Predicting the turns of the virtuous circle
Saturday, 1 September 2007
Richard Parkhouse
Fund management firms had a great year in 2006.
The latest research on global fund management shows operating profit margins are at record levels, while cost/income ratios are at their lowest recorded level. And even though performance-based pay went up by 21 per cent, the relative amount of profit paid away to employees went down by 15 per cent because assets under management, revenues and profits were all significantly up.
Firms are now spending around 30 per cent of operating profits, and 45 per cent of net profits, on incentives for staff.
Successful fund managers delivering "high alpha" are earning record amounts. So is everyone a winner in this virtuous circle?
All the indicators are favourable on first sight, but what everyone in the industry wants to know is: how sustainable are these trends and are there any underlying issues that are being masked by buoyant market conditions?
Employee productivity has certainly increased significantly over the past five years to a position where revenues per head have almost doubled to close to $700,000 (£345,000, £510,000). Operating profits per head have almost tripled during the same period to just over $300,000.
A 2006 McKinsey study of US firms suggested that productivity was stalling after market growth was taken into account. The latest global data shows growth rates slowing, suggesting this stall is real.
Even so, the annual growth rate on net profits is still around 30 per cent. This is not Armageddon by a long way, and firms are already aware that revenues are becoming harder and harder to grow.
Revenues per head seem to have peaked after allowing for market growth (at a very conservative 5 per cent). There are some early warning signs here.
Firms will need to keep their fingers firmly on the compensation and productivity pulse.
People costs are now 64 per cent of all costs for a typical asset management firm that has revenue sharing plans in place for investment and sales personnel.
Such plans are now the norm since the advent of hedge funds and the business imperative to launch alternative products.
There is little doubt that firms have been good at controlling costs and are getting better, albeit helped by market growth.
The data also indicate that fund managers are earning more than they have ever done if they can achieve "high alpha". The average amount of performance fees paid out by each firm increased by 14 per cent in 2006. Sales commissions also went up 30 per cent in the same period.
How can increasing compensation in real terms be compatible with a cost control culture?
The key to this paradox is that these compensation plans are truly performance-linked: the firms only pay if the revenues are generated.
The industry's emphasis on performance is bearing fruit, allowing costs to be controlled, and the key revenue earners get fantastically well paid if they deliver. This seems to be a good deal for all the asset management stakeholders - pension fund members, shareholders and employees.
But can it last? Of course not. The key questions are, how long can firms maintain this, and what should they do to be the winners when the market turns?
Two essential elements for success are never to share management fees (a few firms do), and to gradually reduce the percentage of performance fees that are shared (50 per cent is too high).
It is also important to keep a close eye on the following metrics, which are highly correlated with increasing profitability:
* Variable compensation as a percentage of fixed compensation
* Cost-income ratio
* Revenues per head
* Operating profits per investment professional.
One of the biggest challenges facing asset managers is managing the increasingly large disparities in pay (fund manager pay shows a seven-fold difference between the best and the worst) while at the same time trying to build a sustainable corporate culture.
Because these disparities are (or should be) based on big differences in performance, a transparent approach to compensation decisions is not only more effective but is now essential. The old days of relying solely on discretionary decisions are long gone.
Alternatively, some firms now prefer to acquire or set up separate boutiques with varying compensation strategies.
This partially avoids the complexities of managing pay disparities and also solves some of the compliance issues involved in mixing absolute return products with benchmark funds.
(Richard Parkhouse is managing director of
remuneration specialists)
-- FT Syndication Service
Fund management firms had a great year in 2006.
The latest research on global fund management shows operating profit margins are at record levels, while cost/income ratios are at their lowest recorded level. And even though performance-based pay went up by 21 per cent, the relative amount of profit paid away to employees went down by 15 per cent because assets under management, revenues and profits were all significantly up.
Firms are now spending around 30 per cent of operating profits, and 45 per cent of net profits, on incentives for staff.
Successful fund managers delivering "high alpha" are earning record amounts. So is everyone a winner in this virtuous circle?
All the indicators are favourable on first sight, but what everyone in the industry wants to know is: how sustainable are these trends and are there any underlying issues that are being masked by buoyant market conditions?
Employee productivity has certainly increased significantly over the past five years to a position where revenues per head have almost doubled to close to $700,000 (£345,000, £510,000). Operating profits per head have almost tripled during the same period to just over $300,000.
A 2006 McKinsey study of US firms suggested that productivity was stalling after market growth was taken into account. The latest global data shows growth rates slowing, suggesting this stall is real.
Even so, the annual growth rate on net profits is still around 30 per cent. This is not Armageddon by a long way, and firms are already aware that revenues are becoming harder and harder to grow.
Revenues per head seem to have peaked after allowing for market growth (at a very conservative 5 per cent). There are some early warning signs here.
Firms will need to keep their fingers firmly on the compensation and productivity pulse.
People costs are now 64 per cent of all costs for a typical asset management firm that has revenue sharing plans in place for investment and sales personnel.
Such plans are now the norm since the advent of hedge funds and the business imperative to launch alternative products.
There is little doubt that firms have been good at controlling costs and are getting better, albeit helped by market growth.
The data also indicate that fund managers are earning more than they have ever done if they can achieve "high alpha". The average amount of performance fees paid out by each firm increased by 14 per cent in 2006. Sales commissions also went up 30 per cent in the same period.
How can increasing compensation in real terms be compatible with a cost control culture?
The key to this paradox is that these compensation plans are truly performance-linked: the firms only pay if the revenues are generated.
The industry's emphasis on performance is bearing fruit, allowing costs to be controlled, and the key revenue earners get fantastically well paid if they deliver. This seems to be a good deal for all the asset management stakeholders - pension fund members, shareholders and employees.
But can it last? Of course not. The key questions are, how long can firms maintain this, and what should they do to be the winners when the market turns?
Two essential elements for success are never to share management fees (a few firms do), and to gradually reduce the percentage of performance fees that are shared (50 per cent is too high).
It is also important to keep a close eye on the following metrics, which are highly correlated with increasing profitability:
* Variable compensation as a percentage of fixed compensation
* Cost-income ratio
* Revenues per head
* Operating profits per investment professional.
One of the biggest challenges facing asset managers is managing the increasingly large disparities in pay (fund manager pay shows a seven-fold difference between the best and the worst) while at the same time trying to build a sustainable corporate culture.
Because these disparities are (or should be) based on big differences in performance, a transparent approach to compensation decisions is not only more effective but is now essential. The old days of relying solely on discretionary decisions are long gone.
Alternatively, some firms now prefer to acquire or set up separate boutiques with varying compensation strategies.
This partially avoids the complexities of managing pay disparities and also solves some of the compliance issues involved in mixing absolute return products with benchmark funds.
(Richard Parkhouse is managing director of
remuneration specialists)
-- FT Syndication Service