Opportunities in the Changing Landscape of Emerging Hedge
Andrew Godfrey and Dan Barnett
Revere Capital Advisors LLC
Despite the turbulence and trauma that 2008 exacted on the hedge fund industry, there are those who argue that the financial markets have generated an extraordinary set of business and investment opportunities. Nowhere is this more prevalent than in the emerging manager space, as the current quality of managers looking to start or re-launch a new hedge fund, coupled with the scarcity of capital, means that active seeders can be very selective. Although it is essential for emerging managers to work with a strategic partner today (given the lack of credibility in hedge funds, costs and expertise associated with operating a fund), managers should be equally as selective when choosing a partner.
Over the last two years, considerable changes in the hedge fund industry have significantly altered the landscape for seeders of emerging hedge fund managers. Financial firms have been portrayed as the culprits of the economic downturn and the breaking of the Madoff scandal further bolstered this already cynical view many have of the industry. Even among the managers running successful businesses, the trust of investors has been tested due to the imposition of gates and side pockets in response to large redemptions and drawdowns. Ultimately, hedge fund indices posted respectable relative returns in 2008 compared to those of traditional investments, though the industry did suffer its worst annual absolute performance on record. During this period, the seeding landscape became more restricted and fewer eligible candidates emerged. Industry commentators have therefore looked on with interest when new seeding institutions have appeared on the scene.
The Emerging Manager Argument
Emerging managers’ outperformance has been well documented from both an academic and industry perspective. In one such paper, “The Performance of Emerging Hedge Fund Managers”, Rajesh Aggarwal and Philippe Jorion demonstrated that managers tend to outperform within their first two years by about 2.3% a year, relative to later years, and that this outperformance tends to continue for up to five years before fading away1. Reasons for these enhanced returns may include access to a wider number of market opportunities, a greater nimbleness than larger funds which simply cannot react to the markets in the same way, reliance on performance fees, and a greater degree of focus and commitment in the early stages. David Swensen (CIO of Yale) maintains, "The partners of newer, smaller funds focus predominantly on generating investment returns…. Big partnerships devote more time to cultivating and nourishing limited partner relationships – the source of the funds (and fees). Less time remains for investment activity. Returns suffer2.”
To be fair, there are some notable negatives to emerging managers as well. These may include: lack of stability, depth of infrastructure, length of track record, and the size and experience of the firms’ staff. Part of evaluating an emerging manager is assessing the business plan to address each of these operational issues, with an understanding that their development goes hand in hand with time and assets.
However, the appropriate strategic partner can accelerate the process of institutionalisation for a young fund by supporting and developing areas where the business may be lacking.
A number of seeders argue that the recent market turmoil has created a set of unique investment opportunities. Specifically, the withdrawal of arbitrage capital and deleveraging has led to mispricing in equity markets. Furthermore, the contraction of the bond repo market and forced selling by large financial institutions and hedge funds has caused dislocations in the fixed income markets. Catastrophic levels of default are now priced into even investment grade credits. Many hedge funds and traditional funds remain sidelined with pre-existing ”legacy” positions for which there are no buyers, limiting the manager’s ability to act opportunistically. New managers with fresh capitalcan be buyers of last resort and effectively take advantage of this.
The above dislocation in the markets has been coupled with a second equally powerful factor which enhances the attractiveness of seeding in the current environment. The significant personnel reduction in banks’ proprietary trading desks and structured credit desks combined with large redemptions from the hedge fund community has resulted in an increasing pool of talented and experienced money managers looking to re-launch or create new companies. This is a difficult task in normal market conditions, and with many investors and seeders temporarily on hold, the challenge is much greater. Managers, and often whole teams, are finding themselves in need of both investment and operational support.
Now more than ever, managers have a need for an institutional partner. In previous years, launching a fund with significant capital was enough to encourage the investment community to take notice and follow suit. However, investors require substantially more in today’s environment. Independent risk oversight, financial stability and operational depth are now vital components of the evaluation process. The right institutional partner will assist in the build out of these functions and create the credibility and soundness institutions require.
