Prerequisites for emerging managers in the post-crisis world
Emerging managers are enjoying something of a renaissance among some sophisticated investors. In the immediate aftermath of the financial crisis, many institutional investors opted to put their cash into brand name, established hedge funds – vehicles they believed offered steady security of their investments in an incredibly uncertain and volatile economic environment.
While many investors do remain cautious and conservative, there is ground for optimism among emerging hedge fund managers. Funds of hedge funds (FoHFs) have expressed enthusiasm for emerging managers – a poll by research specialists Preqin revealed 72% of FoHFs would invest in an emerging manager while a further 13% said they would consider it. Endowments remain supportive of emerging managers too – 66% of those surveyed acknowledged they would put money into one.
However, pension funds, insurance companies and family offices seem to be getting somewhat more reluctant to allocate capital to these individuals. In 2010, 54% of family offices said they would invest in an emerging manager – compared with 63% in 2009.
The barriers to entry for emerging managers have also been raised. In 2009, more than half of the institutional investors polled by Preqin said they would contemplate putting their assets into a fund with a track record of two years or less. That figure now stands at just 38%.
Operational due diligence or lack of it in some circumstances was something investors, particular FoHFs were criticised for in the post-2008 autopsy reports. The high profile links some FoHFs had to Bernard Madoff’s mammoth $67 billion fraudulent vehicle alarmed many investors. Things have now changed and operational due diligence has been elevated in importance - institutional investors are not leaving anything to chance.
Managers’ education, background, criminal record and trades are ruthlessly pored over by investors. A solid track record is now incredibly important for managers hoping to establish themselves.
It is relatively simple to check the trading history of an emerging manager who has left a hedge fund – these shops are often rather small and easy to access. However, those who have come from investment banks are at a slight disadvantage.
“Identifying the trades someone has made at an investment bank is much harder. Not all banks will verify someone’s trading record. You might be able to get informal references from former colleagues but that is it. This is important because it can be hard for a proprietary trader to enter the hedge fund world – prop trading and hedge funds are not the same,” stresses Hamlin Lovell, a freelance hedge fund consultant (pictured).
Traders leaving prop desks hoping to set up their own funds will rarely have an audited track record – the only exception to this might be if the fund is spun out by the bank.
In these difficult circumstances, what should emerging managers do to get that investor capital, and what in turn are the investors looking at and wanting?
“We have been investing in early stage managers for 17 years,” says Kevin Mirabile, chief operating officer at New York-based FoHF Larch Lane Advisors. “We want people with experience who are from banks or hedge funds. We are not looking at people fresh out of their MBA course or some 25 year old inexperienced manager. We want people from large multi-strategy firms who have made significant amounts of money and have sufficient capital to launch a fund and sustain it for several years,” he says.
Investors also want assurances that these emerging fund managers can perform, particularly in bear markets. Those managers who survived the turbulent last few years have a significantly stronger competitive advantage than those just breaking into the industry when it comes to winning over investors.
So apart from money-making ability and experience, what else must an emerging manager have to impress?
For a start, investors are increasingly demanding brand name service providers as a prerequisite for allocating capital. “There has to be a solid operational infrastructure,” says Phillip Chapple, executive director at hedge fund consultancy firm KB Associates. “Investors want funds to use recognisable service providers especially in regards to prime brokerage, administration and auditing. Even before Madoff, investors preferred a big four auditor. Having an appropriate prime broker, auditor and administrator is non-negotiable,” he adds.
This is something Lovell too feels strongly about. “A recognised auditor is nearly always essential and a big red flag for fraudulent activity has almost historically been when small local auditors are doing the books as we saw with Madoff,” he says.
However, Lovell adopts a slightly more liberal attitude to emerging managers’ choices of lawyers. “I don’t think you need a Rolls Royce lawyer if the strategy is simple or liquid. An ‘off the peg,’ standardised or Ucits prospectus may remove or reduce the need for the most expert lawyers to draft a more ‘bespoke’ prospectus,” he says.
Utilising a quality bulge bracket prime broker is something that investors are increasingly demanding as these companies will generally have sound balance sheets. People are often uncomfortable having their assets held in smaller firms or mini primes – institutions, which some individuals believe to be somewhat riskier.
“We don’t generally make investments where the fund uses a prime broker who is too far off the map or not established. We generally want an established brand – a prime broker with capital backing and an excellent credit rating. We would not usually invest in someone who uses a low capitalised, international, non-rated prime broker in say, a jurisdiction with controversial laws and requirements. Prime brokers are starting up all over the world and we want the more traditional choices. The only exception would be if there was a specific rationale with a boutique firm,” says Mirabile.
