How to Build Moats in a Hedge Fund Business?
This idea occurred to me during one of my “wisdom walks”: Why not apply the 7 Power framework to the hedge fund industry?
In this article, I will discuss how a hedge fund can successfully build moats in this ultra-competitive and fragile sector and what paths a start-up hedge fund must take to gain power.
As a reminder, the 7 Powers are scale economics, network economics, counter positioning, switch costs, brand, cornered resources, and process power.
We can skip network economics because the network effect doesn’t apply to hedge funds, unless I am missing something.
Scale economics
Hedge funds exhibit high operating leverage. They don’t need a big office (though they pay for nice spaces) and compliance costs don’t rise in lockstep with growing AUM.
Even a small team of 5-10 soldiers on the investment team can make decisions on how to allocate billions of dollars. The firm (and the founder) can get leverage out of the investment team members. This propels profits as the firm generates returns and assets grow.
The profits can be reinvested in the business to attract the best talent, creating a virtuous cycle where the best talent becomes the next generation of contributors to superior returns. This, in turn, drives brand recognition, increasing the chances of fundraising success, and the ability to hire more top talents.
Allocators prefer established funds because scale equates to survivability.
Large funds can also afford the best resources, such as Wall Street research, alternative data, expert networks, and travel budgets, theoretically improving return prospects thanks to better information flow.
Conversely, smaller funds face a vicious cycle. They struggle to attract premier talent due to underwhelming compensation.1 Without talent, returns suffer which hurt AUM growth. Without more assets, smaller funds can't generate enough profit to hire great talent. Furthermore, they are forced to ration research resources, resulting in inferior information flow.
Therefore, a startup fund must get to critical mass quickly. The days when David Einhorn was able to launch Greenlight Capital with $900,000 are long gone. Most successful startup funds today achieve scale before even launching. Unfortunately, they come from good brands anyways.
For example, some of the “Tiger Grand Cubs” launched with at least a billion under management.
D1 Capital was $5 billion AUM at launch, where Dan Sundheim invested $500 million of his own money.
Lone Pine-cub SurgoCap (Mala Gaonkar) launched with $1.8 billion.
Viking cubs Voyager Global (Grant Wonders), and Avala Global (Divya Nettimi) both started with $1 billion.
In addition to brand name lineage, these founders have invested significant personal wealth into their venture to signal skin in the game and confidence. Finally, their bosses such as Andreas Halvorsen (Viking Global) or Stephen Mandel (Lone Pine) may have even invested in these ventures, providing that golden stamp of approval that dramatically enhances these ventures’ marketability.
For the start-ups who don’t have that kind of brands and lineages, they must generate strong multi-year returns, or suffer the fate of becoming zombie funds that are one redemption away from going out of business.
Counter positioning
How many times have you heard that a hedge fund adopts a “long-term, private equity approach to the public market, aiming to own good businesses run by good management?” Probably many times.
This signals overcrowding in the hedge fund land, turning the industry into a highly fragmented market with too many players.
Nevertheless, some senior analysts at established funds are contemplating launching new funds as you read this article. They need to come up with a unique value proposition where there is none.
Investors will demand an answer: What unique exposure does your fund offer that we cannot obtain elsewhere?
Startup funds typically counter-position against incumbent brand-name funds by narrowing their scope. And by definition, the incumbent can’t counter because they must have a broader scope to move needles at a larger scale.
For instance, Maverick Capital, a Tiger Cub hedge fund, differentiates itself by specializing in TMT. Others can specialize in consumer (like Lone Pine) or macro (like Duquesne run by Stanley Druckenmiller.)
Geography and market cap are two other ways startup funds narrow down. Some funds operate as crossovers in both private and public markets, positioning themselves as having superior information flows compared to peers focused solely on one market.
However, counter-positioning is a double-edged sword: the very constraints that propelled a small fund into the mainstream become the exact bottlenecks as the fund scales.
