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E-MailLin Sun is Assistant Professor at the Fanhai International School of Finance and School of Economics at Fudan University and Melvyn Teo is the Lee Kong Chian Professor of Finance at the Lee Kong Chian School of Business at Singapore Management University. This post is based on their recent article, forthcoming in the Journal of Financial Economics.
Recent years have witnessed a slew of public listings by mega asset management firms including Amundi Group, Man Group, Och-Ziff Capital Management Group, Blackstone Group, and KKR. These publicly listed mega asset managers together managed an impressive $2.38 trillion in 2017. How does the transition to public equity markets impact investment performance? Fund management companies argue that going public allows them to enhance investment performance by better incentivizing their staff through employee stock options and by investing the initial public offering (IPO) proceeds in superior technology and business support. Moreover, listed firms can be operationally more robust than their unlisted competitors given the higher transparency required of listed companies. However, fund investors contend that public listing allows firm founders to sell off their stakes to outsiders, which exacerbates potential conflicts of interest. For asset managers, the transition to public markets weakens the alignment between ownership, control, and investment capital, engendering a rich combination of agency problems, hitherto unexplored in the academic literature, which could have significant implications for the fund investor. In this article, we shed light on these agency issues by investigating the impact on hedge fund performance when asset management firms go public.
Investors in hedge funds and private equity funds (and, to a lesser extent, mutual funds) that are managed by publicly listed firms need to contend with a combination of agency issues: the conflicts that surface between management and fund investors and the conflicts that arise between firm shareholders and fund investors. A privately held investment firm is often controlled by its founder-owners, who also invest a substantial portion of their net worth in the funds managed by the firm. This engenders alignment between ownership, control, and investment capital. Post-IPO, the founders of the firm sell out to new shareholders who typically do not invest alongside the limited partners, thus separating ownership from investment capital. Furthermore, the founders may not reinvest the substantial proceeds from the IPO in the funds managed by the firm, thereby distancing control from investment capital.
We find substantial differences in expected returns on the portfolios of hedge funds sorted by fund management company listing status that are unexplained by risk. Hedge funds managed by listed firms under-perform hedge funds managed by unlisted firms by 2.89% per year (t-statistic = 4.73) after adjusting for risk. The results are not confined to the smallest funds in our sample and cannot be explained by differences in share restrictions and illiquidity, manager incentives, fund age, fund size, return smoothing behavior, backfill and incubation bias, and manager manipulation of fund returns.
Using a difference-in-differences analysis, we find that, relative to the five-year pre-IPO period, average fund risk-adjusted performance deteriorates by an annualized 8.40% and average firm alpha wanes by an annualized 7.20% during the five-year post-IPO period. Despite the post-event under-performance, public firms harvest annual fee revenues that are $17.28 million or 54.96% greater than do comparable private firms. Relative to the control group, public firms are able to grow their assets under management (AUM) by $617.62 million or 77.52% during the same period. The surge in firm AUM stems both from organic growth in existing fund AUM and from the launch of new funds post listing, suggesting that the new capital raised goes toward the marketing of existing and new products.
In line with an agency story that derives from conflicts between control and investment capital, we observe substantial differences in the under-performance for funds sorted on metrics that capture the incentive alignment between management and investors. The alpha spread between funds managed by private versus public firms is smaller for funds with high manager total deltas, better governance scores, and fund manager personal investment. In keeping with an explanation that relates to conflicts between ownership and investment capital, the short-termist pressures associated with a stock listing also drive the under-performance of publicly traded asset management firms. We find that firms with high earnings response coefficients (ERCs), whose stock prices are more responsive to earnings, under-perform more than do firms with low ERCs. Moreover, consistent with the overall conflicts of interest view, the under-performance is more pronounced for firms that exhibit greater separation of ownership, control, and investment capital post-IPO. Amongst listed firms, those with low insider ownership and whose IPO prospectuses reveal that existing shareholders cash out under-perform more.
The conflicts of interest can translate into fund under-performance via the drive to gather assets post-IPO. Equity markets tend to reward revenue growth, which, for investment firms, generally corresponds to growth in AUM. Short-termist pressures can also induce excessive asset gathering because asset gathering boosts current fee revenues (or current earnings) at the expense of future returns (or future earnings). We find, consistent with the asset gathering view, that the under-performance is most severe for funds with the lowest liquidity risk exposure and, therefore, have the greatest capacity to gather assets. We also find that high ERC firms raise more capital and launch more funds than do low ERC firms.
Our empirical results therefore challenge the view that asset management firms go public to enhance investment performance. They indicate that, for an asset management firm, the process of going public separates investment capital from ownership and control, heightening conflicts of interest, which are in turn associated with poorer performance.
While our work highlights the conflicts of interest that accompany listings of asset management firms, it is important to emphasize that benefits to public listings exist. The capital raised via the IPO can allow firms to market to investors in different geographical regions or make the necessary investments to launch new funds that engage in novel investment strategies. Shareholders benefit from the greater fee revenues generated via the growth of new and existing fund products at listed firms. Fund investors can also derive value from the launch of new funds. Through the new products, they can access different investment strategies and markets with minimal switching costs. Fund investors can appreciate the increased transparency at listed investment management firms. For these reasons, notwithstanding their under-performance, the proportion of industry assets managed by public hedge funds could well continue to grow going forward.
The complete article is available for download here.