While it is important for emerging managers to opt for decent service providers, many investors want sure-fire guarantees that operationally the hedge fund is sound. With standards being significantly higher, emerging managers must be on the top of their game and aware of all that is going on around them operationally.
“Due diligence questionnaires (DDQ) and processes have got significantly longer. Investors want to know a lot more about counterparty risk – they want to know if the manager knows the credit ratings of counterparties. DDQs also need to be thorough. Some managers’ responses are like pitch books occasionally, which is inadequate and they don’t come close to answering questions. It is purely a sales pitch,” says Lovell.
The Alternative Investment Management Association (AIMA) has its own DDQ template, which managers are encouraged to try and answer. While it might not be as rigorous as the DDQs submitted by sophisticated investors, it is a useful starting point. “If a manager cannot answer an AIMA DDQ, that manager has a credibility problem,” says Lovell.
One way to impress investors could be joining the Hedge Funds Standards Board (HFSB), which sets the industry benchmarks for best practices. Membership costs £2,000 per year for fund managers whose assets are less than £100 million. Lovell, whose services also include advising managers on taking steps to meet those HFSB standards, says this is a small price worth paying given the credibility boost it provides to managers who attain these basic requirements.
It is not news that managers, in attempts to reduce costs, are frequently outsourcing operations. While investors understand some managers do not have the capital to purchase high-end technology or do everything in-house, they do nevertheless expect the manager to have a firm grip over what is being outsourced.
“Many managers are outsourcing the middle office and that can be a good thing. But investors want to know how the manager is controlling such a relationship and how they are continuously monitoring the outsourced tasks. If a lot of operational processes are outsourced and oversight is not performed, a manager might not catch a mistake,” warns Chapple. At the other end of spectrum is the notion that portfolio managers ought not to control too much. Lovell says alarm bells ring if the portfolio manager also oversees risk management and compliance, for example. “It creates a conflict of interest,” he says.
Emerging managers are currently caught in a slight quagmire – investors expect high quality service providers and solid operational infrastructure – and rightly so. However, some vociferous investors have also been calling for fee discounts. Since the crisis, the traditional 2 and 20 management and performance fee structure has been challenged by larger institutions - many of whom resented paying such high amounts given the lacking alpha and low returns some investment management companies offered.
Chapple says managers need to get the balance right between giving investors incentivised fee deals and ensuring the fund continues to operate in a risk-averse and efficient way . “Emerging managers need to have a solid infrastructure to perform their investment strategy and there is a cost to that. It is bad business to not cover the fixed costs of the manager with the management fee and to rely on the performance fee,” he says. Management fees should therefore be structured in a way to allow the manager to spend appropriately on infrastructure and solid service providers.
Nevertheless some investors feel they are taking a risk with emerging managers and should be rewarded for that. “Early stage investors as a group should be recognised for taking the business risk and they should be compensated for that. During the early stages, investors need to get fee concessions, enhanced liquidity or transparency or other things that are similar to that to reduce business risk,” says Mirabile.
However, this may become problematic for managers especially as the Financial Services Authority (FSA) is demanding they become transparent in regards to disclosures they make. Under the European Union’s Alternative Investment Fund Managers Directive, managers must disclose the fee discounts they give to certain investors. Again, this is something that might prove difficult for managers in the future.
While some emerging managers may be more eager to get certain investors on board, they should be wary of creating side letters or different material terms for certain individuals, advises Chapple. This, he says, is “a big red cross for. Investors are extremely nervous about this and are keen to ensure that other investors do not have an unfair advantage over them.”
Side letters may sometimes be totally innocuous – however, the manager is usually bound by confidentiality agreements not to reveal the nature of side letters regardless of its insignificance. Therefore when investors enquire about side letters the manager will have to disclose they are in place but cannot provide the details of what has been agreed. On this basis Chapple reiterates side letters are “big no go area” for him.
Emerging managers should rightly feel that things will steadily get brighter. However, using quality service providers and ensuring operations are smoothly maintained is an absolute necessity to obtain capital from investors – especially as they seem to be regaining their confidence once again. In turn, new managers should, however, be careful about how or if they decide to structure fees differently for various investors. As Preqin’s research has illustrated, investors are far more diligent now and managers need to be on top of their game as the barriers to starting up have got much higher.