For a while, boutique fund managers were flavour of the month. They were exciting new businesses that offered the promise of above average returns, in funds management slang called 'high alpha', and the chance for those in charge of distributing the vast flows of superannuation money to show off their knowledge of the industry. But then the global financial crisis (GFC) hit and the exuberance disappeared along with the abuse of Greek letters.

The crisis caused many to pause and ask whether managers could really deliver on the hype. As a result, boutique fund managers today are subject to far greater scrutiny than in the pre-crisis years. It is not so much their ability to make money that is being questioned, but how they set up their businesses.

It seems ironic that professionals who are well-versed in dissecting companies and ask managers who run multi-billion-dollar corporations tough questions about strategic decisions would not be able to head a business venture themselves, and looking at the chain of events that lies behind the demise of a fund manager a much more complex picture emerges.

For some sectors of the market the GFC was so savage that no matter how good your business was the ride you were facing would almost certainly be fraught with peril.

Fortitude Capital managing director John Corr was one of those managers who saw their funds under management (FUM) dwindle despite having a sound business model.

It is somewhat ironic that Fortitude's flagship fund got its edge from its ability to withstand any type of market conditions, but as it turned out, the hedge fund's performance was not the problem.

"Over the 5.5 years of the existence of the fund, we've averaged about 10.5 per cent returns," Corr says.

"During the GFC we did have some negative months, but the biggest drawdown was 0.6 to 0.7 per cent."

As the fund built up a track record, it attracted more inflows and grew from $2 million in 2004 to about $200 million before the crisis hit. But the fund's client base consisted almost completely of international fund-of-fund managers and as investors started to panic the redemptions started to pile up.

"We have seen large redemptions from offshore as fund of funds withdrew from Australia and some went out of business," Corr says.

If not for BT Investment Management, which kept its money with Fortitude, the company would have shut down.

"We've spent the last year trying to look at different ways of promoting our fund locally," Corr says.

"We needed to go from being a somewhat inward looking firm to having a more external approach and find new clients and prove that we have a process that works in all types of markets."

Fortitude has now teamed up with Aurora Funds Management and Sandringham Capital and is looking to list the merged business on the Australian Securities Exchange.

Corr says a merger with Aurora would give the firm access to the retail market and he already has a number of clients lined up if the deal goes ahead.

If the crisis made one thing clear for investors, then it was the importance of defining the business risk inherent in fund managers.

Standard & Poor's Fund Services (S&P) was one of the research houses that realised this should play a larger role in the rating of products.

It came up with a questionnaire that grilled investment managers about their plans to deal with the reduction in revenues.

"During the GFC we spoke to the boutiques, as well as the large fund managers, about how they were going to manage through that period, so that is when we brought out our first business sustainability questionnaire," S&P head of fund research Leeanne Milton says.

"We were very keen to understand what kind of backing they had for those that were very new or had profitability issues. Did they have parent company support or did they have backing from investors or what was it that was going to get them through that period?"

Not everybody appreciated the additional questions, Milton says.

"It took some encouragement to get some of the fund managers to respond to us. They needed to understand it was part of the ratings process and that if they didn't respond there was the potential for rating actions to occur. They understand now that if they don't answer that we will be asking some serious questions," she says.

Milton is not just talking tough. The responses from the questionnaire led the research house to construct a list of 12 managers that were flagged as problematic, and ultimately two downgrades were issued. She does not name the funds in question. S&P is restricted in the information it can provide due to confidentiality agreements.

"We weren't explicit in the actual report. From our perspective it was part of the overall confidence in the manager if they were able to manage the money going forward, but it was definitely something that had an effect on the actual rating," Milton says.

S&P has decided to make the questionnaire an annual survey and will shortly issue a new questionnaire, which has been expanded from 21 to over 50 questions, including questions about cost-cutting measures and future strategies.

"We will actually be a little bit more explicit in our fund reports this year without breaking any confidentiality agreements," Milton says.

Fund managers have clearly noticed the increased scrutiny on their businesses. Australian Unity Investments general manager of institutional and joint ventures Adam Coughlan says the additional questions initially caused some confusion.

