When you think about it, the investment management business is one of the weirdest in the world because the two premises an asset manager advances to clients are:

1. I am a fearsomely sharp operator, and even given unlimited competition to provide and use liquidity, I will systematically profit at the expense of my counterparties, and

2. Would you care to take the other side of a deal with me?

More people have gotten rich charging fees for assets under management than paying them, but that's exactly what you should expect. There's a continuum of strategies' return profile: people who talk about capacity constraints (e.g. some niche crypto strategy where you need $100k in capital to make $100k a year, but the next $100k doesn't do anything for you) are often talking about something they run with their own money. Prop trading firms tend to pursue—and in fact, grow around—these strategies. Their constraints are talent and infrastructure, not capital. One step down the ladder, there are strategies that do face these constraints, but at a scale where raising incremental capital still increases returns. A small-cap value investor who could print 50% returns on $1m in capital can still earn more in the aggregate by producing, say, 25% gross returns on $100m in capital (at least, assuming the overhead of managing outside money doesn't eat it—more on that in a bit). In that category, deciding whether or not to raise outside money is a question of whether you think the opportunity is basically permanent, in which case you might prefer to just compound your way to higher assets, or whether it's transient, in which case you're grabbing the upside that you can and splitting the proceeds with your backers. And then there are strategies that are primarily selling exposure to some asset class—large-cap stocks, fixed income, whatever—and trying to add enough alpha on top of that to cover what's likely to be a management fee but no performance fee.

One complication is the compliance-and-IR wedge. There's a big difference between managing your own money and managing someone else's, and an even bigger difference between managing money for one person or a handful of people and dealing with institutional investors. So there can be a case where a strategy works fine with between $50k and $20m in AUM, and would ideally raise the $20m and manage that, but where the overhead cost of actually raising that money more than eats the fees it would pay. This wedge has been growing—one of the reasons the newest generation of suddenly-huge financial firms has more prop traders and fewer hedge funds is that it used to be viable to raise single-digit or low double-digit millions to launch a fund, but today the minimum is higher.¹

You could imagine a story where someone trading their own capital and finding adjacent strategies to what they've already done well eventually reaches the point that it's best for them to take outside capital. As long as their capacity growth exceeds their returns, that's eventually optimal. One problem with this is that it's hard to increase capacity, but a subtler problem is that firms that find themselves in this position tend to have a core business that prints money (it prints variable amounts, but its personnel costs vary a lot with gross trading revenue), so it's actually a decent borrower. One way to look at earning 2 & 20 is that it's incentive-aligned, but another way to look at it is that it's very expensive capital. If you earn a 22% return for your investors and charge them 2 & 20, you're getting about 6% of their AUM in fees that year, but another way to look at it is that you're paying 16% for their capital, which is a lot more than you'd pay for other kinds of capital. The most plausible ways for capacity-constrained firms to expand is to identify longer-scale strategies in existing asset classes (if you've found a good strategy betting on intraday correlations between stocks, you're in a good position to bet on intra-week, intra-month, and beyond; as you expand the return on capital tends to drop, but since your holding period is longer, you have more time to execute trades and won't have as big a market impact). So their incentive is to scale into slower-moving strategies by borrowing, not by letting other people invest alongside them. The usual situation with an entity that has multiple strategies with different return/capacity tradeoffs is that the low-capacity ones are constantly overflowing into the higher-capacity ones.²

Providers of capital are in a tough situation where they face constant adverse selection. For every strategy, they have to answer the question of why someone would let an outsider reap some of the profits, and, further, why they happen to be that outsider. If they back a winner, there's a good chance that they'll be told that they can't put in as much as they'd like, and may have to take some of their capital out. (The losers are naturally quite happy to have them reinvest. 2% of a sufficiently big number is itself a big enough number for many purposes.) There is still alpha in manager selection, but like other sources of alpha it's some combination of temporary, opportunistic, and based on personal networks. There were some very lucky investors who decided that a Midwestern insurance geek who slept with a Moody's Manual under his pillow could produce alpha, or that a mathematician with a theorem named after him could outsmart the median MBA. One way or another, that alpha decayed, and when limited partners got excess returns, it was from the usual sources: a mix of skill and luck, with no aggregate free lunch.

The question of why LPs can get good returns at all turns out to be more interesting if you reframe things so they're in the same business as the people they invest in, just at another layer of abstraction. And there's even some symmetry around which firms need capital and which don't; a building full of EUV machines is more expensive than a building full of accountants or consultants, so the professional services companies tend to stay more private while the asset-heavy companies have to go public. It comes up a lot:

• We've looked at hard-to-scale strategies that seed big companies.

• Sometimes, returns erode because everyone thinks the same way ($).

• Financial products inevitably get democratized.

• Some things that start as novel assets that can support unique strategies end up being just another asset class ($).

• The question of where assets should live is never settled. Consider the case of printers with a subscription attached ($).

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1  There are other reasons: the tax code used to have high nominal rates and extensive discounts, and has slowly shifted towards taxing people amounts they won't go to endless lengths to avoid paying. So feeder structures, engineering tax losses on one leg of an offsetting trade, wrapping the entire fund in an offshore reinsurance company, etc. could all defer taxes and ensure that they were treated as long-term capital gains when they finally arrived. Most of the loopholes have been tightened (or, at least, the people who found the new ones are less chatty than the previous generation). So the natural holders are overseas investors and nonprofits. It's interesting that changes in the financial system and tax code mean that the hedge fund LP base used to be mostly high net worth Americans, but this cohort now gets the worst tax treatment; for tax-optimization reasons, it's a much better deal for a public school teacher to be an investor in a hedge fund through their pension than for a wealthy American to invest in the same vehicle.

2  Renaissance Technologies launched as a hedge fund but evolved into a proprietary trading firm by slowly cashing out its external investors. It still has limited partners who don't actively participate in the fund, but they're retired employees who are also slowly being cashed out as the people who work there accumulate money. Warren Buffett's early career is also interesting here: he had a fund he managed, but also had outside investments in less liquid companies. In Buffett's case, he eventually rolled much of this into the main fund, because it demanded too much of his time to run two portfolios at once. Since Buffett was earning the same returns his investors were, but also earning fees, he ended up representing a growing share of the fund's capital. After he wound it down, he still had outside investments, and filed the occasional 13G on little REITs and the like. As much as VCs want to be ahead of the curve, Uncle Warren was getting quick markups on low seven-figure investments in Gundo-based tech companies a quarter-century ago.