Boutique fund managers - survival of the fittest

With less money going around, boutique fund managers are facing a dangerous period and those with unsustainable business structures are set to be driven out of the market, writes Chris Kennedy.

The post global financial crisis (GFC) investment market has proved a challenge for investors, financial advisers and money managers alike.

If anything, the changing environment has emphasised both the pros and cons of operating in the boutique funds management environment.

Those boutiques with skilled managers and sound processes with a solid base and sustainable levels of funds under management (FUM) have largely continued to outperform their respective indices.

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However, boutiques without sufficiently sustainable business models will be found out in the current environment of stagnant markets and high volatility – which could spell danger for standalone boutiques in particular.

It could also mean the end – at least in the short-term – of further innovation in the sector, with new start-ups unlikely to be able to attract significant enough flows to make new ventures worthwhile.

The value proposition

The value proposition of boutique fund managers is compelling: portfolio managers, often with high profiles and strong track records – their personal equity pooled with that of investors guaranteeing an alignment of interests – manage money with the autonomy to make whatever decisions they feel are best for the investments.

Freed from having to report regularly to shareholders, they are able to take a genuine long-term view.

Freed from funds-under-management targets and often with strict capacity limits, they retain the nimbleness to take concentrated positions in their high-conviction stock bets, move quickly in and out of the market when required and, theoretically, stay ahead of the trends.

In the multi-boutique structure, for the price of an equity stake they are also freed from the responsibilities of running a day-to-day business and all the headaches that entails: marketing the product to advisers, dealer groups and investors; distribution; back office administration, compliance and other support services.

This allows portfolio managers to concentrate on what they’re best at – making money.

The risks

The boutique model also brings its share of risk. In fact, one of its greatest strengths can also be a double-edged sword in the shape of key person risk – as was seen in the 2010 closure of Peter Morgan’s 452 Capital due to health reasons.

Even larger organisations aren’t immune, as witnessed by the profit falls and fund outflows at Perpetual following John Sevior's departure last year.

As such, succession planning could present a key challenge as the Australian boutique funds management sector continues to mature and the over-reliance on individuals becomes a liability as some of those individuals begin to move on.

Those boutiques choosing to stride out without the backing of an institution or incubator also take on an element of capital risk, and are betting on being able to hit critical mass in terms of attracting enough FUM to become self-sufficient before the management and administrative costs start to bite.

The fact that boutiques do often take a more concentrated position on their investments creates inherent investment risk, such that they are more susceptible to fluctuations – although it is this strategy that allows the best managers to consistently outperform the index over a long period.

A numbers game

Morningstar research manager Tom Whitelaw, Lonsec research manager Paul Pavlidis, and the head of ratings at van Eyk, Matthew Olsen, all say that in general there is no long-term observable difference in performance between institutional and boutique managers.

Rather, it is contingent on the individual investment teams and comes down to a case-by-case basis.

“In general terms, boutiques tend to be a little bit higher risk, with a little bit higher potential for returns and a little bit more expensive, whereas institutional managers tend to be a little bit less volatile and a little bit cheaper,” says Whitelaw.

“In both buckets, there are very good managers in each side and average managers in each side. Our four highest rated gold managers in large caps – two come from the institutional side and two from boutiques. You can’t just think ‘a boutique will be good’ – you have to do the legwork.”

In broad terms the difference is marginal, he says – one is always going to slightly outperform the other, but there is no certainty which it will be.

Looking at the performance of large cap Australian share funds within managers on the Morningstar database over the 

12 months to April 2012, there is a wider dispersion of returns in the boutique managers than in the institutional managers, highlighting the potential for greater short-term volatility.

In the institutional space, the best performer over one year is Lazard Select Australian Equities with 8.38 per cent, while at the bottom over the same period is the SMI ME Australian Share Fund with -11.45 per cent.

By contrast, the best of the large cap boutiques was Pengana’s Australian Equities which returned 9.3 per cent for the year, and at the lower end the Naos Long Short Equity fund lost 22.43 per cent.

Because boutiques tend to less closely follow the index, these short-term fluctuations are to be expected, but as Table 1 and 2 show, on a three-year basis those fluctuations tend to balance out – with institutional managers actually having a wider range of returns (although from a much larger sample size of 328 funds compared to 150 boutique funds).

van Eyk data (based on a sample of 44 Australian equity core managers in its database, of which 18 were deemed to be boutiques) does seem to show a slight but significant outperformance of boutiques over the past three years – with fractionally lower volatility.

