Interesting article in Bloomberg yesterday on how hedge funds in Hong Kong are being squeezed out of Central as a result of higher rents coupled with industry-wide fee pressures. Apparently, more funds are now moving their offices out to suburban areas such as Wong Chuk Hang, Cyberport and Tin Hau because of affordability and unit economics concerns.

According to data from CBRE, Grade-A office rents in Central rose 8.7% last year, driven by lack of new supply and increased demand from mainland Chinese businesses, which now account for 42% of newly-leased floor area in the district. Rent is typically among the two largest expenses for fund managers in Hong Kong. The other is, of course, compensation. The third major cost is regulatory compliance, which has increased significantly for funds in recent years and, like rent, is a fixed cost.

At the same time, the economics of the fund management industry is changing. The emergence of lower cost substitutes (e.g. index funds) and a sustained period of underperformance by many active managers have reduced the willingness to pay from the perspective of both retail and institutional investors. Fee structures are not only moving lower but will also be weighted more towards performance going forward, as they arguably should be.

The net result of all these forces is that scale, in terms of AUM, is now increasingly important for the economics of the fund management business to work. Smaller funds, for example those managing <US$100m in assets, will find it difficult just to get to break-even, especially in high cost Asian cities such as Hong Kong and Singapore. One might argue that it will be only the big funds who survive but they face their own issues in that size is often the enemy of performance, which is likely to exacerbate the fee pressure dynamic.

A few other thoughts, in no particular order:

• This is really not as big a deal as the article makes it out to be. Fund management is a business like any other and, at the end of the day, the economics have to make sense. Fund managers also tend to be very critical of [investee] companies with bloated overheads, so there’s no reason they themselves can’t adjust downward. I don’t really buy the “struggle to attract talent” argument.
• By the way, simply solving for lower rental costs doesn’t completely solve the problem. As discussed previously, the other big cost driver for funds is staff compensation, both fixed and variable. Variable compensation might be a function of performance, but what is the driver of fixed compensation? I would argue that it’s still real estate, on a look-through basis. Salaries are high in Hong Kong because the cost of living there is high and the biggest portion of living costs is rent. So you can have your offices in Wong Chuk Hang, but your staff still want to live, for example, in the Mid-Levels.
• Ultimately, smaller funds may find that the solution lies outside of cities such as Hong Kong and Singapore. Everyone seemingly wants to live in the tier-1 global cities today, but this may be based more on the perceived rather than actual quality of life. That demand may decrease over time as the quality of life in other Asian cities improves and there is access to better career opportunities. Also, if you’re living month-to-month (not literally, but this mindset is not uncommon even for high income people living in tier-1 global cities), it is difficult to believe you can really take a long-term view at work. So re-basing to somewhere lower cost and quieter may even help performance over time. To be clear, however, there are still significant advantages to being in a Hong Kong or Singapore – for example, regulation, tax policy, branding benefits, ease of access to/for investors as well as the proximity to an ecosystem service providers. These factors won’t go away anytime soon but they might not be enough in the longer term.