Since the financial crisis, big hedge funds like Paulson & Company, Millennium Management and Och-Ziff Capital Management Group have not turned away money, eagerly collecting billions of dollars from investors who have tended to stick with the industry’s marquee firms.

The situation makes Anthony Bozza all the more unusual. With assets swelling, the hedge fund manager is closing the door to new investors at his four-year-old firm, Lakewood Capital Management. In a little more than a year, his fund has grown from $200 million to $900 million, according to investors in the fund.

Small hedge funds were supposed to be the big losers in after the crisis, hampered by costly regulation and investors who flocked to the seeming safety of larger institutions.

But three years later, some small and midsize managers are flourishing, attracting assets at a rapid rate. Rather than risk their returns, they are just saying no to new investors.

RouteOne Partners and Point Lobos Capital, started by alumni of the approximately $21 billion fund Farallon Capital Management, stopped accepting new money. Brenner West Capital Advisors, which tripled its size to about $480 million in less than a year, did the same this month, according to people with knowledge of the fund. Jericho Capital and the Redmile Group raised hundreds of millions of dollars before turning away new clients.

“There was a period where the bulk of the money was flowing to the very largest players, and now it’s trickling down,” said Dean C. Backer, global head of sales and capital introduction at Goldman Sachs in prime brokerage. “From the manager’s perspective, there are folks who really just want to be disciplined in terms of how they build their business.”

Lakewood, RouteOne, Point Lobos and Brenner West declined to comment. Redmile and Jericho did not respond to requests for comment.

Their discipline stands in contrast to the hedge fund math. Most portfolios charge a management fee of 2 percent on the total assets, an incentive to welcome new investors.

But the credit crisis taught managers the perils of growing too quickly. Amid major redemptions, some hedge funds were forced to scale back their operations. Others suffered lackluster returns because of a dearth of good investment opportunities.

Chastened by recent history, some newer hedge funds are trying to temper their growth.

The allure of smaller funds is their nimbleness. They can dart in and out of investments with speed that some of their larger competitors struggle to mimic. They can also concentrate on their best ideas, experts say.

“What you see with small or newer managers is they are engaging in strategies that are different and new and haven’t been seen before,” said Meredith Jones, a director at Barclays Capital’s strategic consulting group. “In many cases, that’s where a lot of the innovation comes from and that’s what keeps the industry from becoming homogenized.”

The start-ups that tend to gain traction have two main characteristics: pedigree and performance.

Mr. Bozza of Lakewood worked at the hedge fund SAB Capital Management and as an analyst at the buyout shop Kohlberg Kravis Roberts. RouteOne was started by William Duhamel, a former partner at Farallon. The Brenner West co-founders Craig Nerenberg and Josh Kaufman spent time at MSD Capital, Michael Dell’s family office. Josh Resnick, the head of Jericho Capital, was a managing director at TCS Capital Management, a hedge fund.

The recent returns of these managers have also caught the attention of investors.

After a rough 2008, where the firm lost nearly 20 percent, Lakewood notched gains of 70 percent return in 2009 and 16 percent last year, according to investors in the fund. Its bets against stocks, known as short positions, have been particularly successful, earning the fund about 20 percent a year on average since inception in 2007, according to a person with knowledge of the fund who spoke anonymously because the information was private.

To assuage anxious investors, many start-ups are hiring white-shoe law firms, and top firms for prime brokerage, legal work, auditing and administration. Brenner West, for instance, uses Goldman Sachs for its prime brokerage and Citco for its fund administration, two of the industry leaders.

“Those kinds of things make the guys with the money feel a lot more comfortable now,” said Karl D’Cunha, a senior managing director at Madison Street Capital, an investment bank.

Smaller funds have a tougher time attracting institutional investors like pensions and endowments, which represent the majority of new money being plowed into hedge funds. These investors typically invest big chunks of money, sometimes as much as $200 million, and do not want to account for a large percentage of any single fund.

But many big investors are finding new ways to work around that issue. So-called seeding funds have proliferated in the last year. These firms come up with the initial capital to individual hedge funds that are just getting started in exchange for a piece of the business. Often, such investments serve as a marketing tool for funds, enticing other investors.

The Blackstone Group, Reservoir Capital and Goldman Sachs have all raised money to invest with start-up managers. Reservoir Capital, for instance, made a seed investment with Lakewood. Brenner West was seeded by Protégé Partners, another investor in start-up hedge funds. Major institutions like the Ohio Public Employee Retirement System and the California Public Employees’ Retirement System have started their own portfolios focused on emerging managers.

