The Ephemeral Life of an Emerging Fund Manager
J OEL S HULMAN
T he investment industry has been undergoing massive transforma- tion. Traditionally, members fol- lowed a predictable path from graduate school to portfolio manager. Wall Street firms would pluck fresh MBAs from leading business schools, such as Harvard, Wharton, or Chicago, and groom a lucky few for a privileged existence. Salaries and bonuses were not extraordinary by national standards, but they provided a stable, enviable career. This tranquil path no longer exists. It has been replaced by one filled with unpre- dictable change and heartache. Many still enjoy a fulfilling, perhaps even extraordinary, career. But survival has been made more chal- lenging with market upheaval, technological advances, consolidation and excess talent. Members in the industry have been deprived of long-term job security. Some leave due to industry downturns while others depart due to poor performance. A few embark on their own journey as emerging managers. In order to survive, all investment professionals need to adapt to the changing environment or shift energies to an entrepreneurial paradigm. Otherwise they will perish. Those who blaze their own trail will discover an unforgiving environment replete with numerous haz- ards. Most don’t last very long or come close to reaching their potential. For many, their dream as an emerging manager will end after a harsh, ephemeral life.
RISE OF AN INDUSTRY
J OEL S HULMAN is founder and CIO of Entrepreneur Shares and a professor of entrepreneur- ship at Babson College in
As hedge funds became more pop- ular during the economic expansion of the 1990s, money management practices began to change. Investment professionals no longer settled for a mere six-f igure salary—they wanted billions! And with compensation structures providing management and per- formance fee percentages, managers could structure deals with enormous upside poten- tial while risking very little. Generous terms created an extraordinary return on invest- ment (ROI) situation. An epic bull market and quick access to fresh cash fueled a once- in-a-lifetime wealth-building opportunity. But the good times came to a halt with the 2008 market crash and Bernie Madoff ’s epic Ponzi scheme. Everything changed. Consumers blamed Wall Street for our nation’s woes, politicians created more regu- lation, and clients discovered problems with fund lockups and transparency. Some inves- tors pulled their money in waves without looking back. Others shifted to seemingly safer harbors in passive funds and govern- ment debt. The practice of money manage- ment was drastically changed—probably forever. These adjustments in the market affected money management f irms of all sizes, with the large ones making prominent news headlines. The effect on small, young,
Babson Park, MA. shulman@ershares.com
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EMERGING MANAGERS—AN INTRODUCTION
“emerging managers” was not often discussed. Subse- quent to the 2008 financial crisis, emerging fund man- agers had to learn how to market and sell themselves like never before. Competition stiffened, fees dropped, and barriers to entry exploded. Differences between pre- and post-crash practices were like night and day. Industrial consolidation created a handful of winners and many, many losers. Regulation and infrastructure costs tight- ened at precisely the same time that new entrants were pouring in. Trusted gatekeepers with direct access to clients ruled supreme. In an effort to survive, emerging managers were required to alter their business models to adapt to changing market conditions. Pivot or die; it was just that simple. Managers had to raise assets and chart unfamiliar waters while navigating SEC regulations and jumping gatekeeper hurdles. They also had to ensure a unique investment strategy and differentiate themselves among an expanding set of competitors. Most importantly, they needed to accomplish all of this while simultaneously gen- erating strong, verifiable performance—preferably with a five-year, GIPS-compliant track record and a minimum of $100 million assets under management (AUM). And therein lies the conundrum: without a lengthy track record and significant AUM, emerging managers cannot attract new assets, and without a significant level of assets, emerging managers cannot generate a lengthy track record. It is a formidable Catch-22.
What exactly is an “emerging manager”? By defi- nition, emerging managers are often referenced in the context of performance track record and assets under management. Of the two factors, AUM is more impor- tant. The length of time or level of AUMvaries depending on the audience, but as a general rule of thumb, the threshold is less than five years performance track record and under $1 billion in AUM. Some programs state that an emerging manager is anything below $2 billion. Life as an emerging manager involved a constant balancing act between raising assets, managing money, and running a business. Post-2008 market conditions made for bleak odds of success. Emerging manager sur- vival rates plummeted. Similar to the woes of a newly hatched sea turtle, only a small percentage ever reaches maturity. The vast majority fall victim to hostile envi- ronmental factors and predatory industry practice.