For example, a fund specializing in small-cap stocks may run out of needle-moving small-cap stock ideas as AUM grows, raising concerns about scalability in the eyes of LPs. As Warren Buffett aptly noted, size can be the enemy of outperformance in the investing business.
I don’t know how successful hedge fund founders thought about building their firms. I suspect most learned to pivot their strategy as they reached certain AUM marks.
For a startup fund to hit the ground running, counter-positioning is a must to generate returns and appeal to LPs. Otherwise, most LPs aren't interested in investing in a subscale Tiger Management or Bridgewater Associates.
Switch costs
A hedge fund product has low-to-no switch costs. Clients demand the ability to redeem quickly if they choose. This makes a hedge fund fragile.
Therefore, owning long-duration capital is a significant moat. One approach is offering incentives, such as discounted fees, to clients who are open to multi-year lock-ups. Realistically, only funds that have a brand and track record can have some bargaining power on such an arrangement. In contrast, most subscale funds are desperate to accept any fund-of-funds money that comes their way.
Proactively identifying aligned LPs is another way to achieve switch costs. The founder must be able to clearly articulate the strategy to LPs. When LPs are aligned with the fund's strategy and time horizon, the fund reduces the risk of investors pulling money at precisely the worst moment when the market gets turbulent.
During turbulent times, some hedge funds have disallowed redemption, such as when Michael Burry disallowed Joel Greenblatt to redeem after Greenblatt heard Burry’s “big short” trade. This is an example of forced switch costs, which not only are legally ambiguous but can also antagonize your clients. So, I wouldn't consider that an actual switch cost.
In building a startup fund, the best approach is to clearly articulate the strategy and identify aligned investors upfront who will stick through thick and thin. Having been in the industry myself and having seen enough turmoil from friends and public news, I argue that generating returns is easier than finding aligned LPs and babysitting them when things get rough. And inevitably, things do get rough.
Long-duration capital is the true moat to a hedge fund’s long-term success.
Branding
A strong investment track record is not the sole reason (and sometimes not even the reason at all) why clients invest in a hedge fund.
For example, it makes zero sense to me why top mutual funds would kick out their research associates who have been operating under the firm’s process for 2-3 years, building rapport with multiple portfolio managers. Instead, these top long only hire MBA graduates from elite schools as Analysts who might have zero public investing experience.
Sadly, most mutual funds don’t generate alpha over any period; they are only incentivized to gather assets because their fee model is based on only AUM (another classic moment of Charlie Munger’s “show me the incentive and I will show you the outcome”)
Many mutual funds operate as marketing machines, targeting LPs who may not be aware that trusting someone with prestigious qualifications, such as a CFA or elite MBA, does not guarantee investment acumen.
Similarly, in the hedge fund land, the allure of associating with prestigious and well-known funds serves as a shiny object for investors. A brand-name fund becomes a point of conversation at exclusive venues, enabling investors to boast about their involvement with recent hedge fund launches or established shops. With their high minimum check requirements, hedge funds excel in curating exclusivity, creating a sense of privilege associated with being invited to invest in them when most are ready to incinerate all of that money with no consequences (since it’s not the hedge fund founder’s money.)
The importance of branding extends beyond attracting investors: it plays a crucial role in talent sourcing. Nowadays, young aspirants gravitate towards well-known multi-managers due to their high publicity and campus recruitment efforts, offering a direct path for undergraduates to work in investing without doing investment banking.
How to create a brand for a start-up hedge fund?
The easy way (but hard if you didn’t come from the right lineage) is for the founder to come from a reputable shop. Even better, his or her boss invests in the venture, which is a huge signal of endorsement.
The hard way is to build an exceptional 3-5-year track record that speaks for itself. As Lee Ainslie mentioned, in these days and age, a monstrous track record requires aggressive risk-taking.
