One sign of the revival of the hedge fund industry is a return of M&A activity. In 2006 and 2007 some managers listed on stock exchanges, notably Och Ziff and BlueBay; some funds sold minority stakes to investment banks, including DE Shaw, Avenue and Lansdowne. The Petershill Fund, a product managed by Goldman, has purchased minority stakes in a number of funds including Trafalgar, Winton and more recently Shumway.
2010 has seen renewed M&A activity, with the biggest deal to date being Man Group's purchase of GLG. This week, the Royal Bank of Canada used some of the fees it charges Castle Hall on every wire transfer to buy Blue Bay in London (yep, we bank with RBC, and it certainly feels like our bank charges are $1.5 billion!) and Orix purchased a majority stake in Mariner.
In the aftermath of these transactions - and in anticipation of new ones - we thought it helpful to outline some operational considerations.
1) The institutional parent will likely not impose its systems on the asset management subsidiary. In general, institutional parents - even when they assume majority control - do not intervene in the day to day operations of the newly acquired asset management company. Investors should not, therefore, assume that systems and day to day operational procedures will be upgraded to full "institutional" quality. Typically, systems remain much as before - so a strong manager with strong controls will remain good, while a firm with a weaker infrastructure will not get a sudden boost in operational quality.
2) The institutional parent can provide more oversight. Having made point #1, we would agree that having an institutional parent can increase oversight, at least when the parent is a majority owner. In the US, the parent entity may be subject to the Bank Holding Company Act and will bring the full weight of Sarbanes Oxley. Equally, we would expect to see the benefits of a properly conducted internal audit function and particularly more compliance resources. All can be favorable to investors.
3) The institutional parent can provide deep pockets. Purely practically, perhaps the strongest benefit for an institutional "takeover" of a hedge fund manager is deep pockets. In the event of financial loss caused by honest error - or dishonesty - at the fund manager subsidiary, there is a helpfully increased likelihood that the parent company will step in to make investors whole. BlueBay, of course, already experienced this situation as a listed company, when a portfolio manager amended prices to fool both the back office and the fund's administrator. Once discovered, the firm immediately reimbursed the fund (and therefore investors) for all losses.
4) Institutional control gives more comfort than a minority shareholding. Points 2 and 3 above are far stronger when the management company is a majority owned subsidiary and is therefore subject to the governance of the parent entity. A minority shareholding, however, is typically structured as a passive investment, giving the institution a participation in profits but no management or governance control. What a minority stake does do is create a monetizing event for the management company's principals.
5) Reinvestment of sales proceeds is critical. One of the biggest due diligence issues is always what happens with the proceeds from an M&A transaction. Investors should have a very strong preference to see virtually all proceeds reinvested back into the firm's products, ideally with a long lock up and / or some form of earn out structure. This will create an enduring - and potentially strengthened - alignment of interests. What is less optimal, of course, is for the PMs to cash out. Having made several tens of millions of dollars in a sale - and then taken that money off the table - will certainly cushion the blow if the business gets into difficulties a couple of years later. Investors should, therefore, always be very conscious of the changed dynamic if a sale would allow the principals to walk away, having banked proceeds which fall in the "I'm now safe for life" category.
6) What is the new business plan? Access to an institutional parent's distribution platform can transform the capital raising capability of a management company. That may be wonderful news, enabling the manager to scale up its capacity and investment capability. However, new assets and new products may also place huge stress on the manager's back office, especially in the short term. Investors need to be very watchful should a manager face the high class problem of rapidly increasing AUM. Managers should have a business plan which considers back office resources, and make commensurate investments to improve both systems and people as AUM increase.
7) Beware new conflicts of interest. Purchases of asset management companies by investment banks can create new conflicts. Is the new owner a major prime broker or derivative counterparty to the fund? Is the new owner also the fund's administrator? Sometimes closer economic relationships can help, but sometimes they create conflicts which require changes in structure and service providers.
8) What about changes in control? In the corporate world, change of control clauses often provide a comfortably golden parachute for key executives. For a hedge fund investor, however, there is no ability to break a lock up if an investment management company is purchased. In some instances, investors may not care and be strongly in favor of the new parent; in other situations, however, we can imagine investors who wanted to allocate to an independent, boutique firm, and have no desire whatsoever to serve out the remaining 19 months of their lock up with a new parent. This raises an interesting question - funds can have a key man provision in their offering docs. If M&A activity picks up, should they also have a change of control clause?
9) What happens in the long term? As a final point, investors always need to consider the long term outcome of M&A activity. In some instances, deals are hugely successful - JPM's purchase of HIghbridge would be a great example of an enduring deal. The landscape of other transactions, however, may change over time - even if the hedge fund manager can do nothing about it. Back in March 2007, for example, DE Shaw noted that "Lehman has demonstrated a strong commitment to investment management, and will be a valuable resource to us as we continue to innovate." More recently Front Point, having been purchased by Morgan Stanley in 2006, was yesterday subject to a management buy out to take the company back into private ownership.
Every deal will always be sold as a winning transaction on Day 1, and some will turn out, over time, to be materially beneficial for investors - not just lucrative for the manager. To be realistic, though, we must acknowledge that other transactions will be less positive, and some will be a complete disaster. The observation for investors, then, is that M&A activity introduces another moving piece to the due diligence process, increasing the spectrum of issues, risks and outcomes faced by the manager. Ironically, bringing an institution to the table may actually increase the need for ongoing due diligence.
Hedge Fund Operational Due Diligence.
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