One year rolling returns (Table 3) show boutiques consistently outperforming institutional managers by between 1 and 3 per cent from June 2009 to May 2012.

Both tended to slightly outperform the S&P/ASX 300 index over the same period, although both underperformed the index over the first half of 2011 on a one-year rolling return basis.

Lonsec’s Australian equities large cap league table, when separated out by genuine boutiques, institutionally-backed boutiques and institutions (Table 4), shows a noticeable outperformance by genuine boutiques over one, three and five years, but not over seven years where the three converge, and institutionally-backed boutiques are slightly ahead of institutions, with the genuine boutiques fractionally behind them.

Movement at the station

Given the carnage in global markets that has been ongoing since 2008, there have been surprisingly few fund closures of late and a number of new partnerships announced – although there has also been a lack of genuinely new businesses commencing in the past 12 months.

NAB's multi-boutique platform nabInvest announced in March this year that it would be closing Lodestar as of 30 June 2012 because “the business is not sustainable in the current environment”, despite its statement the fund had “outperformed the domestic share market by nearly 1 per cent per annum (net of fees) since inception”.

Wilson HTM announced in October last year that it would be looking to offload some or all of its 80 per cent stake in boutique platform Pinnacle, which it had grown from one to seven boutiques, with close to $9 billion in FUM and annual revenue close to $40 million.

As of 4 June this year, with FUM at $10.5 billion, those plans have been shelved due to a lack of appealing options and deteriorating market conditions, according to the manager. Wilson HTM also cited a likely full financial year loss of $7 million to $8 million for the group.

In May, Treasury Group bought 30 per cent of Melbourne-based absolute return manager Evergreen Capital Partners for $1.4 million plus a deferred performance-based payment, and Treasury Group chief executive Andrew McGill says the firm should have another boutique relationship to announce in the near-term.

Also in May, Challenger' boutique funds management arm, Fidante Partners, partnered with Asian equities specialist MIR Investment Management, which had around $1 billion in FUM in Asian equities.

Fidante’s general manager Cathy Hales says the group remains open to investing in more opportunities as they arise, and is actively looking for more boutiques that fit its criteria.

BT's multi-boutique platform Ascalon partnered with Regal and launched the Regal long-short fund to the retail market just over a year ago (after the fund had opened to the institutional market in 2004).

Ascalon has also recently partnered with alternatives firms in Asia. In December 2011, it partnered with Hong Kong-based alternative manager Athos Capital Limited, taking a 35 per cent equity stake, then in January this year took a 30 per cent stake in Singapore-based Canning Park Capital.

Global manager GMO recently closed down its Australian equities division, which could be a pointer to more local boutiques closing their doors in the near future.

The strong will survive

Ongoing market volatility has created an environment where the less sustainable and the less well-resourced business models will get found out, according to the chief executive of Boutique incubator Bennelong Funds Management, Jarrod Brown.

“It will be harder for new boutiques post-GFC,” he says.

“It’s getting harder for asset consultants and research houses to tick all of the boxes [without being able to demonstrate significant backing or resources].” 

This comment is backed up by Pavlidis, who says most managers on Lonsec's radar are the more established managers, and that Lonsec would be reluctant to have a look at managers that can’t demonstrate adequate resourcing.

Each business strategy, irrespective of whether it is institutional, multi-boutique or independent boutique needs to resource its business and strategy appropriately, he says.

“In the face of a negative growth environment, it’s placed all businesses under pressure.”

Businesses that have based their models on certain growth assumptions and have had to endure several years of negative territory may now be reviewing their commitment.

“You can only go on so long burning cash,” Brown says.

“When you talk about financial capacity, the question is how long can the business, independent of its structure, continue to sustain its cash commitments.”

Australian Unity Investments (AUI) chief executive David Bryant says that where boutiques or boutique backers haven’t chosen their partners well, it will really show through during this period.

“The last thing anyone wants after years of commitment is for their backer to no longer be interested in being the backer. It’s really important you’ve got an understanding around the time frame and the commitment to the businesses, and everyone proceeds with certainty,” he says.

Cathy Hales, general manager of Challenger’s recently rebranded boutiques division Fidante Partners, says one of the most compelling reasons for a boutique to join with an institution like Fidante Partners is the provision of a corporate governance framework in which they can operate.

“We provide a lot of support on the administration side as well as sales and distribution, which allows them to focus on managing money. When you’re in a testing environment like we’ve been in, being able to spend that marginal time being focused on the market and your portfolios is very important,” she says.