Still, the amount of money dedicated to small funds remains modest by industry standards. Gone are the heady days when unproven firms could raise $1 billion before making a single investment.

Now, success is limited to a more select group of managers with the returns and experience to back their business.

“You’ve had a very fast growing, entrepreneurial industry that needed to go through the Laundromat a little bit,” said Drew Chapman, a partner at Cadwalader, Wicksham & Taft. “The crisis weeded out the weak.”

 

Obtained from The New York Times DealBook.  To view the article, click here.

Know Your Score and Get to the “Sweet Spot”

 

Executive Summary

Over the past two years, Merlin has published several white papers that are designed to highlight and help managers implement industry best practices – from shoring up their business model to identifying their target investors based on the development stage of their fund.

In continuing with this theme, our latest white paper discusses the importance of business process automation within an asset management firm at all stages of development and how these organizations can measure their current processes versus investor expectations.

It is critical that business process maturity and automation evolve over the life of a fund in a disciplined and forward-looking manner as they are key components to maintaining a scalable business. As a firm grows, processes that are maintained manually or with home-grown spreadsheets will stress and may break, adding business risk and overhead to a firm’s operations. This concept is especially important for fund managers because they cannot afford distractions and errors caused by broken or manual processes that affect the viability of the fund.

 

THE IMPORTANCE OF BUSINESS Process Automation

Managers, investors and due diligence teams all analyze and measure the business risk and process maturity of a fund. Funds must continually review both their organizational structure as well as the level of automation resident in their systems and procedures. For example, it is easy to see key-man risk if only one person holds all the senior positions in a fund (chief compliance/operating/risk/financial officer, portfolio manager, trader, head of marketing, etc.) versus each role being occupied by a distinct experienced professional. Business process risk is as critical, but can be more difficult to identify. Manual processes, for example, are present in one form or another at all hedge funds. Some of these processes are obvious; trade reporting and position monitoring are done on paper or a home-grown spreadsheet or an operations person is tasked with pulling together reports each night by collecting data from disparate sources such as emails, the Web and prime brokerage reports. Many times, performance, financial, research and investor information are stored in ways that increase the risk of data corruption, loss or simple human error.

The Risks of Ignoring BUSINESS Process MATURITY and Automation

A hedge fund’s assets, number of strategies, the number and type of its investors, and the amount of people required to run a fund, invariably strain the original processes a fund used when it was a startup. At some point, legacy processes, lack of automation and the lack of delineated roles pose significant operational risk and often impede a fund’s ability to scale and succeed.

For example, the use of spreadsheets to track positions, manage investors and calculate performance/risk/attribution, etc., is risky even when a hedge fund initially launches. In fact, because spreadsheets are so powerful – they are visual, quick, iterative, flexible, well-known and inexpensive – many hedge funds erroneously believe they have the same functionality of mature systems and as such become embedded. However, as a fund grows and its investors become increasingly institutional, the reliance on spreadsheets can be cumbersome and appear unprofessional. Existing investors may ask why their reports seem to be prepared manually and, in the worst case scenario, errors caused through spreadsheet use can seriously jeopardize a fund’s credibility.

Furthermore, the sophisticated investors a fund seeks to attract as it grows expect a certain level of process maturity. Investor due diligence will quickly reveal where a fund comes up short. Due diligence teams and investors not only want to see scalable businesses and repeatable performance, but also want to see automated systems, processes and tools that are being used by sophisticated professionals.

As funds grow it is imperative that their business processes have the rules, controls and a level of automation that is commensurate with the growth of the fund and the type of investor being serviced. Funds that ignore the natural progression of process maturity will do so at their peril.

 

MEASURING BUSINESS PROCESS AUTOMATION

Merlin has created a score sheet for funds to assess and measure their process automation risk. We call it the Process Automation Score Sheet, or PASS.

 The PASS analysis extends to:

• The processes and procedures for keeping track of a fund’s critical information (performance, attribution, risk, investors, multi-primed assets, etc.); and,

• Reliance on either manual spreadsheets or automated tools that are scalable and not dependent on specific individuals.

Some funds may be perfectly content managing a limited amount of capital for a fixed number of investors. For them, the business process automation analysis is perhaps irrelevant. However, the majority of fund managers aspire to attract larger, higher-quality institutional investors. In order to do that, funds must build out certain processes today that will attract the investors it wishes to have tomorrow. A process that is tolerated by investors in the early stages of a fund’s lifecycle will likely not be acceptable to investors in later stage funds and will almost certainly be disallowed by the institutional investors who allocate to mature, successful funds (see Merlin Spectrum of Hedge Fund Investors white paper).

