The Business of Running a Hedge Fund

March 2nd, 2011
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Contributed by: Merlin Securities
Best Practices for Getting to the "Green Zone" --- Most hedge fund managers would agree: given the broader market environment and the specific challenges facing the industry, 2010 was a difficult year. In fact, the past few years have tested the industry in unprecedented ways. The industry, by and large, has passed that test, and there are a wealth of excellent funds operating today that are poised for growth.

Managers are more focused than ever on designing their business models to thrive under a wide range of market scenarios. While performance and AUM growth are still important levers in the hedge fund business model, they are no longer foregone conclusions and are not wholly controlled by the hedge fund manager. Expenses are the only lever the manager can reliably control.


While there is no one-size-fits-all business model for hedge funds, there are several consistent elements and best practices we have witnessed among well-managed funds with staying power.

As a starting point, the diagram below highlights the basic revenue and expense scenarios that describe three types of hedge fund operating models: red zone, yellow zone and green zone. A fund operating in the red zone is dependent on outsized performance to cover its expenses; a fund in the yellow zone requires minimal performance; and a green zone fund can sustain itself when its performance is lower than expected, nonexistent or even negative. Funds that structure their business model to operate in the green zone are better positioned to navigate through downturns and therefore have higher survival rates over the long term.



The remainder of this paper examines hedge fund revenue inputs, expenses and business model considerations. We discuss the importance of identifying a fund’s breakeven point (i.e., the point at which revenues cover expenses) and seek to isolate several practices that have helped funds operate
in, or closer to, the green zone.

THE BIG FIVE HEDGE FUND EXPENSES

Where do hedge funds allocate most of their spending? The answer to that question also explains where funds can find opportunities to lower their expenses.
1. People and HR
2. Office space
3. Technology
4. Manual processes
5. Third-party providers (e.g., order management systems, risk, aggregation, analytics for investors, allocation tools)

THE HEDGE FUND REVENUE MIX

Hedge funds have two revenue inputs: the management fee, which is a fixed percentage of assets under management (AUM), and the performance fee, which is a percentage of positive performance. Incentive fees are what lure the most talented financial professionals to join the hedge fund industry, and they offer tremendous upside. It’s the management fee, however, that keeps people alive in this industry. While tempting, it is risky to build a business around the hope of large incentive fees rather than the guarantee of management fees.

To better understand the relationship of these revenue inputs, consider some basic scenarios. Based on a 1.5% management fee and 20% incentive fee,1 a fund with no returns is 100% dependant on its management fee. A fund with gross returns of 5% gets 60% of its revenue from management fees. In order to derive more than 50% of its revenues from performance fees, a fund needs to generate returns of at least 7.5%. Refer to the chart below for a map of hedge fund revenues based on a variety of asset and performance levels.

Putting some real numbers around this provides more color. A fund with $200 million in AUM and zero or negative performance would generate revenue of $3 million. A return of 5% bumps the total revenue up to $5 million. With a 7.5% return, the fund’s revenues are $6 million: $3 million from the management fee and $3 million from the performance fee. Beyond the 7.5% performance mark, the incentive fee becomes the primary revenue contributor.

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