“An institutional partner that has a broad relationship, such as Fidante Partners has, can be there when a boutique may be going through a period of difficulty,” she says.

“Whether it be a short-term cashflow issue or something of that nature, [we can] help them through any difficult period that they may be going through so the business succeeds long-term.”

To succeed in this environment, a boutique needs to be very clear about what it is that they do that is distinctive and how they will deliver outperformance consistently, and ensure the proposition is a very strong one for the client, she says.

Treasury Group’s McGill says that from a multi-boutique perspective the market difficulties can help weed out some of the less compelling opportunities, but he believes that successful managers will be successful in any market.

For a portfolio manager ready to launch their own boutique, doing so in a difficult market is an inconvenience, but it won’t dissuade them from their medium to long-term agenda, he says.

Critical mass

Pavlidis says that any small or boutique operation could find themselves under pressure when the market is not being conducive to fund flows, but it is the ones that are not yet profitable – ie, that have not yet built sufficient FUM to be self-sustainable – that will come under the most pressure.

“It then comes down to the personal finances of the sponsoring portfolio manager,” he says.

For boutiques in that situation they could either attempt to stick it out, or they may be tempted to give up a portion of their equity and partner with a boutique platform such as nabInvest or Challenger, he said.

van Eyk’s Olsen agrees that those equities managers that have not yet achieved critical mass would be struggling to attract new flows at present, but adds that the sluggish flows are predominantly in the equities investment environment - so it is those managers that will feel the pinch the most.

“In other asset classes this may not be the case, but equities broadly are struggling to attract inflows,” he says.

AUI’s Bryant says it is definitely much harder to establish a boutique today because there is less money moving around and it is much harder to win a mandate now compared to five years ago.

“This is where having the right partner is fundamentally important; continuing to operate the business without pressure and paying bills is key,” he says.

Boutiques can take as long as five years to be profitable, so for a backer it’s important not to sign up or participate in any business without a clear acceptance that that may be the amount of time needed to commit to it, Bryant says.

“To be successful in winning mandates in this environment you’ve got to be perfect. That’s where it falls to us to make sure we have the top-notch support team; you have to relentlessly pursue the best people. Your ability to do the things you want to do with these businesses depends upon it.”

Ascalon head of business development Jason Collins agrees that it can be hard to start a boutique without some sort of pre-commitment or a very solid network base, but says the same challenges apply whether it is within a boutique incubator environment or not.

Hales says the majority of Fidante Partners’ boutique businesses have passed the critical mass point.

“But boutiques that are in those early stages of growth, having that support to get them on their feet and get them to a critical mass scale is really valuable,” she says.

If there has been a trend of less institutional money moving around, then Hales says the clarity of purpose a boutique model brings to the institutional market and clear alignment of interest between portfolio managers and clients has meant boutiques in the Fidante stable have bucked that trend.

“That’s enabled our boutiques to win a number of mandates,” she says.

“It’s no surprise that in the retail market a large part of the cashflow has been going into cash and term deposits, but a number of our boutiques have received more positive flows in the conservative types of investments.”

Tim Samway, managing director of Hyperion Asset Management which operates under Wilson HTM’s Pinnacle stable, says the real problem for start-ups is that the gatekeepers in the institutional market, such as the asset consultants and larger investors, are not interested in taking risk.

“Even a star [manager], there are so many things that can go wrong in the early life of a fund manager, they don’t risk their clients’ money,” he says. 

Co-founder and executive director of standalone boutique Prime Value Asset Management, Y. Yong Quek, concedes the barriers to entry have been raised since Prime was conceived more than a decade ago, but believes with a good track record and the right stewardship a good manager can still attract money.

Quek agrees balance sheet strength is important and says his business is lucky – that is, has family backing to fall back on, although the business has been self-sustainable over a long period.

“It helps us to look beyond the current volatility and challenges,” he adds.

Capacity constrained

Although managers without a long track record may be struggling to attract new flows, the reverse can be true for established managers with enviable track records, which means they have to make a decision as to how much capacity they can build before it threatens to affect performance.

It can also mean that investors are left clamouring for what capacity is left at the higher profile boutiques.

One of the advantages of boutiques is that due to the ownership structure, you are not driving growth for growth’s sake.
 

“One of the advantages of boutiques is that due to the ownership structure, you are not driving growth for growth’s sake,” says Bennelong’s Brown.

“There is a greater consciousness in regard to not getting too big as it directly compresses your performance towards the benchmark. Sizeable institutional models by product of size become less concentrated, less nimble and literally have less room to move from an investment perspective.” 

