Profits in the hedge fund industry dropped by 30% to $21.9 billion in 2014 due to poor performance from $31.2 billion in 2013, according to Citi’s 3rd Annual Hedge Fund Industry Operating Metrics Survey.
Institutionalization of the hedge fund investor base has shifted the profitability ratios of the industry, Citi notes.
Profits derived from management fee revenues now equal profits from performance fee revenues in years like 2013 when managers meet institutional targets of 10% annual returns.
Citi’s report, formerly known as the Hedge Fund Business Expense Benchmark Survey, is based on proprietary analysis and detailed responses from 149 hedge fund firms that collectively represent $581 billion in industry AUM – 19.8% of total industry assets.
The title of the survey has been changed to reflect a broader focus on industry margins, profitability and valuations rather than on detailed expense benchmarks.
Citi global head of business advisory services Sandy Kaul said, "Management fee revenues have become an increasingly important part of the industry’s profit base in recent years. Lower institutional return targets and concerns about excessive volatility make it more difficult for managers to earn outsized performance fees.
"With AUM at record highs, profits from management fee revenues now account for a larger share of total profits, coming in at nearly 2.5 times performance fee profits in years when performance is down such as in 2014."
Tracking hedge fund profitability is critical due to the outsized influence these firms exert on the asset management industry’s total profit pool.
Using Boston Consulting Group’s (BCG) industry-wide estimates to frame their findings, Citi calculates that in 2013, hedge funds’ $31.2 billion in profits accounted for 34% of BCG’s $93 billion forecast on total asset management industry profits versus only 4% of BCG’s $68.7 billion estimate on total asset management industry AUM.
Citi puts average hedge fund operating margins from management company fee revenues at 67 basis points in 2013, significantly above BCG’s figure of 12 basis points for the asset management industry overall.
For 2014, Citi sees about a 10% improvement (7 basis points) in hedge fund industry operating profits from management company fee revenues with that figure rising to 74 basis points.
The most notable change in hedge fund operating margins in 2014 was a 17 basis point improvement in operating margins for small hedge funds with average AUM of $100 million and individual fund AUM of between $0 and $350 million.
Despite this improvement, Citi reports that firms in this band are still unable to cover their operating costs based solely on their management fee collections.
In 2013, they posted an operating deficit of 86 basis points, but in 2014 that shortfall fell to only 69 basis points.
This helped push break even for these firms looking to cover costs from management fee income down from $330 million in 2013 to only $310 million in 2014, Citi notes.
"Poor performance will be most acutely felt by small hedge fund firms. 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. We see a $615 million industry-wide shortfall across this tier of firms and this is likely to result in more closures of small hedge funds," explains Kaul.
While poor performance cost the hedge fund industry 30% in profitability in 2014, this factor only resulted in a 7% drop in the theoretical equity value of the industry, Citi reports.
This difference is explained by Citi using industry experts’ approach of counting profits from management fees at 4 times the value of profits from performance fees in their model.
Citi puts the total theoretical equity value of the hedge fund industry at $239 billion in 2014, down from $257 billion in 2013.
The diversity of a firm’s product mix and investor base are key factors that affect how large a multiple to use for management company fee profits in valuation calculations, Citi reports.
This is leading to greater product expansion across the largest hedge fund firms, they note. Survey respondents in Citi’s $10 billion AUM tier had 83% of their assets in their core hedge fund product but those in their $10 billion AUM tier with average AUM of $31 billion had only 35% of their assets in that category and by contrast had 36% of their assets in publicly traded long only or liquid alternative assets.
"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," concludes Kaul.