Just the other day, a friend of mine called and asked me what I thought about a “new investment platform” being hucked by yet another quant hedge fund. Without discussing what the big name was behind this, I should pause for a moment an elucidate what these investment platforms are. Superficially, they purport to provide the “back office solutions of the top quant hedge funds in the world,” all made available to pension funds, sovereign wealth funds, and family offices. I say superficially because that is not what they are. To understand what these services really are, one must understand the historical structure of quant hedge funds and the pickle they currently find themselves in.
2+/20+ and the Golden Days of Hedge Funds
Quant hedge funds were known in the golden days for their 2+/20+ fee structure, meaning that they often charged at least two percent or more of assets under management (2+) and at least 20% of the profits (20+) every year. While this was rich, there was more. What wasn’t commonly known was for the select few who argued that they made their money from their “clever deployment of technology,” they often argued (successfully) that they should be able to pass the specific charges of their technology directly through to their clients, over 50% of which were pensions, sovereign wealth funds, and family offices. These technology charges could add up quickly, with some companies passing through fees of up to 5% or more of assets under management every year for technology charges. Let me be clear…this means that for a quant hedge fund running $10 billion, they would spend $500 million on technology every year paid for by its clients. As high as this seems, it was all tolerated as long as the fund made enough money, i.e., it better earn way over the 5% cost of the tech and the +2% cost to justify this expense.
For many years, the top quant hedge funds made way over this 7% threshold, and this structure became the dominant structure with the groups just throwing money at technology as fast as they could with horrible technology architecture in the process. Consider this. One of my closest friends, one of the top computer systems architects in the world, was asked to come into one of these beasts and propose a more efficient computing architecture. This firm had a 1,000-person technology staff at the time, which was 100% paid for by clients. After an audit, he announced somewhat undiplomatically that the firm could restructure with proper architecture and do the same work with 20 of the right people. At first, the tech team challenged his assertion, but then when presented with evidence from similar industries with even higher processing, data integration, and transactional demands, the existing tech team capitulated that he was right.
Taming the Techno Beast
As my friend presented the new architecture to the massively swelled technology team, he could see all the senior people looking around, obviously considering who would survive the 98% cull in the coming Hunger Games. Please keep in mind that these people had all just recently seen such a thing happen in their group’s trading operations, so they knew it could and would happen. Ultimately my friend declined the firm’s offer because the firm’s leadership did not have the gut for such a severe tech reorg, something that Clayton Christensen pointed out is not unique in industries riding high on the profit cycle. That said, the management’s propensity to hide their heads in the sand did not stop the cull because within a few years, the firm started to experience performance problems, and this is where the real Hunger Games began.
The performance problems caused a massive need to restructure and rebuild, but now they were trying to do it under pressure. The analogy is that it is hard to improve on Formula One racing vehicles in the shop, but impossible on the track which was what they were trying to do. It did not work, and as performance declined, the clients began to refuse to pay the extra fees that fed the techno beast. This said, the hedge fund had to keep the beast alive, but they couldn’t just cut the bloated tech staff or salaries, so they came up with an “innovative solution,” i.e., to do what my old corner bottega Beni’s did in New York, to repackage day old H&H bagels in a cute bag and sell them as “new.” Old tech would get a new package and then be sold to the same pension fund, sovereign wealth fund, and family office clients as “back office solutions.” This is how some of the biggest players in the hedge fund industry have responded to the “Innovator’s Dilemma” and how investment platforms were born.
The main problem here is that where day-old H&H bagels might be chewy and give you a little indigestion, tech past expiry date will put you out of business. This brings me to state that the most appropriate analogy is not Beni’s Bottega, but instead Upton Sinclair’s The Jungle. Famously in The Jungle, companies would sell food past expiry dates such as milk “fortified with formaldehyde.” That’s a product that will make you do a bit more than lose your cookies from day-old bagels.
My advice to my friend was to avoid the bargain basement in food and tech. They both always end badly.
Welcome to the Jungle, Baby!