HIGH INDUSTRY DEFAULT RATES
Exhibits 1 and 2 represent the Evestment database of investor products. Managers who wish to present their performance to potential investors list returns and firm information on this database, among others. It is not used by all managers, although it represents a large number of professional funds. As Exhibit 1 illustrates,
E X H I B I T 1 Traditional Manager Survival Rate
Source: Evestment (Traditional Investments), September 1, 2015.
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E X H I B I T 2 Alternative Manager Survival Rate
Source: Evestment (Alternative Investments and Hedge Funds), September 1, 2015.
18,049 of 28,174 (64%) traditional investment products still exist today. Exhibit 2 shows that a mere 8,204 of 27,205 (30%) of alternative investment products are active. “Alternative” references hedge funds, among others. Because 64% of traditional and 30% of alterna- tive are active, by implication, at least 36% of traditional investments and 70% of alternatives no longer exist. Invariably, managers stopped sending performance due to failure. The following exhibits provide a glimpse of
the survival/default rate of traditional and alternative fund managers. Arguably, the actual bankruptcy rate is much higher—the exhibits represent the most estab- lished firms and fund track records.
WHY ENTER THE MARKET?
Given the likelihood of failure, why do managers rush to get into this industry? If done correctly, fund
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management can lead to extraordinary wealth. But only a few succeed. Managers need the proper skill set, team, investors, strategy, and market conditions to achieve their goals. Moreover, a little luck doesn’t hurt. In the rare circumstance that all of these factors come together simultaneously, everyone benefits—both investors and managers. In extreme cases, top managers earn billions. Some even reach this target year after year. According to the latest Forbes Billionaire listings, the single largest industry category is Finance, with more than 40 mem- bers boasting investment management as their primary occupation. Luminaries such as George Soros, James Simons, Steve Cohen, John Paulson, William Ackman, and David Tepper, among others, grace this list. Exhibit 3 shows the top 10 hedge fund managers of 2015. But the annual list is no surprise. Compensation is far from a well-kept secret in the investment industry. Industry regulations require managers to disclose their compensa- tion; the popular press displays top wages prominently akin to a baseball player’s batting average. Winners and losers are showcased for all to see. Winners gather more assets and speaking engagements, while losers quietly exit the business to shame and scorn. It is not an industry for the fainthearted. But because of the potential for an extraordi- narily lucrative livelihood, managers continue to f low into the industry in unprecedented waves. Would-be emerging managers, f lush with theoretical back-tested strategies, no longer depend on requisite ivy MBAs to
engage in the money management profession. They f lock to Wall Street in ways heretofore unseen. Many come without any formal business education or direct investment experience. This includes medical doctors, lawyers, computer engineers, mathematicians, astro- physicists, and virtually all-imaginable skills and aca- demic backgrounds. They descend on Wall Street from every possible country in the world in hopes of winning a financial lottery. From a naïve perspective, barriers to entry appear low; many believe they can compete with a mere laptop and idea. Most don’t get beyond the hobby stage, scraping together their personal savings or investments from of a handful of friends and relatives. But on occasion, some build a credible track record and break through into the professional ranks. All engage in a common mis- sion to provide quality, risk-adjusted performance for their clients. Occasionally, new entrants do bring a unique twist to money management. No longer beholden to the traditional rules set forth by Graham and Dodd, new-age managers seek their own logic and methods for gauging security valuation and outperforming key benchmarks. They may pursue a quantitative approach, high-frequency trading arbitrage, or some other novel method. Of course, they also set out on the traditional path of money management secure in the belief that they can provide fundamental investing in a more efficient, effective manner. Regardless of the endeavor, constant information f lows, disruptive technological breakthroughs, new investment offerings, evolving academic research, and unanticipated market shocks all create opportunities for emerging managers to enter the marketplace and gen- erate profit. Most emerging managers are confident in their ability to manage a portfolio. Whether it’s garnered from prior experience or gleaned from independent research, emerging managers enter their business with self-assurance that they can successfully invest funds. Unfortunately, they often don’t consider the entrepre- neurial, business, and managerial experience necessary to fully achieve success. Individuals working within a large corporate office, accustomed to secretarial, sales, MANAGING MONEY AND A BUSINESS—GETTING STARTED
E X H I B I T 3 2015 Rich List
Source: 2015 Rich List, Institutional Investors Alpha. See http://www. institutionalinvestorsalpha.com/Article/3450284/The-2015-Rich-List- The-Highest-Earning-Hedge-Fund-Managers-of-the-Past-Year.html.
