Scaling up anything in the services business is a great challenge, more so in the investment management business, where nothing stops the primary asset from walking out the door. Indeed, that is how legendary names in the business made a name, not to mention their fortune: by hanging their own shingle. Citadel’s Kenneth Griffin was an exception, starting right in his dorm at Harvard. In this panel discussion on ‘The intangibles of building a great hedge fund’ at the Milken Institute’s Global Conference 2015, moderator Ilana Weinstein asks Griffin, Jason Karp of Tourbillon Capital, Alex Klabin of Senator Investment Group and Gideon Berger of Blackstone the secret to successfully scaling a hedge fund
Weinstein: When we think about hedge funds, we often think of many players in an industry that has proliferated quickly. What might be surprising, though, is just how concentrated this industry is. There are almost 5,000 actively managed hedge funds, but only 11% manage 92% of the assets in this industry. This amounts to $2.8 trillion of the $3 trillion under management. Jason, I will start with you because you are the unwitting author of the title of this panel. Jason and I met a few months ago and he said to me, “Hedge fund managers focus on products and they focus on returns. Shouldn’t people be an asset class?” What did you mean by that?
Karp: I meant that in our industry, people spend more time on stocks than they do on people. With stocks, you can sell them. You can get out of them. With people, it is a bit more complicated. In my 17 years of doing this, what I have discovered is that if you invest in them properly, they have more duration, more yield and more optionality than any stock that I have purchased. I find it ironic that most of the people in our industry spend so much time studying individual investments and looking for upside and downside asymmetry. And yet there isn’t enough focus on how much reward you can reap from investing in people.
Winner takes all
90% of assets are managed by 10% of hedge funds
Weinstein: So, I am assuming that that is the differentiating philosophy that led, in part, to Tourbillon’s ability to scale as quickly as it did. Not to not mention, performance. It goes without saying that you can’t get and stay in that 11% without outperforming your peers over time. But it is also true that time and again, we have founders coming to our office. They have been out 4-6 years, have a great track record and just get stuck at a couple of hundred million. Ken, what do you see as the key variables outside of performance that lead to a hedge fund’s ability to become an institution and a magnet for capital?
Griffin: You spoke about the manager who’s stuck at a few hundred million dollars and can’t grow. That is actually not atypical because many managers don’t aspire to run a complex organisation. They are incredibly focused on the joy they derive from investing directly in companies.
And so, what you might think as being stuck, they think of as being a very healthy business that meets their personal aspirations. I think the more important question is why are some managers focused on building platforms and having a variety of teams around them, such as we do at Citadel. I think some managers, such as myself, really do enjoy the art of investing, but quite frankly take great satisfaction and pleasure at building a business. And building a business means you have to think about issues like attracting, developing and retaining great talented professionals.
Weinstein: Gideon, part of your oversight is finding new managers. Alex and his co-founder Doug were analysts at York when you gave them capital. These guys didn’t have a discernible track record. What did you see in Alex and Doug that led you to believe that they will be able to get to $10 billion when so many others aren’t able to get that point?
Berger: Alex and Doug are examples of great success. They don’t all work out that way. But there are certainly some things we look for, and Alex and Doug have them. We ask, what are you trying to build and why are you trying to build it. I think that a lot of people refer to ‘talent’ and the word ‘talent’ is substantially overused; what it really is about is hard work. And the other thing, frankly, is character. It is harder to find people who have successfully navigated adversity and continued down the path that they set out for themselves. So, the two things we focus on the most is commitment to building an organisation, a real determination to do it and a character that suggests that they can withstand adversity. Then, there are a whole bunch of yardsticks in terms of basic capabilities. But, frankly, there are a whole bunch of people who went to Wharton who wouldn’t make the cut.
Weinstein: Alex, there are plenty of very smart people who are attracted to this industry, but their returns are not so great. Apart from the obvious things, what are some of the magic ingredients that you need to be one of the greats?
