Hedge Fund

C: Okay, seems like an interesting case. Before proceeding, I’d just reiterate the statement once, just to ensure that we are on the same page. Our client is a hedge fund facing a decline in profits and they want me to analyse the same, right?

I: Yes right! You can proceed with the case.

C: Okay, so I would like to understand the client first and the industry in general. If I’m right, a Hedge Fund is like a Mutual Fund in which majorly HNI’s invest since the amount being invested is very high. And just like a Mutual Fund, there is a fund manager who invests the money on our behalf, right?

I: Yes, your understanding about a Hedge Fund is correct. You may go ahead.

C: Okay, now I’d like to know what exactly is the time period we are talking about (COVID/Pre-Post COVID), where exactly is our client located, what is our AUM, what kind of assets we invest in, since when have we seen the decline happening and if we are aware of the magnitude of the decline?

I: Okay. We are a US-based fund, and we invest majorly in Equity markets i.e. NASDAQ and NYSE. The decline has been happening for 2 years now and our profits were steady till 2019 but in 2020 and 2021, our profits have gone down by 5%. This hasn’t been faced by any other player so you can maybe ignore the effects of COVID. Our AUM in 2019 was 1600, in 2020 was 1800 and in 2021 was 1900.

C: Okay makes sense. Now I’ll break profits as a function of the difference between revenues and costs. A decline in profits can be due to a decline in Revenues, an increase in costs, or an interplay of both factors. So is our client aware, where exactly are facing the issue?

I: So, there is an issue with both Revenues and Costs.

C: Okay so I’ll start with the revenues side of it. The major revenue streams that I could think of over here are: (i) Management Fees charged by the Hedge fund and (ii) Any profits made on the invested money in the Hedge Fund. Am I missing out on anything?

I: You have identified it correctly. Just to clarify, Management Fees is a fixed fee paid on balance of AUM. The share of investment that you were talking about, that is known as Carried Interest and it is charged @20% of all gains in excess of a Hurdle Rate of 15%. Focus on both the revenue streams.

C: Okay makes sense. I’m sorry but I’m not sure how the Hurdle Rate works. Can I get some clarity on that?

I: Sure. hurdle rate is a minimum acceptable rate that the investors expect from the fund. So, when the fund is giving a return on more than 15%, you get 20% of the gains that the firm has earned. In case returns are less than 15%, you don’t get anything.

C: Okay, clear now. Okay starting with the Management Fees. It would be a function of AUM and % of fees we are charging. AUM, as we discussed has gone up. My hypothesis is that the % rate we are charging has gone down. It may be due to any company policy change, any change by the competitors, or any new demands by the customers.

I: Yes, you are correct! % of fees being charged has gone down from 2% to 1.5% owing to the demand of low-cost investment opportunities by the investors. 

C: Okay, and in order to calculate any change in the carried interest, we would need to find out the net gains for which we would be needing the costs. So, firstly I’ll move ahead with the cost side to it. Costs can either be fixed or variable in nature. Fixed costs would include infrastructural costs like those of physical and digital infrastructure, operational costs like employee salaries, marketing costs and admin costs and finally other costs like interest payments if any. Variable costs would include costs like salaries dependent on returns etc. Is our client aware, where exactly are they facing the issues?

I: This seems like a comprehensive enough break up. We have seen an increase in the fixed employee salary costs.

C: Employee salaries can be a function of the amount of salaries we are paying, the number of employees that we have and the mix of those employees. Is our client aware of the root cause of the issue?

I: Yes, you have identified it correctly. The issue lies with the employee mix. The number of Analysts that we hire have gone down while the associates have gone up. This is because we want a better professionally managed portfolio which gives investors the trust that they want while investing in us.

C: Okay! Would you like me to do anything else now?

I: Yes. Now use the data that I’m about to give to calculate the actual decline in profits that have incurred to us. So, as you know, the AUM details are 1600, 1800 and 1900 across 2019,20 and 21. The Return we generated on the investments across the 3 years was 20%, 12.5% and 5%. Talking about the employees, we have reduced the number of Analysts from 12 to 9 and increased the number of Associates from 9 to 18 from 2019 to 2020 and 2021. Analysts are paid 200 per year and Associates are paid 300 per year.

C: Okay! I’ll take some time to calculate the revenues and costs. For costs, is it fair to ignore any other kind of costs than the employee costs?

I: Yes, fair