When hedge funds add performance fees into the mix, their revenue growth can often be remarkable. But in times of crisis, when there is low or no growth, a hedge fund that depends on performance fees to sustain its profitability may have to rethink or reshape itself.
Finding out where your business model falls within the zone of profitability is just the first step towards running a sustainable hedge fund business.
Effectively leveraging third-party vendors can make the difference between stagnation or growth, between prospering as a business or going under.
Are You in the Zone?
The two most important levers in a hedge fund's basic business model are its fees and fixed expenses.
- The green zone represents funds that keep their fixed expenses lower than their management fee revenue.
- Yellow zone funds, which spend more than their management fee but less than their realistic performance fee expectations, require some degree of positive performance revenue to stay profitable.
- Funds in the red zone may be forced to take drastic, unplanned actions during low-performance years.
Even during low- or no-return periods, a conservatively modeled approach can help a fun sustain, adapt and emerge. And levering third-party vendors can be a key component to that approach.
What's Your Breakeven Point?
Distinct from raising AUM, delivering strong performance or changing the management fee structure, the only lever that managers have complete control over is fixed expenses.
Choosing between in-house and third-party service providers for back office work is a difficult choice, especially for funds which prefer to do as much of this work in-house as possible. As a result, these funds tend to build up significant fixed costs, which has a multiplier effect on their breakeven point. In other words, increasing fixed costs demands they increase their AUM – or risk operating outside the zone.
Are You Effectively Leveraging Third-Party Vendors?
Leveraging third-party vendors moves the burden of high-expense activities from their own P&L to a service provider. It reduces fixed expenses, and gives funds the ability to ramp up or ramp down, as needed, without adding significant new recurring expenses.
In the post-crisis environment, managers need to be focused not only on their investment performance but also on their business models to maintain sustainability and grow in the future.