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and infrastructure support, along with a nice salary and corporate expense account, often receive a rude awak- ening when introduced to the complexities and costs of running an individual business. Exhibit 4 displays the necessary steps for getting started as a new manager. The catalyst to getting started usually begins with an opportunistic setting for raising assets and/or bringing together key members of a team. The team is the crit- ical component for setting up a fund. Typically, the key member of the team begins with an experienced man- ager who has an investment idea and performance track record. But soon afterward, other members will need to be brought in to help run the organization. An integral component includes raising assets. Without new assets, revenues will not grow and there will be no ability to achieve economies of scale. From the very beginning, emerging managers must focus on raising assets. The impetus for launching a fund often originates once a manager convinces a seed investor to allocate some discretionary money to the new fund. Seed inves- tors typically receive incentives (such as equity participa- tion in the management company) as compensation for being early backers. They are characteristically successful entrepreneurs or institutional investors who meet invest- ment managers through an affiliated network of friends and acquaintances. They not only have hopes for gen- erating strong returns in their underlying investments, they also expect to receive an additional return from a fund harvest a few years into the future. Managers typically add their own personal savings into their company along with assets from family and friends. Investors prefer emerging managers who show
conviction in their own strategy and inject risk capital. Seed capital investors feel more comfortable knowing that an investment manager has life savings in a joint project. This provides high motivation for the manager to succeed. The investment pledges from family and friends usually enter the f irm with modest effort and little formal contracting. This creates both a blessing and a curse. Although pledges from family/friend/angels in early stages are always welcome news for emerging man- agers, it often creates unrealistic expectations regarding future fundraising challenges from non-affiliated inves- tors. To the extent that emerging managers set up their funds with overly optimistic fund raising expectations, it can lead to numerous operational inefficiencies (e.g., overspending on superf luous items) and a drain on scarce working capital resources. Regardless, once emerging managers have a siz- able asset commitment, they will typically launch their firm. They may start with as little as $1 million or $2 million, but savvy managers will often wait until they have gathered at least $5 million or $10 million in AUM. Although emerging managers may be anxious to com- mence operations, they need to think about the con- sequences of starting too early with unsustainable cash “burn rate.” There are many up-front costs and ongoing costs of operations (see Exhibit 5). Starting operations with too little in AUM may significantly lower the odds of success, although the manager needs to also consider the patience of prospective investors to maintain interest given market conditions and other investment options. Once managers are comfortable with budgeted cost outlays and assurances from seed investors to execute their pledge, they can proceed with the actual setup of operations. Lawyers will initiate fund documents. This includes, but is not limited to private placement memo- randum, corporate registration documents, manager’s operating agreement, along with various equity partner relationships and corporate terms. Managers that choose to create an exchange-traded fund or mutual fund will require extensive legal work and SEC interface. This undertaking incurs appreciably higher fees over a six- to-nine-month process.