Klabin: In my view, good investors make analogies. They don’t just make good investments. We use analogies a lot for two reasons. One is, we use them in our process to help us identify patterns and anomalies to generate ideas. We also use analogies to communicate how we invest to our clients. I will give you an example of the power of analogy. If I told you that an acre of land was 43,560 sq ft, you might forget that tomorrow. Some of you may have already forgotten that. If I told you that an acre of land was approximately the size of a football field with the end zones cut off, you might never forget that. So, great investors — in my view — are able to distill complicated ideas and situations down to the one or two things that really matter and then make an analogy in their head to distill what the core of the investment is.
Weinstein: Do you think there is an art part to being a great investor, because you are one of the greatest?
Griffin: In every one of our businesses, there is a science and there is an art. The science is usually the process and hard work that goes behind every investment decision. But you use that to assimilate information about how the company is progressing and how the business is unfolding or developing. If you are really good, then you have a perspective on how earnings are playing out, what guidance might look like.
But at the end of the day, the art comes down to not how well you can do all that work, but how well you can differentiate your idea from what other people perceive the reality to be. You are successful in this business when you have a differentiated point of view and the market agrees with you when the information you have becomes known by all. That is really the art in this business. It is understanding how the market is going to incorporate the information that you have that others don’t have.
One of the common mistakes people make when they are young is that they say, “This company is going to have blowout earnings. The street says they are going to earn 50 cents, my sheet says 55 cents.” The company announces 55 cents and the stock goes down. Because you are not aware that other sophisticated investors have done the same work and estimated 56 or 57 cents. For them, it is a disappointment.
So, you need to take a step back from all the hard work you have done and have the ability to understand how other investors will respond to this information when it becomes known. That is the art to the business. It is a tough art.
Weinstein: Gideon, you allocate to plenty of funds. When a fund has a difficult performance, what are the things that keep you from redeeming?
Berger: Well, actually, it is no different from a fund having great performance. Past performance is not an indicator of future return; it depends on the specific strategy, etc. But there are a lot of things that go into performance that are very independent of talent. So, what we try very hard to do is very explicitly write down our investment thesis going in. Why are we making this investment? Where do we think the edge or the opportunity comes from? Whether it is a top-down view of the environment or a bottom-up view of the way this person or a group of people make money? We fast-forward a year and hopefully, you are reflecting a lot less on performance than on how the thesis has played out. If the thesis is playing out but the investment isn’t working out, that is actually potentially an opportunity to add money. If the thesis isn’t playing out but you are making money, that is called good luck, which is probably better than bad luck. But it is not a repeatable strategy that will hopefully call for redemption. I think you are trying to separate why you are making an investment from the outcome, although over periods of time we are all investing for outcome, but over a shorter period of time, separating investment from results is very important in order to have discipline while investing your money.
Weinstein: I want to go deeper into what are the unique challenges of managing the kinds of people the hedge fund world attracts. I am reminded of a conversation that I had with a client, who said I am bringing in an NBA head coach to talk about how to motivate and get the most out of people. He said, “This is nothing to do with basketball and everything to do with psychology, discipline and organization.” He went on to describe the three analogues — One, an NBA head coach has to manage 20- to 30-year-olds who are wealthy enough to choose not to play. Each player was the captain of his college team but now has to work at the NBA level as a cohesive team. Three, the next season, all teams start with a score of 0:0 and the coach has to come up with a new bag of tricks to keep it fresh. What do you guys do to attract, retain and keep it fresh for the people who get the best seats in our industry?
Klabin: Culture is really important in our industry, as we manage a people’s business. In my view, culture is a combination of the values that are important to your firm and the rituals that you use to reinforce those values. The values that we have as a firm are based on the fact that we are inwardly collaborative and outwardly competitive.
I am thinking of a couple of stories from the great basketball coach of North Carolina: Dean Smith. He did two things that were really awesome. One was to emphasise process, that process matters more than outcome. He would break his squad up into two teams and have them scrimmage against each other. He wouldn’t keep track of points for players who scored a basket. That was not what determined points. What determined points for Dean Smith was: did you take high-probability shots or low-probability shots. So, if you are a player that took a three point shot off-balance when somebody is in your face, even if you scored a basket, he wouldn’t count it. But if you passed the ball to a player who had an open approach and made a layup, he would count that because that was a high-probability shot. He even had points for blocking, assists, etc. So, he really wanted to emphasise to his players that process matters and that is what wins games. The other thing that he did was that he created a rule called point-to-pass, where every player who scored a basket would point to the player who gave him the assist. That simple gesture was a really strong statement about togetherness, teamwork, humility, selflessness, etc. For me, creating a great culture is all about the values that you believe in and the rituals that you use to reinforce those values.
