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Hedge Fund Optimism Up, Profits Down

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Two studies released recently presented different perspectives on the hedge fund sector, one showing participants strongly optimistic about the industry’s prospects over the next five years and the other reporting that hedge fund profits had fallen by 30% in 2014 on the back of poor performance.

Pensions Need Us

A global survey commissioned by State Street of 235 hedge fund professionals found that 55% of respondents expected pension funds to increase their exposure to hedge fund strategies over the next five years.

This figure rose to 63% when the question more broadly asked about institutional investors increasing their exposure to hedge funds in the next five years.

Among the professionals who expected pension funds to up their allocation, 53% said the main driver for this would be performance challenges facing investors’ portfolios.

Thirty-five percent said the driver would be a growing focus on portfolio diversification, and 13% thought it would be improved terms offered by hedge funds.

However, to capitalize on the growing appetite for hedge fund strategies, some 90% of industry professionals interviewed believed hedge funds would be required to more clearly demonstrate their value to prospective investors.

In terms of how hedge fund professionals saw their own firms changing over the next five years, 60% expected to broaden the range of investment strategies they managed, 37% anticipated that they would expand abroad and 10% expected to acquire another company.

According to the survey, regulation would continue to have a significant influence on hedge fund managers. Although the full effect of Basel III is yet to be determined,  29% of respondents believed it would significantly increase their firm’s cost of financing, compared with 42% who said it would not do so and 29% who said they did not know.

State Street said the findings also suggested growing competition from alternative mutual funds. Half of interviewees thought these would seize market share from traditional hedge fund strategies over the next five years.

Bad Year Blues

Citi’s annual Hedge Fund Industry Operating Metrics Survey found that industry profits fell from $31.2 billion in 2013 to  $21.9 billion last year.

Citi noted that institutionalization of the hedge fund investor base had shifted the industry’s profitability ratios. Profits derived from management fee revenues now equal profits from performance fee revenues in strong years such 2013, when managers meet institutional targets of 10% annual returns.

The report was based on proprietary analysis and detailed responses from 149 hedge fund firms that collectively represent $581 billion in industry assets under management — 19% of total industry assets. “Management fee revenues have become an increasingly important part of the industry’s profit base in recent years,” Sandy Kaul, Citi’s global head of business advisory services, said in a statement.

“Lower institutional return targets and concerns about excessive volatility make it more difficult for managers to earn outsize performance fees.”

Kaul said that with assets under management at record highs, profits from management fee revenues currently accounted for a bigger share of total profits: nearly 2.5 times performance fee profits in years when performance was down as in 2014.

According to Citi estimates, the hedge fund industry represented 34% of the profits generated by the entire asset management industry globally in 2013 ($31 billion out of $93 billion), even though it controlled only 4% of the industry’s total assets under management ($2.8 trillion out of $68.7 trillion).

Small Hedge Funds Squeezed

The report found that the most notable change in hedge fund operating margins in 2014 was a 17 basis point improvement in operating margins for small hedge fund firms with average assets under management of $100 million and individual fund assets of between $0 and $350 million.

Despite this improvement, small firms were still unable to cover their operating costs based solely on their management fee collections, the report said.

“Poor performance will be most acutely felt by small hedge fund firms,” Kaul said. “These organizations were able to use their performance fee profits in 2013 to cover their management fee operating shortfalls, but as a group, these funds simply did not generate enough performance fee revenues in 2014 to cover their gap.”

Kaul said Citi expected a $615 million industrywide shortfall across the small tier of firms, “and this is likely to result in more closures of small hedge funds.”

‘Theoretical’ Value Down Only 7%

Despite the hedge fund sector’s 30% loss in profitability because of poor performance, this factor cost the industry only a 7% drop in theoretical equity value, Citi reported.

Researchers estimated how much capital could be raised from the sale of shares in hedge fund firms, and put the industry’s total theoretical equity value at $239 billion in 2014, down from $257 billion the year before.

Citi said the decrease in value was less than that of profits because in its model, profits from management fees were weighted four times more heavily that those from performance fees, which tend to be less stable.

The report found that the diversity of a firm’s product mix and investor base were key factors that affected how large a multiple to use for management company fee profits in valuation calculations, and this was leading to greater product expansion across the largest hedge fund firms.

“For large hedge fund firms, having a mix of privately traded and publicly traded funds helps support higher firm valuations in all our scenarios except when hedge fund performance is at 10% or better,” Kaul said.

— Check out Alternative Assets Surged to $6.9 Trillion in 2014, Led by Hedge Funds on ThinkAdvisor.