"Our boutiques came to us and said: 'Why are we being asked all these questions? We have never been asked them before,'" Coughlan says.

Bennelong Funds Management chief executive Jarrod Brown agrees.

"Throughout the GFC and beyond, the level of due diligence undertaken on the ownership structure and corporate governance has been higher," Brown says.

"You can't be a Bloomberg screen, a desk and a couple of chairs."

Pengana Capital chief executive Russel Pillemer says the one-man-show firms are now a relic of the past.

"In the past, the fund manager was also the chief financial officer, did the marketing, et cetera. Investors don't want to see the people who run the money to be the same ones who are running the business. There is now a huge focus on the operational side of the business and there should be a separation of roles," Pillemer says.

Building scale

The increased scrutiny from research houses is only one part of the equation.

Additional pressure on boutiques has come from platforms, which have tightened their listing requirements and demand a certain level of guaranteed revenues before they add a new fund to their systems.

Yet in a cynical kind of way, the financial crisis was probably the best thing that could have happened to the boutique industry in Australia, for what has resulted is a sector that is cleansed of accidents waiting to happen and has left solid and reliable investment houses in its wake.

This baptism of fire combined with the fact that an increasing number of boutiques have now built up a multi-year track record has brought an unparalleled confidence to the sector and, along with that, inflows.

"It is the case that the willingness to commit funds has increased," Treasury Group executive director David Cooper says.

"The concept of boutiques has become easier and allocations to boutiques are getting better."

Super funds are at the forefront of this development and now have healthy allocations to boutique fund managers, Cooper says.

However, the inflows from financial planners are still quite low, although these are also showing signs of improvement, he says.

"The allocation by financial planners is getting better," he says.

Partly this is the result of more analysts issuing reports on these funds.

"Research houses are more resourced to cover boutiques than in the past. Six to seven years ago a research house wouldn't research them, but now they are mainstream," Cooper says.

Brown says: "It feels like the [retail] market has opened up a bit, but I don't have any absolute examples."

Bennelong Funds Management has raised about $800 million in FUM so far this year, but it has been virtually all institutional mandates.

"Hopefully, we'll see the retail investor become more active next year again," Brown says.

Yet, there is unmistakably a renewed confidence in boutique fund managers filtering through the financial system, and this is not in the least due to the emergence of a number of boutique backers over the years, which have provided solid foundations for managers to build their business on.

They have supplied the fledgling businesses with back-office, compliance, distribution and marketing services, which enables fund managers to concentrate on what they do best, and their approach is starting to pay dividends.

Treasury Group is one of them, but also the large institutions have played their role through businesses such as Westpac-owned Ascalon, Nabinvest and Challenger Financial Services. They have all been gathering steam and built out their stables of managers to become multi-billion-dollar businesses.

Challenger-backed fixed income manager Kapstream Capital set up business in June 2007 and started with about $300-400 million in funds from Challenger and other clients.

"We are $1.6 billion today," Kapstream managing director Kumar Palghat says.

Palghat says boutiques have made their mark on the industry and are increasingly attracting funds.

"From what I've noticed in the market, I find more people are allocating to boutiques," he says.

He says this is unsurprising because the boutique model has a number of fundamental advantages over institutional fund managers.

"If you look around in debt markets and fixed income markets globally, there are few very, very large players in the marketplace. If you think of PIMCO, they've got $1.1 trillion under management in debt and now they are going to do equities as well," he says.

"Then you have BlackRock, which has got $2-2.5 trillion after the BGI (Barclays Global Investors) merger and then they also advise the Fed (US Federal Reserve), so they got another . well, rumours say $4 trillion or $5 trillion. But the problem that larger firms face is that they have discrepancies in performance among their clients, because they have an incredible amount of mandates, systems and structures. The larger you become, the more dispersion you have among individual investors," he says.

In contrast, the boutique structure is more in line with what clients want, he says.

"The guys have quit their jobs, and most of the guys are specialist fund managers who have done well and no longer want to deal with the bureaucracy of their firms, so they are willing to take a personal risk and put their life on the line and say 'I'm going to back myself and set up a shop of my own'," he says.

