Sushi and Hedge Funds
Recently, I have been thinking about the different perspectives between being a GP and a LP of a hedge fund. Intuitively speaking, I know the best business model for GP may not be the same for LPs. From a GP’s perspective, the best business model generates a stable fee income from a large asset base. From LP’s perspective, the better business model generates a higher performance from a small asset base. We tried to mitigate this conflict of interests by demanding a GP to invest more capital in their own fund as a LP. So far, this discipline worked in favor for our interests as a LP.
As we discussed in our Farewell My Hedge Funds, there are more hedge fund billionaires than private equity and mutual fund billionaires despite the hedge fund’s shorter history. Based on the Forbes List of 2015, there were 48 hedge fund billionaires with $220 billion total net worth vs. 30 private equity billionaires with $78 billion total net worth. While there are many multimillionaires by investing in Berkshire Hathaway, I’ve never heard of a story of becoming a millionaire by investing in hedge funds. It seems that hedge funds are very lucrative business model for those who are operating, not investing.
Exhibit: Dominance of Hedge Fund Billionaires
From a private equity manager’s perspective, a hedge fund business is very attractive. It generates very high recurring cash revenue. It is incredibly scalable with very high operating leverage (for Equity Long/Short strategy, it costs almost the same to manage $500 mm and $5 bn). As shown below, a hedge fund business with $5 billion assets under management can be valued at $500 mm or more as the valuation multiple used in this table is conservative.
Exhibit: Hypothetical Valuation Model for A Hedge Fund
There are several questions. Firstly, can hedge funds protect their fee structure as they are facing pressures from investors lately. It is possible that the industry’s profit margin is at peak. Secondly, how sticky are their customers? In my view, 99% of hedge funds are offering undifferentiated products. How many allocators are choosing managers without being influenced by their brands (i.e. platform, pedigree)? Thirdly, why are the owners of hedge funds selling their stake if it such an attractive business? This is particularly an important question because, unlike private equity, a hedge fund business is heavily dependent on a single person. There aren’t many successful transition from one generation to another. In any way, there might be a case for investing in a hedge fund business as a GP, not as a LP — I’m open for any suggestion.
I think a good hedge fund manager is like a good sushi chef. If you don’t understand what I’m talking about, please watch a documentary movie Jiro Dreams of Sushi, or visit Sawada, one of our favorite places in Tokyo. Both a hedge fund and sushi businesses are capacity-constrained, not because of the liquidity or availability of fresh fish, but their dependency on a single person. The maximum number of customers one sushi chef can serve at once is 4~6. Each day, he or she can serve 20~30 customers if he wants to keep the quality. Sushi is really a simple cuisine, fish and rice, but the customers are happy to pay for the exorbitant price for the quality of their work. Small is beautiful — that’s why we want to keep them secret.