Cornered resources
The most important asset to a hedge fund is its investment team (no offense to everyone else at a hedge fund who helps keep the lights on). The prowess of the investment team, from the founder to sector heads / senior analysts, and junior analysts, is the critical driver of return generation, which is the only product a hedge fund offers.
A founder who can make money, manage risk, and raise money is a rare breed. Coupled with sector heads/senior analysts who can generate ideas and junior analysts who can perform the analytics and qualitative deep dive while growing into idea-generating capacity, a fund is unstoppable.
A hedge fund that has a high-performing, long-tenured investment team has the strongest moat. Of course, that’s easier said than done when there is so much money in the hedge fund business, conflicts inevitably brew around bonuses and partnership equity, driving rifts that turn into, at best, departure and worse, lawsuits (can probably get worse than that, but those we can make documentaries on.)
For a start-up fund, the easy way to start is with brand and scale, both of which attract the best talents because juniors want to get paid well (otherwise they would have gone non-profit) and want to learn from people who have a repeatable process of making money.
For funds that don’t start from that pedigree, the founder must be very cautious about what kind of people to partner with (if it’s not a solo shop) and what kind of juniors they let into their venture in terms of raw talent and philosophy alignment. When you get the investment team right and incent these cornered resources properly, everything else is easier.
Processing Power
Most of you are investment aspirants, so I understand you might forget that a hedge fund is also a business. A well-operated business is a moat in itself.
The hedge fund founder can only maximize the leverage they can get out of the assets and the personnel if robust business processes are in place, which can include the back office operations and firmwide investment decision process. As the firm gets bigger, the benefits of processes start to show.
The multi-managers are a role model for running a well-oiled risk management machine. It’s a brutal approach to treating each portfolio manager like a stock in a portfolio, but it is necessary when they use leverage, and it works. And competitors find it hard to replicate because the technology stack is unique and the processes are constantly refined.
In the case of a single manager, Viking Global has been one of the most successful ones.2 Andreas Halvorsen has transitioned from an investor role to an operator role long ago. Yet, the fund continues to generate returns and mint CIOs who go on to establish their successful hedge funds.
The importance of processes applies to the investment side as well. Paul Enright, an ex-Viking portfolio manager, shared insights into how ideas are systematically ranked for portfolio sizing purposes. These processes, when thoughtfully designed and scalable, can serve as a significant advantage, especially as a fund grows.
For a start-up fund, establish processes early and tweak the process when the fund grows. The founder may simply borrow from their former employer, which many of them do, because why reinvent the wheel when the founder succeeded under his / her prior shop’s processes? Or the founder can take best practices from the funds he/she respects and mold them into their unique processes.
I have heard many seemingly reputable funds are in complete chaos on the inside, where every sector head is doing their own thing and engaging in a free-for-all battle to get names into the portfolio. That is bad for the fund and for junior talents who not only are early in their pattern recognition development but also have to navigate the internal chaos.
Conclusion
Hedge fund is a competitive industry. You can argue there is some barrier to entry. Plenty of senior analysts at big funds will start a fund if they choose to, so the barrier is not as high as one thinks it is.
That said, starting a fund is one thing, sustaining one is another. You need to have the best investment team and a world-class process.
Let’s look at two examples.
Citadel has scale. Its brand has helped attract junior talents. They have dominated in return in their genre consistently for keeping the best market-neutral style PMs. And their risk management process is top-notch.
Viking Global, a Tiger Cub fund, has scale as well. Top talents from 2+2 or elite MBAs want to work at this brand-name fund. They also have the brand of giving talented analysts the chance to manage money without going to another single-manager fund. Their process of rank ordering ideas has translated to a superior ability to monetize investment team members’ investment ideas.
While this is a textbook analysis of the industry based on the 7 Powers a business can exhibit, hedge fund success ultimately comes down to generating returns consistently. I don’t want you to forget the single most important thing - make money.
Did I miss anything you can think of that can enhance a hedge fund’s moat? Do you agree with my points? Please let me know in the comments.
Thanks for reading. I will talk to you next time.