Weinstein: Jason, what are some of the attributes of the most successful hires that might not be so obvious and what are some of the unexpected red flags that you have learnt to watch out for over time?
Karp: I was with three firms before I started my own firm. I had several managerial positions where I interviewed and managed or indirectly managed hundreds of people. There were a lot of things that I learnt that were counter-intuitive about people, particularly in this business. One of the things that we have done to get around that counter-intuitive notion — and I actually learned this two firms ago — is that we actually administer a 3-step personality test that is conducted by a former CIA interrogator.
One of the things that we screened for, and it shows up in all of the analysts we have hired, is a variable called openness to change, and it is the single-most important variable we screen for. Openness to change is how well you are able to change your mind when you are presented with conflicting information. That, combined with grit, are the two factors that I seek the most. I actually like to find people who have had a spectacular failure in their life and have gotten through it. The challenge for us is to recognise if they learnt from that failure or is it symptomatic of a deeper issue.
We generally bucket hires into three categories. We have excellent candidates, dangerous candidates and we have nuisance candidates. Excellent candidates are the candidates that have some of these variables. They are very open to change, they are very resilient, they have done a lot of diverse activities in their life that shows that they are overachievers and like to win despite the odds. The dangerous hires are the ones that are actually the most brilliant people. The dangerous hires are the ones who are so brilliant that they think that everything they believe is correct. There is no way they think they are wrong. When they are presented with conflicting information, they don’t change their mind. They are impervious to pain. So, they are reckless. Sometimes, they are reckless in their social life. In our business, you are not supposed to connect social life with business life. But I find it to be irresponsible not to look at both. Because if someone is reckless in their personal life, it is highly unlikely that they are not reckless in their business life.
The nuisance hires are where I erred the most in my early hiring. I tend to like to hire neurotic people. I am neurotic. We have several forensic accountants. We have several people who are very high on attention to detail. Details are extremely important in the investment business. What we found was that sometimes when you hire someone who is too neurotic, all they are is a drag.
Weinstein: Ken, what is the most surprising thing that you have learned about people from managing people?
Griffin: There are some important lessons that I have learnt about human capital. Number one is coach your stars. Don’t waste your time on team members who are fair, let them sink or swim on their own merit. If I can get 10% more out of my best colleague, that makes a huge difference to the success of Citadel. But If I can get 10% more out of somebody in my bottom decile, it doesn’t move the needle. So, one of the most important things that I have learned from managing people is that I have to spend the vast majority of my time with individuals on my team who really have the highest potential.
We are in business to maximise the returns of our shareholders and my time is best served by really trying to get the 10 or 20% more out of the top decile. That is one of the biggest things I have learned about managing human capital. I had learnt some 15 years ago from someone who had coached the senior leadership of Goldman Sachs. We are a big fan of coaching. But we are really thoughtful of where we put our resources. We put it against the very best and brightest with the greatest potential in our organisation. The second reality is the reality that we are going to have turnover. You can’t be in denial and we have accepted it.
In much of our business, success comes at being not good at what you do but extraordinarily good at what you do in a very narrow range of activities. You could be a healthcare portfolio manager at Citadel because you hugely understand the biotechnology of the products that you have invested in. The problem is that when really smart people do the same things for 20 years, they burn out. There are no ifs and or buts about it. What makes people so good and so smart and what makes them burn out is that they get bored. We need to deal with the reality that we have to take on new challenges that reignite their passion for what they do. We need to have a mature conversation that it is time to do something else in life.
Weinstein: As organisations get bigger and it gets more crowded at the top, it is challenging for managements to figure out how to give somebody that new challenge. How do you implement what you are saying?