 The personal involvement of managers means they have more incentive to keep clients happy, he says.

"As firms get larger [the allocated money] is just a number. If someone gives $100 million to a large firm that has $1 trillion in assets, you are just a number. Whereas you give $100 million to a boutique, it is huge," he says.

Palghat knows about large institutions. He worked for a decade at the World Bank, an organisation with over 10,000 employees and 100 offices worldwide. This was followed by an equally long stint with fixed income manager PIMCO, which employs more than 1300 employees, not counting the staff of parent company Allianz Global Investors.

"You work for large organisations and you see inefficiencies within the organisation and you find it difficult to make actual effective changes to the organisation, so it becomes frustrating after a while," he says.

However, he was also enticed to start his own business by a desire to explore his entrepreneurial side, he says.

"Timing says you have opportunities only at certain times in life to quit your job and take the risk of starting your own company. I felt the market was right; it needed a new product. The industry I was in was a growth industry. I had colleagues who had the skills in that space and we decided we didn't need the bureaucracy," he says.

Palghat has big plans for Kapstream. In the long term, he says he believes there is space for an Asian fixed income fund and he likes the idea of opening an Asian office. But he says the firm has to have at least between $5 billion and $10 billion in FUM.

"You can always dream, right?" he says.

Looking for partners

Boutique incubator Ascalon is another backer that has been gaining scale, but its model is slightly different from that of Challenger. Rather than forming long-term partnerships, Ascalon has more the flavour of a private equity firm.

"Our model is a bit different because we exit businesses as well. We buy and exit businesses," Ascalon chief executive Andrew Landman says.

"We recently exited First Samuel, a private client business, so our FUM does move around. The actual growth of funds under management has actually grown fourfold, but it looks like threefold, because we sold out of assets," he says.

Because the firm's FUM is fluctuating depending on its level of activity, Landman would rather not disclose Ascalon's current size, although he does indicate it is multiple billions of dollars.

Nabinvest investment director Nick Basile says his business currently stands at about $20 billion in FUM, but the size of the division is somewhat distorted by the inclusion of fixed income manager Antares Capital. Antares was originally created in 1990 to manage the fixed income portfolio of MLC.

Today the firm is still 100 per cent owned by National Australia Bank, in contrast to most boutique structures where the main principals hold majority stakes in their business, and continues to manage the fixed income allocation. Antares is good for about $12 billion of Nabinvest's FUM.

The establishment of Nabinvest in October 2007 was a radical shift from NAB's earlier strategy, Basile says.

"If you look at the group, we have got very good exposure to most parts of the value chain, but not in the investment management space because the decision was taken, probably 10 years ago now, that we would get out of investment management completely," he says.

"What has happened is that a couple of years ago we have changed that strategy and created Nabinvest as a way of getting exposure to the revenue stream that comes from this management."

The change of strategy created the perfect opportunity to create an efficient investment business, he says.

"The beauty for us is that we could come up with a clean sheet of paper and determine what the best way forward is. Our view is that the partnership model is a good model, where the people running the money have some skin in the game, have substantial equity and where they partner with a substantial institution, who can offer them back-office services, compliance and distribution," he says.

Nabinvest's model differs from its competitors in that it has more flexibility in the structure of the partnership.

"We don't see ourselves as a boutique incubator, but our early investments probably fit into that space, because you've got to start somewhere. But we could own 100 per cent as well," Basile says.

Having said that, Basile does see the benefits of the fund managers' interests being aligned and his preference goes to owning an interest of 33 per cent to 49 per cent in a business.

As Nabinvest has only been a few years in existence, the inflows have been relatively modest, he says.

"With a new capability you always need a lead time; you need research, get on a platform and then do some heavy lifting to actually get through the door. But flows are starting to come," he says.

"Lodestar [Capital Partners] has been longer in existence and they are getting some good traction," he says.

Lodestar, an absolute return manager, currently stands at about $2.5 billion in FUM.

On the prowl for staff

As boutiques attract more funds to manage, they are also increasingly looking to hire new staff.

"Opportunities within the boutiques are increasing; they seem to be gathering more profile in the market," Profusion Group director Ashton Bilbie says.

