The year 2011 has been a good one for emerging hedge fund talent. However, prospective candidates are being put through their paces by cautious investors, finds Lynn Strongin Dodds

Spotters of new hedge fund managers enjoyed a bumper first half of 2011, reflecting the overall recovery in the industry and the wave of proprietary traders spinning out from investment banks in the run up to implementation of the Dodd-Frank Act and Volcker Rule.

But it was still nothing to the halcyon period between 2002 and 2007 when 1,200-1,400 funds were making their debut each year. Back then, the barriers to entry were not only low but the regulatory oversight was weak. Investors are much more circumspect these days - the screws have been tightened in the wake of the Madoff scandal and prospective candidates are put through their paces thoroughly. No one is in a rush to make a decision despite the glut of new talent on the market.

"The bar is considerably higher than in 2008 because operational processes and procedures must be watertight," says Tim Gascoigne, global head of portfolio management at HSBC Alternative Investments.

"Today, there is no sense of urgency," says Dick Del Bello, senior partner at the Conifer Group, a hedge fund administrator and securities services firm. "In 2008, when a $100m (€72.8m) hedge fund was launched investors rushed in because they did not want to miss out. Now they want to see the fund's performance figures before diving in. However, I do think that those that have made it through this current period of market volatility will attract money."

Lisa Fridman, head of European Research at PAAMCO, a fund of funds with a deliberate emerging-manager bias, says that the large number of launches over the past 18 months or so belies the difficulty new managers face raising the same level of assets as pre-2008. "Figures from Hedge Fund Research (HFR) show that the majority of the total assets raised in the industry this year went to managers with assets in excess of $5bn," she notes. "However, interest in smaller managers with less than $1bn in assets has started increasing as well in 2011 versus 2010."

According to the HFR global hedge funds industry report for Q3 2011, less than 20% of net asset flows went to hedge fund firms with less than $1bn in assets for the year to date, while more than 60% went to firms managing over $5bn. This has been a year in which the industry, as a whole, has rebounded sharply, surpassing the previous record level of total capital under management at $2.04trn. There were 578 new fund launches in the first half of 2011 (298 in Q1 and 280 in Q2), with two-thirds of the $30bn raised going to new macro and relative value strategies.

But that activity ground to a halt in Q3 as the prospect of an unravelling euro-zone and sluggish global growth unnerved markets and caused the hedge funds to post their fourth-worst performance quarter in history. Anecdotal evidence suggests that conversations have been put on hold and new launches - ranging from $5m-250m - have been delayed until conditions stabilise.

Over the long term, many agree that institutional investors will need to consider hedge funds as part of their broader alternatives portfolio if they want to close their deficits without taking a punt on equity risk - and one major attraction of start-ups or smaller hedge funds is the existing evidence showing that they tend to outperform their larger brethren.

Numerous academic and industry studies underscore their stellar results. One of the more recent reports, from HFR, shows that in the three years ending in March 2011, newer managers - with under two years of experience - delivered annualised net returns of 9.3%, compared with 4.5% for established managers. Over a longer period - 1995 to March 2011 - those in the emerging camp produced annualised returns of 16.5% against 10.7% for their more mature peers.

There are several reasons for this, according to Jeff Majit, head of European investments and event driven and relative value research at Neuberger Berman. "Smaller hedge funds have the size advantage in that they are more nimble and can adjust portfolio exposures quickly," he argues.

"There is also a psychological element: they are much more dependent on returns for the success of their business, whereas a larger manager can generate average returns and live comfortably on the management fee. There is, though, a high level of dispersion across managers and investors need to be aware of this."

Investors are also advised to evaluate the next generation of hedge fund managers from a wider perspective than in the past. "We have seen a significant number of spin-outs of prop traders from investment banks," acknowledges Stefan Zellmer of Revere Capital Advisors. "However, just because someone is a good trader does not necessarily mean that they will be good at running a business over the long term or have the right risk-management skills, which is very important in today's markets."

Dan Mannix, head of business development at RWC Partners, an independent investment management firm, echoes these sentiments. "It is important for investors to realise that not all smaller hedge funds outperform," he says. "There is an element of survivorship bias in the performance figures but I would say that the good funds do persist over the longer term, with the best performance in the early years. This is because start-up managers have a different mind-set. About 90% of a young fund's success is defined by performance, whereas high returns may not be the primary driver of a more mature fund. Wealth preservation often becomes one of their main concerns."

Jeroen Tielman, chief executive and founder of IMQ, the hedge fund seeding platform backed by Dutch pension manager APG, says: "Talent has many dimensions. It is not just about the technical skills but also the investment, risk and the operational management systems in place. Equally as important are the behavioural aspects of the managers, as well as team dynamics. We look closely at their drive and motivation, as well as the maturity level of the members."

Once managers are identified, according to the HFR research, the preferred route to gain exposure is via a single-manager vehicle as opposed to commingled fund of funds. Although pension funds will look at early stage funds, seeding has traditionally been the domain of high net-worth individuals, private investors, and friends and family of the manager. Institutions have typically preferred to get on the ground floor at a slightly later date - with so-called ‘accelerator capital'.

"Pure seeding is at the more complex and riskier end of the spectrum because it involves more unknown variables than accelerator capital," says Matteo Dante Perruccio, CEO and founding partner of Hermes BPK Partners, the alternative advisory boutique and fund of hedge funds established as a partnership with Hermes Fund Managers.

"Some institutional investors prefer acceleration capital since there are fewer unknowns and the teams have had the opportunity to demonstrate they can perform and work together well, representing what we believe to be a more attractive risk-reward proposition," Perruccio says.

Hermes BKP, along with private equity firm Northern Lights, has joined a number of other players in launching an acceleration fund. Their Accelerator limited partnership is a commingled vehicle that will invest in and receive an economic stake in the growth of early-stage hedge fund managers.

Hermes BPK Partners will handle manager selection and due diligence, while Northern Lights will negotiate investment terms, work with managers to institutionalise their business processes, and provide marketing and distribution services.

So while it might be some time before the hedge fund industry sees the same infusion of new blood as it did before the financial crisis, there is plenty of evidence that sophisticated institutional investors are beginning to recognise some of the advantages of getting in early - which, together with the tighter capital and regulatory conditions, should ensure longer-lived and more robust outcomes all round.