Griffin: We are a $25-billion asset manager in an industry with ₹3 trillion of AUM. That is about a 1% market share. In most parts of our economy, a player with a 1% market share would be irrelevant. If you come to my office and say, “I don’t have any room for growth”, I would think you are out of your mind. I think the real issue here is that the portfolio manager who is good at healthcare, who wants to go and do something different is looking at a material step back in their career. It is hard to shift from A to B. The person who runs our global energy business ran a credit correlation business at Deutsche Bank in the 2000s. He built it from scratch and made it the market leading firm in credit correlation. I tried to recruit him to Citadel in 2005-2006.
He said, ‘Ken, this is interesting, but to be clear, I already built a preeminent shop in the world. When you have something new, give me a call, I would be really interested.’ Then in 2007, I called him up and said, ‘I would like you to do something completely different from what you are doing today. I want you to trade oil, natural gas and power.’ He said, ‘Are you kidding me?’ I said, ‘No. You are the brightest guy that I ever sat across the table from. I think you will be great running this business for us. You said if I had something new, you’d be open to it.’ In 25 years, I will see only a handful of people that have the talent and the audacity to take on a new challenge. He has been incredibly successful with it. That is a very rare person who did at the pinnacle of their career; it is like Michael Jordan deciding to play baseball.
Weinstein: Gideon, how do you assess turnover from the outside looking in?
Berger: Turnover is good. A lot of it gets talked about it as if it is something to be avoided. It is healthy because it creates white space and it is healthy because we make mistakes in hiring. It is healthy because people do burn out. Look, when you are making an investment in a hedge fund, there are obviously a certain set of people that are core to the hedge fund and if there is substantial turnover among them, that is problematic. But a healthy level of turnover in a hedge fund is a natural evolution that I would hope to see, not only expect to see. I think that when it comes to talent mentoring and talent development, the problems never go away. We rarely see situations or problems get fixed. Dedicating a lot of time and energy as a founder or senior member to try and fix problems is not a good use of time. Those who get rid of those as quickly as possible, generally do better.
Weinstein: Ken, it is not that easy to attract, retain and cultivate all the things we are talking about. How did you build this organisation on the go when you had no blue print and no beta testing?
Griffin: History is written by the winners. If you look at the history book at Citadel, there are 20 chapters that we have got dead wrong and edited out. I would say, objectively, there are three things that really define us today. The first was the advice I had from Frank Meyer, who hired me out of Harvard to manage money for Glenwood Partners. I had a single strategy to do bond arbitrage and Frank was quite supportive of this. Frank said, “Look, in life, you don’t want your life to revolve around a single strategy. You want your life to revolve around building a platform that will track the best and brightest across a variety of strategies.” So, that initial vote of confidence from my first investor, my first mentor was really important for me setting my aspiration much higher earlier in life. The second set of events that are important in how I think about the business: the first is that when we speak about cultures of firms, Citadel is a culture of learning. There are a couple of key words that come to my life about Citadel’s culture — team work. You can’t succeed today unless you are part of a great team.
The second part of our culture is that we are a culture of learning. I have always been happy to be surrounded by really bright people with whom I learn and who teach one another. The biggest reason why people come to Citadel and stay is the immense rate of learning that takes place within the four walls every single day. This is very important to make Citadel tick. We get a huge amount of professional satisfaction in knowing that I have learnt something today. I have learnt a lot this week, this month, this year and over the course of five-seven years, I am way ahead of where I would have been in 90% of my alternative career choices. The third part of our culture is Abraham Lincoln’s great quote, “Things may come to those who wait but only those things left by those who hustle.” We hustle. There is a real forward-leaning ethos within our firm. What do we need to do right here right now to get ahead of the next guy?
The third is the fortuitous fact that I decided that I would trade US bonds and Japanese equity bonds when I was just 21 years old. The cool thing about being 21 is that you can stay awake for 16 hours at work. Then, we decided to add Europe into the mix. You can’t be awake for 24 hours. That meant that I had to learn to delegate work when I was very young. That willingness to trust others in their judgements and decisions at such a young age was really pivotal to my career.