Emerging Hedge Fund Managers: The opportunities and operational requirements
While emerging hedge fund managers might not attract as much capital as their larger, more established peers, they are still an appealing investment opportunity. This is something that has been recognised at the Signet Group – we allocate to firms that fit into this “emerging” bracket.
There is a lot of debate as to what actually constitutes an “emerging” fund manager. Our definition includes managers whose assets are below $100 million or whose track records are less than two years old. Institutional investors like us are increasingly recognising the value of putting cash into such funds. A 2010 report by research firm Preqin reveals that 72% of funds of hedge funds (FoHFs) would invest in an emerging manager while a further 13% said they would consider it. Endowments are also keen on these newer outfits – 66% acknowledge they would allocate capital to these managers. Despite this, established fund managers do attract much more cash than emerging businesses. The HFR Global Hedge Fund Industry Report in the third quarter of 2010 says there was $42.3 billion in capital allocated to hedge funds in the first three quarters of last year. Of this inflow, 90% went to managers with more than $500 million in assets with 75% concentrated in managers with more than $5 billion. Being an emerging manager in the post-2008 world is not an easy feat. Investors are inherently cautious given all that has happened to the industry. Nevertheless, emerging managers are increasingly gaining traction among sophisticated investors - so what is their appeal and what must they do operationally to ensure they attract institutional money?
Since the financial crisis, there has been a growing abundance of emerging managers in the marketplace. The Volcker Rule, which is designed to curb banks’ risky behaviour, has prompted an exodus of talent from proprietary trading desks. The inability of some hedge funds to reach their high water marks or bolster their assets under management (AUM) has also facilitated the transfer of talent. It is for these reasons that we are seeing a surge in the number of emerging managers out there. Not only is there a steady stream of these emerging managers, many are also outperforming their established peers by generating higher returns. Emerging managers’ annualised returns stand at approximately 9.49% - compared with 7.61% for their more established counterparts, according to the Neuberger Berman 2011 strategy outlook report. These young guns do after all need to generate returns through their performances to survive and ultimately grow their businesses. Established funds do not always seem to have this motivation. The Neuberger Berman report highlights this point well: “Underperformance of a few, high profile hedge funds has demonstrated that sizeable AUM is not necessarily better or safer. Generally, as AUM grows, a fund’s investable universe decreases and style drift and performance erosion can occur. Large firms may devote more time to cultivating investor relationships (and management fees), leaving less time to focus on return generation,” says the report.
Profitability, while essential, is not the only prerequisite an emerging hedge fund must have to secure institutional money. Operations have to be sound too. For any business to succeed, working capital is a must-have. An emerging manager needs to have sufficient capital to cover their personal expenses for about two years. In the first few years, it is highly unlikely managers will even get salaries or payments – this working capital ensures business continuity and potential success. Like the countless young people trying to obtain mortgages in this depressed market, capital raising for emerging managers is tough. Unless a manager is a star performer, there are not that many opportunities to raise capital unfortunately. Many institutional investors are also demanding fee concessions in exchange for allocating to individuals who are just setting up shop – given the difficulties associated with capital raising, this can pose a major challenge to managers. If an early investor demands a rebate when a manager is struggling to break even, the manager could be forced to charge external expenses such as outsourcing to the fund thereby hindering its performance. This is not a welcome development – investors need to get the balance right. Some 42% of managers acknowledge they have reduced fees, according to a Preqin survey as they become increasingly dependent on institutional investors’ capital. I personally do not mind paying the normal 2% and 20% management and performance fee, respectively, if I believe the product is high quality and will make good returns. I have no objection to paying these standard, industry-norm fees because it will help emerging managers upgrade their technology, systems, and personnel and provide them with adequate compensation. Early stage investors might be best suited to ask for a discount once the fund has reached a certain asset threshold. This will allow emerging managers to run operations without too many cost concerns while simultaneously it will reward early stage investors for taking the risk.