E X H I B I T 4 Steps for Getting Started as a New Manager
THE COST OF DOING BUSINESS
The complicated array of infrastructure setup and ongoing costs can overwhelm a new manager. Running a professional stock or bond fund on a day-to-day basis
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is much different than setting up a few trades with a broker and tracking them in an online portal. Profes- sional funds require extensive services, including account administration, legal organizational fund structure, legal management company setup, prime brokerage account, insurance, trading authorization, security borrowing/ lending availability, auditors, office setup, internal staff, and working capital funding. There are numerous service providers in the field, but many will not assist emerging managers with low AUM. Extensive due diligence procedures compound the difficulty for emerging managers. Most service pro- viders place high hurdles or minimum requirements for engaging in business, and fees vary widely throughout the industry. As the perceived prestige of a service provider rises, the minimum fees or hurdles associated with the provider increase accordingly. Lawyers require upfront cash retainers, and other service providers demand a minimum level of AUM or guaranteed fee income. If the fund generates insufficient fee income to cover expenses, then the emerging manager has to personally cover the shortfall. Sufficient personal assets need to be set aside to handle potential shortages. The latter scenario often becomes the pivotal issue in a fund launch. If, for example, a prime broker, account administrator, and fund accountant collectively demand fee income of $20,000 or more per month (with a personal guarantee), then emerging managers need to decide if they will generate sufficient fees to break even. Otherwise, the minimum requirements can become crippling charges that defeat an already fragile existence. Note, these fund expenses are in addition to the internal costs of personnel and office charges. If emerging managers decide that their fund cannot sup- port the minimum threshold of costs, then they will be forced to either seek other service providers, pay out of pocket for the cost differential, or delay fund setup until the necessary requirements can be met. The “emerging manager” definition itself ignores the harsh realities for firms in the under $1 billion cate- gory. Although those emerging managers who are above $100 million are likely at break-even or above, those with numbers below $100 million, and certainly below $20 million, are very likely struggling for survival. Day-to-day costs associated with an office and staff can be eye-popping—especially in major cities with high rent expenses. Professionally run money management businesses must comply with stiff regulations; meaning
a manager must hire expensive lawyers, certified public accounts, distributors, account administrators, transfer agents, etc. These costs can be extremely high and are charged regardless of AUM levels. An estimate for annual- ized fund operation costs are displayed in Exhibit 5. In addition to fund operation costs, the emerging manager also has to hire and motivate staff. Costs asso- ciated with setting up a basic corporate staff including an analyst, trader, operations manager, chief compliance officer (CCO), CFO, administrator, and salesman can be staggering. Consequently, in the early days of opera- tion, the emerging manager will likely work extremely hard and perform multiple duties. After completing the legal infrastructure, man- agers must consider their needs for prime brokerage, fund accounting, account administration, trading, and auditing. High monthly fee requirements, fixed annual
E X H I B I T 5 Estimated Annualized Fund Operation Costs
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costs, and/or minimum AUM requirements can bring huge challenges to a new manager. In many cases, the monthly and annual costs or minimum AUM hurdles associated with these services may make the fund launch impractical. Exhibit 5 shows the estimated costs for operating a fund. As the exhibit illustrates, the total costs for man- aging a fund, including operational fund costs and back- office management, can easily exceed $800,000 without paying lavish salaries. Moreover, competitive pressures are pushing fee income down, thus squeezing the overall margins to the emerging managers. Depending on the location of the emerging man- ager’s business, costs can quickly escalate. High cost-of- living areas, such as Boston or New York, might require rents above $100,000 for small spaces. Landlords will demand a three- to five-year minimum lease and expect personal guarantees. This means that emerging man- agers will have a legal liability in excess of $300,000 for just office rent alone. Key members of the team will also not be cheap. Experienced salesmen and portfolio man- agers might each command salary + bonus well above $250,000 a year. When emerging managers accumulate all of the start-up legal costs, office rent, administration, fund accounting costs, external audit, equipment, data- bases, management personnel, and other related expenses, they will likely be surprised and overwhelmed. If successful, an emerging manager can generate extraordinary wealth for their clients and themselves. But, it comes with enormous financial risk. If unsuc- cessful, excessive rents, high overhead, fund expenses, and up-front setup costs can drain lifetime savings and wreak havoc on a manager’s life. Because many of the expenses come with a personal guarantee, not many individuals will choose this course. Personal sacrifices may be far too great for many families, and difficult choices can become exacerbated by quarrels regarding future directions. Of course, there are safer approaches to launching a fund, but these also come with risk. Emerging managers may decide on a “middle step” toward fund launch. For example, they could proceed in the direction of becoming a professional money manager without the massive up-front costs or personal guaran- tees. Managers can work out of a home office rather than procuring professional space in a commercial office PARADOX OF FUND LAUNCH
