An Intro to Buy-side Institutions

I worked in the buy-side during the GFC but since our fund’s IRR struggled to meet LP expectations, and so our AUM didn’t support our headcount and I was out of a job.

Did that prior sentence make any sense to you? If so, great, I’ve been able to confess one of the sadder moments of my life to you. If not, don’t worry, we’ll explain it here! It all revolves around the concept of the buy side.

The buy side is made of up of, you guessed it, institutions interested in buying things. But what are they interested in buying?

In the finance and investment world, buy-side institutions are interested in buying investments. Most often these are company-related assets, such as company stocks or bonds, but they can also include government bonds, commodities, and much more.

Generally speaking, the job of an analyst at a buy-side institution is, through extensive research and financial modeling, discover undervalued assets that they can then purchase with a high degree of certainty that their value will increase.

By contrast, investment banks are considered sell side because they are focused on helping consummate a sale. People will use “buy-side” and “sell-side” in conversation often:

• “I’ve been on the sell-side for years and I’d love to try my hand at the buy-side”

• “Is this conference being arranged by a sell-side or buy-side shop?”

• “I’m a sell-side analyst”

Of course, not every buy-side fund is created equal; there’s a whole range of players with varying strategies, openness to investors, and governmental regulations. Below, I break down five of the most recognizable types of buy-side institutions (who also happen to be some of our biggest clients!)

Mutual Funds

Mutual funds are professionally managed baskets of stocks. Instead of investing in a single idea (“I like Tesla”), you can invest in a manager who has shown a consistent ability to outperform the market.

One of the main reasons to invest in a mutual fund is the diversification offered, which helps dull the blow of drops in any particular stock that you buy directly as mutual funds generally have hundreds of company stocks in their portfolio. Investors also receive peace of mind knowing that their money is in the hands of seasoned industry professionals.

We affectionately refer to investors in mutual funds as “doctors and dentists”. That should give you an idea of who typically uses this investment vehicle, though some larger institutions may invest in such funds from time-to-time.

Mutual funds are good old-fashioned buy-and-hold pools of capital. They charge anywhere from 0.5 to 3% of assets under management to buy a basket of stocks.

The managers of mutual funds are very visible and have been around for decades: Fidelity, Vanguard, Capital Group. They are distributed and sold either directly (open up an account on fidelity.com) or through brokers (walk into an Edward James office and get an investment manager).

A key distinction in this industry is active versus passive mutual funds. Ask me in the comments if you want to know more about this.

Hedge Funds

These funds are the opposite of tame. Hedge funds are notorious for their uninhibited trading strategies and lack of traditional trading regulations that offer greater reward (and risk)lax governmental regulations; they’re also regularly blamed (unfairly, IMHO) for the 2008 stock market crash and make newspaper headlines thanks to lavish house parties and pharmaceutical scandals.

However, there’s a reason that hedge funds still managed over 3 trillion USD at the end of 2017: they make their investors money. In the U.S., investors are only allowed to invest if they meet a certain annual income (normally seven figures and up) or possess a high enough net worth. This is officially known as being an ‘accredited investor’, which I was before I went down the entrepreneurial route! Such requirements are in place to prevent so-called “Main Street” investors from losing their money.

One of the greatest differences between a hedge fund and, say, a mutual fund is the use of leveraged, or borrowed, assets. This allows these funds to expand their capital base to potentially increase their return on investment (with amplified risk). Hedge funds also have the option to short stocks, which allows them to make money even while the market drops.

They are also able to invest in not just stocks and bonds but pretty much … anything. Derivatives, sports teams, cryptocurrencies, you name it. We recently hosted an entire webinar on hedge fund strategies just last week, so be sure to check that out if you haven’t already.

Family Offices

As the name belies, family office institutions are responsible for managing the financial assets of high net worth (HNW) or ultra high net worth (UHNW) individuals and families. For smaller families, this could constitute just a personal assistant to help manage finances. For larger UHNW families (think Rockefeller or Kennedy level), this could mean a whole suite of finance professionals, lawyers, and stock portfolio managers. Certainly not accessible to most, these smaller investment institutions still manage a sizeable portion of investments for their clients.

A key concept here, alluded to earlier, is assets under management (AUM). Depending on the AUM, a small family office might resemble a mutual fund. They buy and sell stocks and might make a few private investments. A family office with a large AUM could resemble a hedge fund or a private equity firm.

Indeed, one of the world’s most famous hedge funds had to turn into a family office after regulators found them guilty of insider trading (they’ve transformed into Point72 Asset Management).

Venture Capital

This might be the most glamorous kind of investment firm. The capital refers to the money that these firms invest in their target companies, which tend to be small businesses with high growth potential.

Where does the money for venture capital investing come from? Typically, venture capital funding comes from investors in a venture capital fund or individual HNW individuals (commonly referred to as angel investors); some companies even have their own venture capital funds. Example: Cadence’s very first institutional investment was from a venture capital fund called 500 Startups.

For their venture capital, what do these firms and angels get in return? Equity in, or shares of, the company they provide capital to. It’s a fairly straightforward exchange.

Private Equity

Private equity funds are simple to understand: they either buy all the shares of a public company (“take-private”), or they provide growth financing for a private company that has outgrown venture capital.  The global private equity industry started 2018 with over 1 trillion dollars of capital available to deploy.

These firms use this money strictly to invest in shares of businesses, frequently (but not always) taking control in an attempt to improve the company’s value at an increased rate. When this works, the benefits to the private equity firm and its investors are enormous.

But much like Galadriel’s warning to Frodo, “Stray but a little, and it will fail, to the ruin of all.”, if the investment falters ever so slightly, the downside to private equity firms is enormous. Why is this? L-E-V-E-R-A-G-E.

The investment thesis for a leveraged buyout (LBO) is entirely predicated on a firm being able to service its debt. This is a topic for a much longer blog post, but just remember the key point is that upside can be tremendous while downside can be ruinous. There are very few in-between scenarios.

Unlike venture capital firms, private equity firms invest in larger, more established companies that they believe to be underperforming. After a period of time in which the company grows substantially, they seek to exit with a tidy profit, either by selling to another buyer or through an IPO.

As an investor in private equity, you’d have very limited liquidity when it comes to your investment capital; you wouldn’t be eligible to see the fruits of your investment until after the fund manager has successfully exited a company and returned profits, minus a management fee. This typically includes a 2% management fee and 20% of the profits from the sale or IPO, referred to as the “2/20” fee structure.

There are some extremely high-profile examples of private equity successes and failures. I also recently hosted a webinar on leveraged buyouts, so you'll definitely want to check it out if you're interested in learning more!