Hedge fund seeding
Growth in the hedge fund world is unprecedented and the future remains promising. After a decade of growth averaging 20% a year, analysts now predict that the annual growth rate for the next 10 years could exceed 25%. According to a recent study by Oliver, Wyman & Co and UBS Warburg, European hedge fund assets are forecast to grow from $60bn (E57bn) today to $300bn by 2005. To illustrate the phenomenal commercial opportunity, they go on to forecast industry revenues growing from $1.7bn today to $6.7bn over the same timeframe. Yet despite these money flows and the emergence of a new breed of behemoths of the hedge fund-of-funds world, the industry is still characterised by a plethora of small and vulnerable funds that are unable to access the capital these giants are desperate to deploy.
In recent months, there have been regular pronouncements by institutional pools of capital, such as the pension fund of the UK rail industry, Railpen, of a desire to participate in the hedge fund boom. The mere whiff of institutional money in a segment of the fund management business thus far dominated by private investors and their advisers is enough to set hearts thumping. Ironically, the advent of institutional capital not only stirs the small hedge fund managers, who seek just a small infusion of this warm blood, but also the funds-of-funds that dominate the business and who have realised that the arrival of the institutions heralds the end of the party. The simple fact is that there is already too much capital in the hedge fund industry as it stands today, ie, too much capital chasing too few managers who genuinely stand up to scrutiny and are able to deliver decent returns in the most volatile market conditions in living memory.
The end of the party appears to have been signalled by the exit of some of the pioneers of the fund-of-fund manager; GAM has been sold to UBS, Ivy Asset Management is now part of the Bank of America, Momentum is now a unit of the giant Italian savings bank, Unicredito, Tremont is now part of mutual fund group Oppenheimer, whilst FRM and Mesirow are both rumoured to be on the block. RMF, a Swiss manager of managers, expedited its growth through a strategy of tie-ups with Swiss insurers and promptly sold out on a premium multiple to MAN Group of the UK. The institutionalisation has answered few of the problems that prompted the re-evaluation of the industry’s fortunes by its founders; it has simply exacerbated them. The real issue here is not whether there is too much capital in the industry but that there is too little capacity.
Risk adjusted returns have, it is generally acknowledged, been pretty satisfactory in the hedge fund industry. With cash and bonds looking decidedly unappealing, and equity markets tumbling all around the world, the case for investing in absolute return vehicles that have, by and large, preserved capital, has become all the more compelling. With little light at the end of the tunnel, this situation is likely to prevail, and funds-of-funds will continue to show healthy inflows month on month. Here is where the problem arises. The hedge fund world can be divided squarely into two camps: the “haves and the have-nots”. Those who fall in the “haves” have in excess of $100m of assets under management, and can run a pretty profitable and stable business. The “have-nots” who remain firmly planted in the less than $100m club are for the large part, floundering with under $50m. These funds fall well outside the radar screen of a meaningful investment from the large multi-manager groups.
Precluded from investing in the smaller and often younger funds, who more often than not are the source of more consistent and sustainable alpha, the giant fund-of-funds groups today find themselves scrambling for capacity amongst a small clique of hedge fund giants, many of whom are disguised as funds-of-funds themselves. Typically, as capital has ballooned, return compression within the core skill set has set in. In many instances, the manager has long since handed over the reigns to younger acolytes and has little to do with the day-to-day management of money. Under these circumstances, and in this harsh climate, many of the once great managers have stumbled. This in turn has taken out some of the excess capacity in the industry, yet amongst the newer managers, those that might have flourished, have discovered that the biggest investors are not interested.
With over 8,000 hedge funds to wade through, and transparency still a problem, finding the diamonds in the rough is a labour intensive exercise for any hedge fund analyst. Conventional wisdom would suggest that a three-year track record, and a predetermined size of assets under management are pre-requisite before one can comfortably satisfy the fiduciary responsibilities that professional asset management confer. Crunching the numbers of a fund whose manager has long since ceased to be at the centre of the investment decision making process is about as valid as electing a political leader on the record of his predecessor. The dynamics of hedge fund investing are after all ultimately asymmetrical. Although a relatively new notion, much empirical evidence points to the fact that early stage funds do better than their more established counterparts. Herein lies the opportunity for the burgeoning breed of smaller fund-of-funds and private wealth managers.
It would be misleading to suggest that seeding new managers was not without risk; but risk relative to what? There is a strong conviction that greater risk lies with the managers who have surpassed the three-year hurdle and whose assets exceed the optimal amount for the strategy. A scarcity of information may make the task of evaluating an opportunity more time-consuming, particularly relative to the size of the investment, than for an established fund. But seed investing can secure material fee discounts and capacity guarantees that save time and money in the longer run. This is not a task to be undertaken lightly, however. Professional guidance is imperative. One still needs to militate against the risk of fraud through rigorous background checks. Portfolio analysis and monitoring requires a detailed understanding of often complex investment strategies, not to mention the transparency that permits such an audit from time to time. Concentration risk analysis requires similar scrutiny, and leverage and liquidity analysis requires a regular dialogue with prime brokers and other participants in the same strategy. Diversification across several funds within the same discipline may reduce absolute returns, but can significantly enhance risk adjusted returns overtime, providing invaluable intelligence as well.
The key to successful seed and early stage investing can be summed up in its application. Inevitably, the new sources of alpha will come from the continued migration of long-only managers and proprietary traders into the hedge fund world. Hence, new funds should form one component of a forward-looking investment portfolio.
For managers who are looking for seed capital there are a number of rules that should, without fail, be adhered to. It might seem somewhat obvious but some kind of track record has to be a prerequisite for establishing a new money management business. A means of differentiating one’s offering is also advisable. Presentations that resemble a common standard are unengaging and unlikely to suggest original thinkers. A simple strap line that effectively describes the strategy is the very minimum needed to communicate to busy investors. Better still, a more sophisticated USP might also be conceived. A sound grasp of the risks of running a business, managing volatility, and running a team can only serve to advance the proposition. Finally, be prepared to give up some of the upside. Seed capital is the lifeblood of a hedge fund. As one would expect to be compensated with a commensurate share of the profits in return for an equity investment in any other business, so here, seed investors should be entitled to negotiate a share of the firm they are helping to create.
Simon Hopkins is managing director at Fortune Asset Management in London and a founder of Global Fund Analysis, Fortune’s hedge fund research affiliate