment their product mix.
Figure 3: Industry Snapshot, Fragmented or Concentrated Industry?
However, the aforementioned 90% group will need to drive M&A activity in the future. This subsector is highly fragmented and in desperate need of consolidation. To compete against the megafirms and rising stars, we believe the performance of the 90% group would benefit from a wave of horizontal integration, particularly transformational deals that can help increase critical operational mass and optimize platforms for better investment performance execution.
Overall, the key drivers for this horizontal integration will be:
This outlook has been prepared by Navigant Capital Advisors, LLC (NCA) for the exclusive use of recipient. NCA has not independently verified the information contained herein, nor does NCA make any representation or warranty, either express or implied, as to the accuracy, completeness, or reliability of the information contained in this outlook. This piece contains predictions, estimates, expectations, forecasts, and projections as to events that may occur in the future. This information is based upon the best judgment of NCA based on publicly available information as of the date of this outlook. There is no guarantee that any of these estimates, expectations, predictions, forecasts, or projections will occur at any time or at all. Nothing contained herein is, or shall be relied upon as, a promise or representation as to the past or future.