In a boutique capacity can be a challenge, but Bennelong will look to grow by adding capacity rather than encouraging the majority owners of our boutique businesses – the asset managers – to keep capacity open.

“You’ve got to protect performance by constraining capacity, and we are aligned in that regard,” he says.

Samway says it creates a problem for institutional investors looking to allocate money to established managers.

“There is a larger group of boutiques who have reached capacity, and there are lots of clients competing for that available capacity,” he says.

“The clients are weighing up the pros and cons of an established business and its longevity and its ability to produce continued outperformance with the risks of taking on a new business and all the things that can go wrong there – it costs lots of money to change managers, and that’s clients’ money.”

Hyperion is soft closed on institutional money but still has a couple of hundred million available but is “not just giving that away” – it is looking carefully at where that capacity should be allocated.

“We endeavour to be fair to clients who have supported us for a long time,” Samway says.

There is a direct correlation between a boutique going over capacity and investment performance, according to Samway.

“Once you go too far investment performance stops. There is a very strong correlation between underperformance and losing funds.”

Boutiques are more cognisant of that because managers have their own money in the business, so their priority remains on long-term performance and they are constantly thinking about how much money they can reasonably manage, he adds.

In a larger business without that equity alignment you become more focused on short-term performance, he says.

“Short-term incentives lead to short-term behaviour. If it’s about how much money you can sell in a year and that’s what you get rewarded on, then that’s not in the client’s interests. Short-termism is a pandemic that’s overtaking this market.”

People power

One of the key advantages of the boutique model is the extra autonomy and profile afforded to portfolio managers, which in turn has the potential to attract the most skilled and experienced managers.

Due to this it continues to be extremely difficult for an institutional model to retain the best talent, according to Brown.

“It’s not just about the financial factors, it is also about the stage of career, a competitive nature and spirit, and the desire to control their own destiny,” he says.

“This is about the asset managers being in charge of their own businesses and not being driven by a range of other stakeholders.”

Talent is also important on the marketing and distribution side, which requires people that understand how to navigate the respective value chains and how to articulate an investment process on behalf of the asset management team, which Brown says is critical to the multi-boutique proposition. 

Quek says that the focus on getting the right people in place meant building the business was a slow and steady process, but it had resulted in a settled team.

Most of the Prime investment team have now been together for five to seven years and there have been no departures to date, he says.

“To outperform you need to have a very small team making the important calls and investment decisions rather than managing by consensus – which is another reason why we wanted to maintain our independence. We are managing [our] own money; I don’t want a big team managing my money by consensus,” he says.

McGill says the more confident and successful managers gravitate towards the boutique model due to that desire for independence. “[But] no-one starts in a boutique – you have to earn your stripes elsewhere,” he says.

A key part of the autonomy afforded individual managers is being able to run a small team, but this also means boutiques are overly dependent on those individuals staying within the business, and creates a headache when those individuals want to move on or retire.

Part of the solution lies within the alignment of interests.

Bryant says the first step in migrating key foundation principles from the foundation members is firstly to recruit and train the rest of their team, generally over a long period of time.

“Also, because they’re an equity owner it’s in their interests to work in a concentrated way on succession planning, progressively handing over responsibility and bringing others to fore. Generally, we find those people look to go part-time,” he says.

“There’s ongoing passion and involvement in the business – the key thing is to tap into that.”

Samway says Hyperion manages succession over many years by having different age groups within the business, with key members aged from their late fifties down to their early thirties.

You’ve also got to lock them in with equity so they don’t leave, he says.

“The real key is having a formula for entry and exit that treats each party fairly and ensures the departing party on retirement has the best interests of the firm in mind and flags it well in advance and transitions that departure over time.”

Collins says it’s an area where an institutional partner can help, but generally Ascalon will step out of the way unless required. “We see it as our job to work closely with our partners if and when it arises,” he says.

Looking ahead

Collins says there are a number of trends in the market that bode well for boutiques: there is a continuing search for alpha, and in some cases a trend towards a passive satellite approach.

“A boutique is well placed to offer alpha if it has the right investment process and team,” he says.

The difficult investment environment will continue to create headwinds for boutique and institutional investors alike, but McGill says funds management in Australia is still a relatively attractive industry in spite of the volatility of equity markets globally and investment returns.

Over the next 12 months the difficult investment markets will remain but the industry can still be fairly prosperous, and McGill says that for business models that are focused on where they can add value, shareholders can expect managers to be successful for them in the coming year.