A Seeking Alpha commentator makes a persuasive argument against I-banks acquiring hedge funds. There are too many risks, no synergies, and little that couldn’t be achieved organically. The greatest risk, however, stems from misaligned compensation and incentive structures:
Structuring compensation to reward and retain employees at a hedge fund is the most important decision a portfolio manager/CEO makes at a hedge fund. It must pay its people enough to retain them and also give their employees compensation in forms that will encourage them to stay and not leave for other funds or to start their own funds.
Once this compensation structuring is taken out of the hands of the portfolio manager, who is the main owner, and the new owner, i.e. the investment bank, has a say, this tough decision becomes nearly impossible to get right. The best talent will realise that since a large asset gatherer like Old Lane owned by Citigroup is highly risk averse, there will be less opportunity for the talent to take risks.
The other key risk comes from inflated valuations. It is difficult to appraise the future value of a hedge fund because the most successful (and unsuccessful) ones often profit from one or a few bold ideas. It’s almost impossible to predict whether lightning will strike twice, and if it doesn’t, the i-bank will have payed a huge premium for either a market return, or worse, a loss:
The valuations given to hedge funds by investment banks are simply too high… They are also too high because the banks are not making reasonable assumptions about the future of these funds… First, they are not adequately factoring in the risk of redemptions if the fund has a bad year or under performs. This risk, which is not that unlikely, basically makes the asset the bank bought worth nothing. They are also not taking into account the fact, that as a general rule of thumb, the larger a fund, the lower its returns will be. Larger funds simply do not have as many profitable ideas to put money into. They have trouble deploying all their capital into their best ideas and often invest capital in ideas that will not generate Alpha.
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