building. For many, it may appear to be a logical step for a variety of reasons, including convenience and cost. Managers can also delay the hiring of other team mem- bers, forgo the registration of a fund, access data for free at a library in lieu of buying, and avoid account admin- istration/fund accounting. Costs will drop dramatically. Unfortunately, by pursuing this low-cost strategy, the manager will be signaling to outside investors that the business is not yet real. Institutional investors will not invest with a stay-at-home manager who lacks data or staff. This does not mean the emerging manager does not have talent. But for many investors and consultants, appearances matter. With so many other investment managers to choose from, it will make it appreciably more difficult for the emerging manager to raise new capital from non-family and friends. Emerging managers must learn how to control costs and allocate scarce working capital efficiently. This means having to constantly balance short-term versus long-term goals. Underlying stock market volatility and family worries only add to a manager’s angst. Not surprisingly, on days when the manager’s portfolio per- forms well, the manager looks ahead and becomes more willing to expend for the future. The behavior tends to revert on bad days. This is the paradox of emerging managers. They need to take calculated business risks in order to be successful, but if their judgment is in error, they can destroy their personal and professional life. Their entire net worth can be wiped out with a poorly timed choice. Decisions regarding a fund launch hinge on a variety of factors—many of which cannot be accurately forecasted or anticipated. Break-even becomes a challenge right from the start. Exhibit 5 shows that a professional money man- agement operation with registered investment vehicles requires more than $0.8 million in annual revenue just to meet total costs. A hedge fund would need less. An emerging manager can reduce expenses by eliminating some office hires, eschew a professional office, and shift to a more basic fund accounting/administration system, but costs will likely still exceed $600,000 a year. This means that, given a management fee of 1% a year (or 100 basis points), a fund will need at least $60 million of assets under management to break even. INDUSTRY TRENDS—DECLINING REVENUES SQUEEZE MANAGERS
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INDUSTRY TRENDS—ETFS, PASSING MANAGEMENT, MARKET CONSOLIDATION The industry has been undergoing an upheaval over the past 20–30 years. As Exhibit 7 shows, the number of UITs (trusts) declined sharply from 1997 to 2014, dropping to about half its numbers. During this same time period, the growth in ETFs has exploded along with corresponding AUM. As Exhibit 8 shows, the largest dollar growth occurred with mutual funds and the strongest percentage growth rate occurred with ETFs during the 1997–2014 period. Mutual funds grew from $4.4 trillion to $15.8 trillion over this cycle, while ETFs increased from $7 billion to approximately $2 trillion. Much of the move- ment occurred in passive fund management and index- based strategies. As Exhibit 9 shows, the average assets per invest- ment company have increased significantly, too. Even though the number of firms has increased, the amount of dollars at each firm has risen at a faster rate. For example, as Exhibit 7 shows, the number of mutual funds has increased 37% (from 6,778 to 9,260), while Exhibit 8 shows that the growth in assets within mutual funds has increased by 254% ($4,468 billion to $15,852 billion). Exhibit 9 provides the simple implication (Assets/Number of firms) that the average mutual fund company has nearly tripled in size from approximately $660 million per firm to $1.71 billion. Interestingly, the average ETF size has dropped in the past 10 years (from $1.5 billion to $1.36 billion), while the number of ETFs has soared (228 to 1,974).
Hedge funds often charge a management fee of 1% (or more) along with a performance fee, but many tradi- tional managers can no longer charge even 1%. Passive investment strategies and exchange-traded funds (ETFs) have been driving management fees down below 50 basis points (0.5%). This brings pricing pressure to the industry. As Exhibit 6 shows, the average expense ratio has dropped by more than 1/3 in the past 15 years (from just above 1% to less than 70 basis points). This pricing pressure is squeezing emerging manager margins con- siderably and shifting more risk to setting up a firm. Managers either have to shoulder the burden personally or cut costs—further limiting essential staff or removing critical databases. Neither outcome is desirable for long- term growth/performance. Running a business below break-even causes prob- lems with service providers, prospective employees, and potential investors. Service providers concerned about non-payment will either refuse to engage business or demand personal guarantees. Top-level personnel will favor organizations that offer superior perks/salaries/ financial security. They will avoid emerging managers until they become established. And savvy investors will shun unprofitable ventures out of fear of morale hazards and hidden liabilities. These converging forces create a tough environment that makes it difficult to gain orga- nizational momentum. As a result, fragile infrastructures tend to decay over time, further reducing the likelihood of success. Once a vicious cycle is set in motion, it is unusual to reverse course. In the financial industry, the rich get richer and the frail go out of business.
E X H I B I T 6 Equity Funds Average Expense Ratio
Source: Fidelity platform 9/1/2015: 16,660 listed mutual funds and ETFs.
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E X H I B I T 7 Number of Investment Companies by Type
Source: Fidelity platform, September 1, 2015: 16,660 listed mutual funds and ETFs.