Knowing when to upgrade processes and technology and when to hire additional people is a common challenge for all businesses. The Process Automation Score Sheet (PASS) is a simple tool to help managers identify their current stage of automation across ten high-level process components.

 

The BUSINESS PROCESS automation sweet spot

Once a fund fills out the score sheet and receives its PASS score, that score is placed on the Automation Sweet Spot chart. Managers can then see whether they are ahead of or behind the curve when it comes to automating the processes that govern their business based on their fund’s stage of development.

If a fund’s score puts it below the Sweet Spot, its processes are overly manual and represent risk to the principals and investors. The scores earned from the PASS will help managers and operators identify where the technology and process gaps exist – in trading, reporting, operations or the middle office. Similarly, if a fund’s score places them above the Sweet Spot, it may become clear that it has invested too much or too early in processes and may need to reassess.

With the PASS results, managers can map expenditures to the achievement of specific fund milestones such as asset growth or number of strategies. As investment management firms grow their assets, having this roadmap makes it much easier for them to invest for growth in the right areas at the right time rather than try to rapidly catch up to it. These tools help managers avoid investing in unnecessary processes that exceed their actual needs or people who will put their firms and their client’s money at risk.

 

The Challenge: Getting to the Sweet Spot

The remainder of this paper examines the strategic approaches managers can implement to get their business into the Sweet Spot.

There are three basic ways a fund can institutionalize processes:

o   Build new systems in-house;

o   Buy prepackaged solutions, integrate and customize them to meet its needs; or,

o   Outsource to a third-party technology provider.

Most funds will be guided by a general bias toward one of these options, however, a fund can, where appropriate, utilize a mix of solutions to create the optimal process. As detailed in a previous Merlin white paper called The Business of Running a Hedge Fund, the most cost-effective way for smaller and mid-size funds to implement mature processes is typically through outsourcing. Larger funds, on the other hand, with significant assets, strong recurring revenues and an existing technology infrastructure, may be best served by building their own process solutions alongside the proprietary systems they already have in place.

Even for very large funds, however, the case for third-party solutions is compelling. They can represent a variable rather than fixed cost and can scale in capacity as needed without additional servers and data center space. Funds can also use third-party solutions to lower their overall technology spend and leverage the scale that those providers have achieved by selling solutions to a broad marketplace of clients. Finally, outsourced technology providers have a very strong market-driven motivation to stay on the cutting edge – to keep pace with changing asset classes and securities, as well as the demands of regulators, investors and, of course, managers.

 

CONCLUSION

The business landscape has changed dramatically for both hedge fund managers and the in­vestment community over the past several years. The industry has matured to the point where managers must cater to the needs of institutional investors in order to grow and thrive. In addition, new risk, reporting and regulatory requirements, along with volatile markets, make having reliable automated processes essential components to running an efficient hedge fund. Manual work, key-man risk and a reliance on spreadsheets will be clear red flags to in­vestors and prospects alike.

As a result, possessing the optimal levels of process ma­turity and automation are no longer just a luxury. Rather, hedge funds seeking to retain institutional assets, grow their AUM and attract more sophisticated investors must look ahead and be prepared to invest in and proactively deploy long-term solutions.

To successfully accomplish this, managers must truly understand where the current and future gaps exist in their businesses’ process maturity and automation and what technology solutions they will need to remedy those gaps. Understanding this through the PASS analysis, and then striving to remain in the Automation Sweet Spot, gives managers a navigable plan as to when to commit the capital and resources required to achieve the process maturity and automation that is commensurate with both the current stage of the fund and where they wish to be in the future.

 

For access to the PDF version, click here.

 

 

 CONTACT

Ron Suber

Senior Partner and

Head of Global Sales and Marketing

rsuber@merlinsecurities.com

(212) 822-4812

 

 

About Merlin Securities

Merlin is a leading prime brokerage services and technology provider, offering integrated solutions to the alternative investment industry. The firm serves more than 500 single- and multi-primed managers, providing them with a broad suite of solutions including dynamic performance attribution analytics and reporting, seamless multi-custody services, capital development, 24-hour international trading, securities lending experts and institutional brokerage. With more than 100 employees, the firm has offices in New York, San Francisco, Boston, Chicago, San Diego and Toronto. Merlin utilizes the custodial and clearing operations of J.P. Morgan, Goldman Sachs, Northern Trust and National Bank of Canada. Merlin is a member of FINRA and SIPC. For more information, please visit www.merlinsecurities.com.