Being able to run an early-stage investment management operation smoothly for two years in this post-2008 environment is made possible only by having access to a top-notch business team equipped with the right chief operating officer (COO). Having a substandard team is a recipe for disaster and is unlikely to appease conservative, sophisticated investors. The chief executive officer (CEO) must have a broad understanding of how to operate a business – they cannot grow their business if they are unwilling to move beyond high-net worth individuals and into the institutional space. Institutions are demanding, especially with reporting and access to the portfolio managers - the CEO must therefore be able to deal with tough institutional investor requests on a regular basis. The COO and chief investment officer (CIO) are the drivers behind the business. As we have seen from some of the high-profile hedge fund failures and frauds, there has to be a segregation of duties between the CEO, COO and CIO – this is non-negotiable. I would be dissatisfied if there is no clear separation between the front, middle and back office – it would prompt me to deem a fund to be non investment grade material. Investigating the experience and backgrounds of the individuals running the firm is an equally important aspect to the operational due diligence. I like investment professionals who have obviously made consistent, positive returns but who have also stuck to their specific strategies and managed a substantial amount of money. The best suited COOs are those with a structuring, accounting, treasury and legal background. It is common for COOs in our potential hedge fund investments to have spent 10years as a COO in a department of an investment bank – preferably focused on credit or equity derivatives, macro or fixed income. We want people who are capable of running the reconciliations, establishing a valuation policy and sticking to it. Finally, I like COOs who are client-facing and can explain to investors their role and their daily activities, such as how they ensure trade processing, valuation, cash management, business continuity and compliance in this increasingly regulated world.
Having top rated service providers is as important as having a top rated team in house. Emerging managers need to have a highly regarded prime broker. I do not subscribe to the argument that major prime brokers do not have time for their smaller hedge fund clients. Quite the opposite, prime brokers, if they see a talented manager, will want to grow their business with that manager. If a bulge bracket prime broker turns down a hedge fund, this can often be a warning sign not to invest. In the event of a prime broker turning away a hedge fund that I was performing operational due diligence on, I would expect an explanation from the manager why this happened. Sometimes, it is not wholly clear cut. There might not be an alignment of interest between the prospective hedge fund and prime broker. For example, a prime broker might not be that specialised or strong in a particular investment strategy. If that is the case, I might recommend a shortlist of prime brokers who have the capabilities of servicing that specific strategy. However, I am somewhat reluctant to force a hedge fund in the early stages to adopt multiple prime brokerage relationships. This is almost counterintuitive because it is far more important during the primary stages of a hedge fund’s life cycle to enjoy a strong relationship with a single prime broker – particularly if that prime broker offers all the necessary services like stock lending, research and capital introduction to name but a few. Multi-priming in the early stages is also an added cost that could be a major drag on performance and implementing a multi prime environment is challenging when it comes to daily data aggregation. Nevertheless, I do expect a hedge fund to increase its counterparty exposure once it reaches a certain asset threshold to mitigate counterparty, financing, liquidity and operational risk and ensure optimal financing. The prime brokerage relationship with the hedge fund is something I look at closely. The same applies to the administrator. I won’t reject a hedge fund purely because I am not familiar with the administrator they use. If I have not heard of an administrator, I shall spend time with their valuation team and determine if they understand the instruments being traded. If there are concerns, I shall make these known to the manager.
Times have changed and the quality of emerging managers has improved exponentially. Complacency is not an option and managers need to maintain high operational standards throughout their funds’ lifespan. Managers must have the motivation to generate solid performances and absolute returns for underlying investors just like they did when they were establishing themselves and make sure they stick to the capacity they have defined for their strategy. There are cases of established managers who are living off the assets and not the returns. This “fat cat” attitude is unacceptable and unfair on end investors. Emerging managers do require a lot of work and effort, but it is worth it as they tend to outperform their established counterparts. This is a truly exciting time for the industry given all the talents that are out there.
Pierre-Emmanuel Crama is head of operational due diligence at the Signet Group, a $1.5 billion fund-of-hedge-funds specialist based in the UK and the US.
Disclaimer – The comments and views expressed in this feature are those of Pierre Emmanuel Crama only. They do not represent the views of the Signet Group, its employees, partners or any of its affiliates.