Exhibit 10 shows the explosive growth in equity mutual funds. Over the 40-year period from 1975 to 2014, they have grown from $37 billion to more than $8 trillion. And, while the exhibit does not show it, much of the growth within mutual funds has occurred in stock index funds with very low management fees.
seemed to be out of touch with traditional value-based investing. Internet startups and telecom stocks without revenues were priced to unprecedented levels based on potential for eyeball conversion into cash revenues. Sea- soned professionals avoided these stocks to their own det- riment. On a relative basis, their performance suffered compared with the dot-com stocks, and many didn’t last in the industry long enough to endure the crash in 2000/2001. Some quantitative models also became pop- ular during the 1990s, although they didn’t survive the recession. Regrettably, their funds couldn’t handle devel- opments when model parameters explored new ground. A notable high-profile government bailout of Long-Term
INDUSTRY TRENDS—SMART BETA AND ROBO INVESTING
In the past 20-plus years, even the approach to proper stock valuations has experienced controversy. During the Internet bubble (dot–com) era in the 1990s, stock valuation
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E X H I B I T 8 Total Assets per Product (U.S.$ billions)
Source: Fidelity platform, September 1, 2015: 16,660 listed mutual funds and ETFs.
E X H I B I T 9 Total Assets per Investment Company
Source: Fidelity platform, September 1, 2015: 16,660 listed mutual funds and ETFs.
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E X H I B I T 9 ( Continued )
Investment Advisors (RIAs) and eliminating their fee income. Again, investment professionals need to learn how to adapt to these changing scenarios. Each approach seems to work well until the next “hot money” fad. Unwittingly, investors are following a market power shift from a manager-centric approach (those who actu- ally manage the money) to a marketing-centric approach that focuses on ad dollars and aggressive sales tactics. The change in the marketplace is significant; it has cre- ated an industry where much of the organization costs go toward marketing and raising assets. This has forced market consolidation as small managers do not have the resources to compete for assets. Ironically, however, large companies are building inefficiencies into their long-term operations by spending such a large amount on marketing and sales. This may create an opportunity for entrepreneurial managers who can employ efficient means, through technology or viral marketing, to reach investors directly. Raising assets is the lifeblood of any financial ser- vices company. Without new assets the firm will be less apt to meet expenses and endure dimmed hopes of survival. Some managers employ third-party mar- keters (TPM). TPMs supply managers with external sales agents who base compensation on a percentage of assets raised. In principle, their services appear as a “no lose” opportunity. In practice, however, this may not be the case. TPMs have recently started to incorpo- rate monthly retainers (e.g., $5,000 to $10,000) along THE COST OF RAISING ASSETS
Capital Management was among a series of quant funds that imploded during this era. Subsequent to the 2001 recession, investors saw a shift toward passive investing through ETFs and explored tactical asset sector style rotation strategies that would shift assets with changing market conditions. Currently, investors seem enamored with “smart beta” approaches and “robo-investing.” Computer-generated portfolio allocations or robo- investing models are squeezing out traditional Registered Note: Figures show the average amount of assets per investment company, in U.S.$ billions (e.g., 0.66 is $660 million dollars). Source: Fidelity platform, September 1, 2015: 16,660 listed mutual funds and ETFs.
