Change on the Horizon for Alternative Asset Management Industry

by: Roger Ehrenberg

Hedge funds (HFs), private equity firms (PEs) and venture capital funds (VCs) are facing historic challenges, many of which are of their own doing. It is easy to point to difficult market conditions and conclude that their problems are largely due to the environment. This would be a convenient, but less than truthful, explanation. The fact is that the top tier of HFs, PEs and VCs are no longer style pure; the are all institutional asset management firms, motivated by ever-increasing assets under management and the sticky management fees that come along with it. And structural issues brought about by fee schemes and scale have been the source of other bad behaviors.

In the hedge fund realm, the incentive fee structure is designed to motivate managers to swing for the fences when markets are against them. Big management fees. Quarterly incentive fee payouts. High water marks. These three features have caused many "top" managers to lose their senses and drop prodigious amounts of capital, risk management principles be damned. Many recent mega-losses aren't the case of simply taking the long view and getting stung by short-term volatility; this is getting carried out because of either too much leverage (the most prevalent cause of failure) or too much concentration. I had always thought that hedge funds were supposed to hedge, and were designed to generate attractive absolute returns regardless of market conditions.

Such thinking is clearly a remnant of bygone days for much of the industry, where managers want the best of all worlds: stable management fees, quarterly performance fees, and the ability to suspend redemptions. There just aren't that many Steinhardts and Robertsons any more. And this is too bad for the industry and its investors.

Private equity and venture capital firms have a different set of issues. The largest shops have become fund-raising machines, coming out with Funds XIII and IX before generating returns on Funds III and IV. Cumulative management fees on the whole lot, with only modest absolute returns relative to the massive amount of capital committed by  limited partners or LPs. These funds have traded on early successes when assets were small, built a brand, and have been living off that brand ever since. Again, not really what investors had in mind. But LPs have made their own bed, constantly re-upping for new funds before getting paid out on prior funds. "If you don't get in on this fund you won't get in on the next one" is the constant threat. But LPs are starting to push back.

Oh yes, and I predict this will show no signs of abating for a long, long time. The model is broken, and the market will fix it. But it won't be that painful for the incumbents with big brands but little absolute performance. They have already made so much money off management fees, they're sitting pretty no matter what. But this is another reason why true seed stage investing, real venture capital investing, has been deserted by the biggest names in the business. They just can't be bothered putting $1-$2 million in companies when they are investing out of an $800 million or $2 billion fund. They need to put $50 million, $100 million to work over the life of a deal. Series C and D. Not seed, A and B. The industry needs to get back to its roots. And it will. The market is pushing it there as we speak.

Today there is a historic chance for LPs to help re-shape these segments of the alternative asset management industry, and to bring them back to their original missions and risk and return profiles. But LPs need to vote with their wallets. They have been so caught up in the big brands as insurance against looking stupid for so long that many have forgotten why they got into alternative assets in the first place. Because at massive scale, the alternative asset world kind of starts to look like the traditional asset world. The world of relative returns. Not what the pioneers of and late-comers into alternative asset investing had in mind.

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