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Whither the boutique asset manager?

04 March 2009 Cannon Asset Managers

Geoff Blount, CEO of Cannon Asset Managers, wonders what the future holds for the flurry of boutique investment houses launched in the mid-2000s and offers suggestions to investors

Do the names Prodigy, DMG Asset Management, Velocity, Infinity or Greenwich ring a bell? These are just some of the smaller boutique investment managers that disappeared around the turn of the century. Most also ultimately failed, which begs the question: What is the fate of the 30 or so start-ups of the last five years?

With the market spooked by the start-up failures, and a flight to the security of the established managers, few new managers emerged in the early 2000s. But then entities like Hermes, Sortino, Trident, Aylett & Co, JM Busha, Polaris, Re:CM, Atlantic, Argon, Renaissance, Meago, Kagiso and Umbono opened their doors for business in the mid-2000s. Bull markets and financial euphoria drove this phenomenon, but will history repeat itself in the bear market? And how should investors approach investing in these new boutiques or should they be wary?

Most of the 1990s start-ups had unrealistic business models, based on overly optimistic new business flows. They began with costly large teams as “full-service” houses. To be profitable, these managers needed hefty assets, which failed to flow due to underperformance in the 2000 bear market and the value-style outperforming. But prior to this, markets in the 1990s were frothy, there was a listings, tech-stock and financial-services boom, and small caps were in vogue. Active alpha (how much you can beat a benchmark by) was high and most managers beat their benchmarks. Many “investment stars” were born – but it was easy for managers to confuse their own ability with what the market was doing for them.

When the markets went south in the early 2000s, so did many of the start-ups (although Oasis and Coronation are examples of boutiques that survived to become substantial houses). The failed boutiques had large capital backing and smart investment staff, so what went wrong? There were numerous factors, but essentially the start-ups could not deal with the change in their operating environments. Most were born out of growth markets, and followed growth style investing. The beginning of this decade has favoured value shares and the new managers simply underperformed because of their investment style and could not attract assets, while high staff complements drained the business capital.

Now, the start-ups from the mid-2000s are value style managers, almost a contra-indicator that we were set for a growth style run and, in fact, that is exactly what we saw from 2007 to late 2008. Growth stocks outperformed, driven first by construction and then resource shares. Most of the boutiques struggled both in alpha and nominal performance over this period, but they did not go out of business. Why?

The new firms appear to follow a more pragmatic and sustainable business model than the start-ups of the 1990s. They are smaller, lower-cost operations offering specialist products focusing on a single niche, such as hedge, specialist equities, active quant or real return. The grand start-up has been replaced by the small, focused and more sustainable operation, which is owner managed and not backed by a large financier, with staff typically on salary sacrifices.

However, these companies derive their income based on the size of assets under management and given that global stock markets have fallen substantially – the JSE/FTSE All Share Index is nearly 40% off its May 2008 peak – margins will be under considerable pressure. Not all the boutiques may survive the weaker market conditions. Also many rely on performance fees in their business model. No alpha means no performance fees, further impacting on revenue and profitability.

The best way to approach this is to ask some key questions regarding the asset manager, in particular about their business model.

One needs to establish the sustainability of the asset manager. What is the management’s experience and, importantly, is the boutique profitable, or sustainable? What is their business plan and how does the revenue-cost structure work? It typically takes an asset manager three to five years before it becomes profitable. In the interim, it needs enough capital in the business to sustain it.

A notable aspect of the boutiques is that they are mostly owner managed, so the portfolio manager is very well incentivised to get the best performance: his personal wealth is at stake if the enterprise fails through poor performance – a true alignment of interests. One risk is that the portfolio manager focuses more on running the business than managing portfolios so it is important to establish if the back office is outsourced or if they have appointed a business manager, and who is doing the marketing. A fund manager who spends too much time marketing may not be focusing sufficiently on investments.

In all likelihood, some of the start-ups of the last few years are going to fail. Massively increased competition (even many large asset managers have split themselves into boutiques), tough market conditions, scarcity of alpha and, very importantly, increased client risk aversion will create many business failures, or business takeovers. However, many more will succeed than in the last manager cycle, and this is good news for investors. More successful players in the industry increases choice, market liquidity and potential alpha for clients.

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