E X H I B I T 1 0 Total Assets in Equity Mutual Funds (U.S.$ billions)
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with their traditional success fee. They attract managers with promises of massive sales forces dedicated to raising assets. Although the lure of a professional sales staff and low monthly fee may initially seem very attractive, man- agers soon discover that their external sales force may be oversubscribed. Third-party marketers have an incentive to contract with as many managers as possible, regard- less of time availability among their agents or ability to sell a product. Moreover, even if TPM agents have the time and interest to represent a product, it will take a long time to connect with a cash infusion. The sales cycle in investments tends to stretch over many months and years—not days and weeks. Consequently, emerging managers might ultimately be paying the same rate for a part-time, non-exclusive agent as they would for a full-time employee. Hiring a sales director can improve matters, but after paying a high fee, the net benefit may only widen the break-even gap. Sales agents in financial services command salaries/bonus well into six figures—far out- stripping the affordability of most small companies. By necessity, nascent firms must either forgo expensive per- sonnel or apply a new compensation structure. Unfortunately, the landscape for sales agents in the investment industry is also cluttered with a wide- ranging talent mix that is often difficult to discern. Top sales agents typically work for major organizations and command very high salaries. In order to entice them to a small firm, it may be necessary to provide an equity ownership stake. Again, there would be no assurances that their existing success would be transferable to a small firm with a different performance track record and management team. Moreover, if an emerging manager has only $15 million or $20 million in AUM, there would be insufficient reserves to pay for the new sales agent/partner without personally subsidizing the opera- tions from savings. This creates a conundrum when a new equity partner receives a salary and equity stake at the expense of the founder. Moreover, the high-power salesman is typically accustomed to fancy travel per- quisites and an expense budget that is no match for an emerging manager. Five star hotels, first-class air travel, high-end restaurants, and enormous expense accounts are the bane of a struggling entrepreneur’s existence. Entrepreneurs thrive on a low-cost environment and efficiency in operations. Ultimately, investors can end up paying asset raisers the same amount that they do for the people actually
managing their money. Importantly, in the attempt to force fund managers to lower management fees, there are a lot of fees that go unnoticed by investors, such as custody fees, currency fees, trading costs, etc. The good and bad news for emerging managers is that sales are becoming the most important part of oper- ations. Institutional investors are very sophisticated, and they no longer are interested in speaking with a smooth salesman who understands little of the investment pro- cess and operations. Investors want to speak directly with the fund manager, analysts, traders, and compliance staff. Consequently, the focus on the emerging manager should be to leverage existing talent and performance track record and engage with professionals for quality materials and dissemination. Another approach to acquiring assets has appeared with changing market dynamics. It is an unpalatable practice, employed by a few, that feeds on the desperation of struggling emerging managers. Given the difficulties for managers to afford a successful sales team, opportu- nistic sales agents have begun teaming up together to acquire cash-starved managers. They don’t prey on all managers—they seek out those with strong performance track records and relatively low assets. Sales organiza- tions lure managers to meetings extolling the virtues of their sales teams with promises of future AUM growth. These agents are extremely aggressive. Despite having relatively modest interaction over phone or email, agents are quick to discuss deal terms shortly after meeting face to face. In essence, agents expect the manager to cede all day-to-day control of operations and focus exclusively on portfolio manage- ment. They provide the manager with a small minority equity stake and earn out upon acquisition, but terms include heavy overhead for executive management and sales staff. Close inspection of the terms show an insidious wealth transfer. Overwhelmed managers may accept these terms because it allows them to focus on the investment strategy and trading of operations. But it comes at a heavy price. The layers of bureaucracy built into the deal ensure that future payouts will be modest. Virtually all of the rewards shift to the sales agents and executive staff, with relatively small residual f lows available to the emerging SALES AGENTS TURN MANAGERS FROM ENTREPRENEURS TO EMPLOYEES
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manager. By the time the manager realizes what’s hap- pened, it’s too late. The performance track record and control will have already been released to the acquiring entity, and the manager will have little recourse to reverse the deal. In an attempt to regain focus on port- folio management, the emerging manager may surrender dreams to be an accomplished entrepreneur and revert to life as a paid employee. As Exhibit 6 showed, managers have been under pressure to reduce costs. Moreover, Exhibits 6 and 9 (Panel B) demonstrate that the financial industry has been reducing management fees and squeezing margins. Another factor that further compounds the challenges faced by an emerging manager are the fees charged to access the selling platforms. Without being listed on a selling platform, the manager has no access to a retail investor and has excluded this opportunity to raise assets. Sales platforms come in many ways. Major brand- name agencies, such as Fidelity, Schwab, and TD Ameri- trade, all charge the investment manager the greater of an annual fee (e.g., $20,000) or 40 basis points. Con- sidering that most managers now charge less than 70 bps, the manager will be conceding more than half of all gross revenues, before all other operating expenses. Moreover, some of the platform providers, such as Schwab, promote robo-investing directly to investors at fees lower than the platform fees they charge outside managers! In fact, many platform providers sell their own passive products at a rate lower than the fees they charge external emerging managers. Thus, the manager has the unenviable task of trying to raise assets against a competitor who can significantly undercut rates to the same customer. This leads to an unsustainable approach for managers who need to differentiate their offerings or, better yet, craft innovative solutions for long-term survival. THE HIGH COST OF … HIGH COSTS
