Succession exposes risks for hedge funds; Why many founding managers are finding it hard to say goodbye

February 3, 2014 8:26 am

Succession exposes risks for hedge funds

By Stephen Foley

Why many founding managers are finding it hard to say goodbye

“As we age, time becomes our most precious commodity.” So wrote Robert Karr, one of the “Tiger cub” hedge fund managers to have learnt their craft at Julian Robertson’s Tiger Management, who decided last week that he would shut down his $5bn fund, Joho Capital.

Mr Karr told outside investors that he wanted to spend more time with his teenage children before they went off to college, and wanted to “try new recipes” with his wife Suzanne.

Many in the wave of hedge fund managers who, like Mr Karr, launched their businesses in the 1990s, also find themselves reaching a crossroads.

The older among them are at an age when they naturally turn their thoughts to retirement or philanthropy. But even those barely in their 50s increasingly complain in private that running a hedge fund is not as fun as it used to be. The institutional investor money pouring into the sector brings with it demands for greater transparency and stricter governance, and regulators have finally brought the industry under their purview.

Managers look like dividing into two camps. As MrRobertson famously did himself in 2000, many will choose to return cash to investors and shut the doors when the founder decides it is time for him to wind down.

More, however, believe they have built firms that can outlive them, and for this reason succession planning at hedge funds has moved sharply up the agenda in the past couple of years.

Handing over the reins

There are a smattering of examples of founders who have successfully passed the torch to a second generation leader, including superstars Jim Simons at Renaissance Technologies and David Shaw at DE Shaw. Increasingly, firms are buttressing their founders with investment committees comprised of other portfolio managers, and inviting investors to get to know this second tier of risk takers.

All of which begs the question of how investors should think about these moves as they start to occur.

A transition is fraught with risk. When another Tiger cub, Chris Shumway, announced in 2010 that he had appointed a new chief investment officer and would step back from his business, backers pulled $3bn from his $8bn fund, leading to its closure.

The right pace is glacial. Investors need time to assess a chosen successor and, frankly, so do the other employees of a firm. If they end up unhappy, performance is likely to suffer.

In one of the best examples of a successful transition, Tom Steyer, the founder of Farallon, began to consider switching his energies to politics and environmentalism in 2006, but while Andrew Spokes took on many of his responsibilities soon after that, Mr Steyer did not step away from the $23bn fund until 2012.

Succession might be more practicable in some hedge funds than others. Vast quant funds whose trading runs on algorithmic autopilot will prove easier to transition than activist equity investment firms, for example, where the gut instinct of a Dan Loeb or a Bill Ackman can be vital to their success.

The industry trend is towards larger and more diverse hedge fund businesses, with the most popular urged to open multiple trading strategies and bespoke funds for individual institutional clients, and some are even dabbling in products for retail investors. These firms have already taken on an institutional culture that exists beyond their founder, however charismatic.

Some of the biggest institutional investors now view succession plans as vital. They would hardly invest in a fund without proper risk management procedures, accounting checks or secure IT systems, so why invest in one that has never thought about what happens when its key man exits the stage?

Becoming institutionalised

Others worry. One hedge fund of funds manager says that, once a firm gets into a process of transition, it can become more conservative, focused on lowering volatility and increasing the consistency of returns, which in turn can lead to lower absolute returns over time.

This may be exacerbating a problem many ascribe to the “institutionalisation” of the industry, whose returns have slumped to an average of less than 10 per cent annually since 2009. Institutions account for 66 per cent of hedge fund assets now, according to Preqin, and managers complain these investors are more likely to bolt after a short period of underperformance than the wealthy individuals that first backed the industry.

One alternative way for Nineties founders to shoot for a legacy is to sell the business – perhaps to a bigger, traditional manager. However, those funds that have quietly put out feelers in recent months have received a frosty reception, precisely because potential buyers are sceptical key portfolio managers will stick around under new owners or maintain the drive that leads to strong performance.

So increasing numbers of fund managers find themselves in the camp of planning a succession – but investors need not go along with the plan if they sense danger.

For all the talk of succession planning, there is honour in bowing out on a high. Investors get the opportunity to seed newer, hungrier managers, while the industry’s pioneers get to step back and, as Mr Karr put it last week, “basically smell the fresh air and enjoy the moment”.