"We have certainly noticed more of a keenness on the boutique side for them to see good-qualified candidates with buy-side experience. The market early last year . it didn't seem like the boutiques or even some of the bigger players were really interested in anything. Now that the market conditions have changed somewhat they are becoming a bit more entrepreneurial and looking for the opportunities. These things were not happening 12 to 18 months ago," Bilbie says.

Although good managers are generally not long out of a job, the financial crisis did see more candidates enter the employment market.

"Most of the candidates in this area were returning home from offshore, so we have many candidates that were coming back from Europe and the east coast of the United States," Bilbie says.

An interesting detail is that most of these individuals had backgrounds in managing alternative assets.

"Many of them were hedge fund managers," Bilbie says.

For these fund managers it has been difficult to transition back into the Australian market, he says.

"You did find that many of these individuals had to look at parallel avenues in order for them to continue their careers. It is interesting, because some of them were wealthy enough to come back and work a vineyard for a while. Others had such strong financial skills that they could put their hands to other industries, like private equity consulting work to smaller and medium-size businesses, they might have needed a restructuring, or even a liquidation," he says.

Yet for these managers the market is getting better. A number of investment houses have released long/short versions of their flagship equity fund, such as Arnhem Investment Management, while others have set up completely new alternative products. Bilbie says this has already translated into more roles in the sector.

"We have had more roles for quantitative analysts, for long/short strategies. We've had three or four roles come through in the last month or so, and some of them are to work on new products," he says.

Boutiques are on the lookout for staff, and luckily for them the interest is mutual.

"Boutiques are seen as attractive employers because of the fact that there is the potential for equity," Bilbie says.

"There is also the expectation that there is a greater bonus opportunity. Because the business is much smaller, it is much easier to form the attribution and see how much you affect the bottom line," he says.

"There is also the fact that generally speaking you are working more closely with the head of a business, which facilitates career progression and helps develop the skill set. That is seen as really appealing factors that often people in the bigger houses would be attracted to."

Although equity ownership is a definite carrot for potential staff, salaries are often not the main point of focus, he says.

"I actually think that the base salaries of the bigger players are better, but the smaller players have stronger blue sky on the short and long-term incentives," he says.

He says he expects to see more roles coming up with boutique fund managers in the next 12 months, which will partly be driven by the establishment of new firms.

"I expect there will be more action in the boutique space; more boutiques that will be coming to market in the remainder of this year. This will put more pressure on the analyst and portfolio manager market as the musical chairs starts. I'm definitely expecting the balance of the year for asset management recruitment to firm up for experienced analysts and fund managers," he says.

Regulatory change

Many fund managers expect the upcoming regulatory changes in the financial services industry will impact on fund managers largely by association, and mainly through products that are listed on the platforms.

Yet a few managers see the potential of boutique fund managers benefiting from these changes, as it could create a more level playing field between institutional and boutique fund providers.

"Until all the legislative change is formalised nobody will know the full impact of it, but to my mind, from a funds management perspective and owner of boutique fund manager businesses, we see it as very positive for the industry," Landman says.

"The thing for boutiques is that they struggle because they are smaller businesses and in terms of the ability to pay big rebates . they don't have the same abilities as the institutions," he says.

"I think for boutiques, if you have a good, consistent performance and drive a sustainable business, then you deserve the money flow, rather than if you have bigger marketing plans and bigger rebate opportunities and you can buy shelf space," he says.

He says he believes financial planners have an active role to play in keeping fund managers on track to achieve the goal they have set out in mandates. The change to fee-for-service could assist with this.

"I think the planning community will need to continuously reassess and keep the fund managers on edge for performance returns and achieving the investment objectives that the planner gets the client to buy into," Landman says.

"You don't want the planning community to sit and forget. I you do fee-for-service and you constantly have to look at it and revisit and make sure that the fund managers are achieving the objectives that they said they can, then it is only a good thing," he says.

Cooper agrees with Landman on a philosophical level, but wonders if in practical terms if much is going to change.

"Intuitively it makes sense that without commissions there should be less bias, but [many planners] will still be owned by institutions," he says.