Seeding – A Changed Landscape
For a number of years, traditional seeders, led by large institutional firms, provided increasingly greater amount of capital to win the next big launch. This was, in essence, the crux of a seed arrangement. Managers looked to find the biggest cheque possible and found several seeders competing; and the seeder that won the deal was usually the one that wrote the biggest cheque. Typically, seeders would toss in investment capital and hope for the best. There were, however, some notable flaws with this model. By and large, the cost of the seed capital was, and still is, expensive in terms of fee and revenue sharing agreements, especially in the early days. The manager was often left on his own to not only skillfully invest his client’s money, but also to perform the functions of sales, management, administration and compliance. Without adequate revenues, seed capital programs tended to create over-dependence by the manager on the capital provider; and without proper support, the chances of these managers creating a successful business were significantly lower.
Recent changes in the seeding landscape include:
Fewer active seeders
Names that were once established in the seeding business, including AIG, Lehman Brothers, Bear Stearns and Fairfield Greenwich, have vanished or discontinued their business over the past 18 months while few dedicated seeders have stepped into their shoes. In a recent survey conducted by Acceleration Capital (a consultancy company in New York), they reported that out of 75 institutions with seeding operations, 10 were actively putting money to work, 30 were opportunistically involved and 35 were not currently seeding3. Consequently, with fewer active seeders in the marketplace, the search for launch capital is all the more arduous, and managers are clamouring to secure deals.
As a result, many seeders have adapted by offering significantly less capital to managers and asking for only modestly reduced economics. Additional concessions which managers are forced to make, may include reduced lock-ups and reduced fees on capital allocated. Thus, many managers fortunate enough to find, and deserving of, seed capital are left with limited means to scale their business to institutional grade. It is estimated that in 2005, ticket sizes were on average between US$50–100 million, with many seeds hitting more than US$300 million in the years following.
Seed capital is much harder to come by in today’s environment. Although there are some notable exceptions, including Renaissance and Citadel which have allotted US$300 million to managers in the last nine months, fewer managers are winning these tickets. Eighteen months ago, those managers would likely have launched without sharing economics. The same manager who would have launched with US$300 million two years ago is now struggling to find enough capital to get off the ground. As of spring 2009, 31% of investors seed with less than US$10 million, while 51% seed with US$10-100 million4, the average being around US$25 million.
Finding the capital
Reduced capital from seeders has not changed the critical mass levels needed to gain significant institutional attention, which is estimated to be US$100 million. Instead of one seeder, this now includes finding additional emerging manager allocators. Fortunately, more investors are willing to provide day one and early-stage capital today, as long as the manager is stable and appropriate infrastructure is in place. Investors are increasingly looking to take advantage of the aforementioned investment opportunities at hand and the benefits of emerging managers. In some cases, this will include manager concessions such as managed accounts, but not always.
Today, investors are seeking increased transparency, better liquidity and safety for their assets, all of which have fuelled a growing trend towards managed accounts. From an emerging manager’s perspective, this may help in providing a track record and some income for the manager, but it does not assist with the build-out of a fund and subsequently, a business. Instead, finding the initial capital to start the fund (which is the growth driver for the company) remains a challenge and likely comes with additional concessions. On the other hand, it is important for emerging managers to have the operational capability to accept and service this growing trend of managed accounts.
Manager platforms offering back office and infrastructure support have been identifying new opportunities as managers recognise the difficulties of launching a fund alone. Similarly, existing hedge fund businesses are offering their talented managers the chance to launch new funds on their internal platforms. Among other reasons, this includes the ability to attract fresh capital to an organisation at new high water marks and maintain talent in-house without paying out significant amount. Economies of scale will be of higher importance as costs continue to mount. Such activities will inevitably lead to significant consolidation in the industry and the emergence of more hedge fund platforms.