biotic partnerships, innovative platform applications, viral marketing, collaborative alliances, and disruptive technologies create new opportunities for growth. In order to succeed, future managers will be required to think and act entrepreneurially. This means finding partners that fit their strategies as well as sales platforms that can be offered for competitive fees and provided conveniently to the consumer. Plenty of oppor- tunities exist to structure deals that are beneficial to both parties, so long as each party provides value-adding ser- vices. A manager brings talent to a deal, but talent alone is no guarantee for success. The investment community is teeming with similar-looking products and investment professionals. Entrepreneurial managers need to separate themselves from the masses. Unique, compelling offerings with strong track records help improve odds of success. Fur- thermore, investment strategies should be rigorously tested (ideally with actual investment dollars under a variety of market conditions) and seeded with a strategic partner. Increasing assets will allow a manager to build out a strong, qualified team. Entrepreneurial managers will prosper following these basic guidelines. But emerging managers who don’t adapt are destined for failure. The current path is evolving quickly and ever changing. Evidence shows that the industry does not favor small, emerging man- agers. Channels of distribution continue to tighten along with declining management fees. The industry is moving toward a polarized existence of haves and have-nots, with few in the middle. There are even fewer at the top. Managers today are not afforded the luxury of second chances. They need to be clear about their core competencies and communications to external parties. They need to be focused on service and keep operating costs low—efficiency and effectiveness rule supreme. Managers should grow organically, where possible, and take care of key members of the team. Finally, they need to maintain the organizational spirit, excitement, and energy. People within the firm need to handle many different job roles, and there is no room for corporate dead weight. Consequently, it is essential that all members of the team think and act entrepreneurially. Entrepreneurial managers will be competing against much larger bureau- cratic companies that have massive staffs, cheaper access to capital, and superior distribution channels. At first,
FUTURE DIRECTIONS
The existing model for emerging managers paints a gloomy picture. High costs, low margins, rising barriers to entry, increased regulation, and competition—all point to a bleak future. But entrepreneurial talent often discovers unexplored channels to success. Strategic, sym-
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it may appear intimidating, but big companies also have some disadvantages compared with entrepreneurs. Entrepreneurial companies are nimble and tend to uti- lize resources more efficiently, allowing them to adapt and innovate quickly to changes in the marketplace. In order to succeed, emerging managers must understand key aspects of the business. Because the trend is moving toward a lower cost structure, this means understanding all of the fees, hidden and otherwise. Investors and members within the industry are familiar with management fees, advisory fees, basic brokerage commissions, and sales loads. These are all visible to the investor prior to completing a transaction. Brokerage commissions, management fees, and advisory fees have all dropped considerably. Sales commissions (load funds) are for the most part, disappearing. But the investment industry has many costs internal to operations that the investor never sees. Most investment managers probably don’t understand them all, either. They are a cost to the manager, investor, or both and provide a drag on performance. Some of them are very complex and include (among others) custody, trading (bid–ask spread), fund accounting, fund admin- istration, legal, investments trusts, platform fees, external auditors, currency swaps, transfer agent fees, regulatory, or marketing costs. In some cases, the bid–ask spread for a trade or currency swap for a simple transaction can usurp the management fees charged for an entire year! Yet, most of the attention in the industry is placed on the management and advisory fees.
As technologies improve, managers will be able to provide money management services directly to con- sumers at lower rates. Because of internal cost efficien- cies, managers will also be able to capture a wider margin. Separately managed accounts (SMAs), unified managed accounts (UMA), and commingled funds are all approaches that help managers lower fees and raise their margin. It is likely to become more popular in the years ahead as managers learn how to better meet the demanding needs of their clientele with innovation solutions. Emerging managers have great potential in the financial services industry, but extraordinary difficulties lie ahead. The easy days have long since ended. Fierce competition and a hostile, predatory environment have combined to make life very challenging. Opportuni- ties still exist for entrepreneurial managers who dif- ferentiate themselves and craft innovation solutions for their clients’ needs. But managers who pursue traditional methods in running their business will likely fall prey to brutal market forces that are shrinking margins and raising barriers to entry. They may commence opera- tions with high hopes and enthusiasm, but without a unique strategy, established track, significant AUM, and clear path to gathering more capital, their existence will be short-lived. In the end, many will experience a brief, ephemeral life as an emerging manager.
To order reprints of this article, please contact Dewey Palmieri at dpalmieri@iijournals.com or 212-224-3675.
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