A New Philosophy
As discussed, managers are finding the process of launching and growing a successful fund much more complex in this changed landscape. Finding the investment capital, albeit more difficult, is only one component of the process today. Seeders need to become partners, adding value beyond the investment. Fund managers need to understand that they are now expected to develop and manage hedge fund businesses, not just a fund. Credibility has never been more vital in institutionalising a hedge fund business, and hedge fund platforms have never been so integral to the process.
Recent deal structures have not altered significantly in terms of logistics. The three main structures are revenue share agreements, discounted fee agreements and equity interest agreements. The majority of classic seed deals look for top line revenue share agreements, which are the most costly to the manager and offer legal separation to the seeder. Discounted fee agreements are generally reserved for managed accounts and do not participate in the underlying business. Equity shares are less common from seeders, but offer the greatest degree of alignment with managers, flow of information and thus credibility for the manager.
Revere Capital Advisors (RAC) is an example of one such platform seeking equity interests. The company strongly subscribes to the “new” emerging manager doctrine and agrees that there has been no better time to be in the emerging manager seeding business.
In RAC’s view, it is essential that the manager owns the lion’s share of his business and that his conviction and passion is to build and grow his company for years to come. This approach includes allowing the manager to concentrate and focus on his investing and trading activities, while the team helps to build his company. Over time, the proposal is that these services will be replaced by in-house personnel, leaving the manager with the majority ownership of a robust, well-run investment company. In turn, RAC will maintain a minority ”bottom line” participation in a then-thriving asset management business. Economics need to be more favourable to the manager, especially during the emerging phase when every dollar is needed and the costs associated with building a fund are proportionately bigger.
The type of manager that will be on a platform today has changed. In addition to the manager’s investment acumen, the prototypical manager needs to have an entrepreneurial spirit and understand the importance of building a business. In contrast to previous years, this will be a team who have left the proprietary trading desk of a large firm or hedge fund, and has already started up their company. The manager would have commenced trading and be in the process of building a very good, albeit short, performance track record. This is the commitment that is expected from managers entering the hedge fund space today. Obviously, the aforementioned lack of active seeders has made the barrier to entry that much more competitive.
The Future for Emerging Managers and Seeders
The emerging manager space is currently experiencing a truly transformational phase. The days of building funds are behind us, and the era of building hedge fund businesses has commenced. Regulatory changes, transparency, liquidity, risk oversight and operations will continue to be of increased scrutiny. It is for these reasons and more that the traditional seed models will no longer suffice to cultivate success for emerging hedge fund managers. Emerging managers need to reach institutional grade more quickly than in previous years, requiring additional affiliated costs for staffing, systems and regulatory filings. As this is a difficult mission in a normal environment, let alone in today’s, the importance of a strategic partner will continue to grow. Managers who approach the marketplace with the appropriate infrastructure and a suitable institutional partner will be successful at securing investments. Trust, liquidity and transparency have never been more vital.
Many see the challenge now as approaching an investor base that is struggling between protectionism and opportunism. The last two years have placed virtually every investor category under intense scrutiny. Nevertheless, this is arguably the most ample trading environment in decades for hedge funds to make outsized returns. Investors need confidence to return to the market. “Stability, and not necessarily an upward move by economies, would be enough to attract investors back to alternative investments such as hedge funds,” says Dr Frank Gerhard of Barclays Capital5. According to the Deutsche Bank 2009 Alternative Investment Survey, perhaps US$82 billion of cash from survey participants will be re-invested over the next six months6.
In the meantime, it is for these reasons why now is the time to be involved in what will be banner years in the seeding of emerging hedge fund managers.
Dan Barnett is CEO of Revere Capital and, amongst others, former CFO of ED & F Man. Revere’s business model was conceived by Barnett several years prior to launch, and was partly in response to some of the criticisms seeders have faced.
Andrew Godfrey is managing director at Revere Capital. Previously, Godfrey was head of the emerging manager programme and member of asset management committee at Focus Investment.