Last November, I commented in this space on a white paper which attempted to make the case that smaller, more nimble hedge funds were less risky and generated greater alpha than larger, more established hedge funds-one of several such papers issued in the last ten years. A recent survey out of Deutsche Bank predicted record hedge fund inflows for 2011 and noted that smaller managers were seeing growing interest from investors. Notwithstanding the expanding list of commentators jumping on the bandwagon, the statistics for 2010 are in, and ,guess what?-once again, the majority of capital put to work in 2010 went to the largest most established firms. Why does this remind me of the old adage-“Do as I say and not as I do”?
The attached article by Steven Simmons, Head of Prime Services, Maxim Group, entitled “Happy Days are Here Again…. Not So Fast…” * caught my eye, and he is absolutely dead on. Allocators are looking for reasons not to invest instead of focusing on the value proposition offered by emerging managers.
Simmons goes on to offer some suggestions on how emerging managers can make themselves more attractive to allocators who have traditionally opted for more established hedge fund names.
With a number of larger hedge funds announcing that they are closing down and/or returning capital to investors, smaller managers can only hope that allocators are forced to focus their gaze upon them and you never know, they just might end up liking how it affects their portfolio’s returns.
*Reprinted with permission of Maxim Group
Chief Operating and Financial Officer
Charter Bridge Capital Management, L.P., Executive Board Member, HFBOA
Happy Days are Here Again... Not So Fast
Many of my industry colleagues have expressed extreme optimism regarding opportunities for capital allocations in 2011, particularly for the emerging and middle tier managers. As a salesman, I am an eternal optimist, however I would like to strike a cautionary note before coming across like the mayor in “Jaws” declaring, “It’s a beautiful day, and everyone should be heading back into the water”. The dialed up rhetoric from some of the largest pension plans and traditional allocators reflects a renewed interest and commitment to the smaller end of the hedge fund spectrum, yet there still remains a decided lack of intestinal fortitude to commit financially. Investor acceptance and greater understanding of the inherent positive return bias during the first few years of fund launch and relative outperformance compared to more established peers has been a proven maxim within the space. And indeed, the number of investor mandates we have received for emerging and middle tier funds has significantly eclipsed those from the last few years. Now before the bottles of champagne are all uncorked, there still remain significant headwinds for the smaller manager in 2011.
Returns for 2010 averaged 10.8 %, not a particularly high benchmark which many emerging and middle managers beat handily. Now while the enhanced alpha typically garners institutional investor, many of the “household” name funds (Bridgewater +38%, Paulson +35%, Third Point + 34%, and Pershing Square +22%) more than crushed the benchmarks. Therein lies the dilemma for an institutional investor with fiduciary responsibility to their respective plan – “Do I allocate to Bridgewater, Paulson etc., or do I put my money with unknown emerging manager XYZ that also put up great numbers?” The old maxim of “not getting fired for buying IBM”, holds true when it comes to hedge fund investing. Despite rhetoric to the contrary, it is still very difficult – even for the best performing emerging managers to attract significant attention - let alone capital- from the largest allocators. The days of simply producing alpha and the money magically finding the firm has long passed and managers have to work harder than ever to attract attention.
With such fierce competition for capital, investors remain firmly in the driver’s seat, and the screening process, due diligence, and investment terms have never been more stringent. Many of the investor mandates we have seen are very specific in nature, however there have been a significant amount of investors simply asking to be shown the best managers capturing alpha – thus opening the door to a very broad playing field. The biggest buzzword among institutional investors this year seems to be “clarity”, specifically regarding the “clarity” of the strategy itself. The manager’s “elevator pitch” and corresponding marketing material has never been more important, and failure to deliver a concise vision of what it is they do to create alpha is the fastest way of alienating a potential investor who is looking for any reason to take a manager off of their radar. Specific attention is also being given to the underlying teams at the funds. The “two guys in a garage approach” is long dead, and smaller funds are faced with the Catch -22 of having enough capital to hire a full time marketer / investor relations person, who can ideally, raise enough capital to help expand and grow the business. Outsized returns may capture investor attention, but the delineation of job roles i.e., the portfolio manager not being the head of marketing and client relations etc. is very important as well, especially for those managers who have just hit the all important 3 year track record. Now more than ever, proper infrastructure and the ability to coherently and concisely define your edge in creating alpha is paramount to just getting your foot in the door.
Finally, there has been, and continues to be a dramatic shift in the landscape for key service providers that deal with the emerging and middle tier managers. The introducing prime space, long the stalwart supporters of the developing managers, has seen a significant shake up via mergers and outright exiting the space. The introducing prime space traditionally has provided support for enhancing and delivering the manager’s message to the institutional investor space (ideally) via capital introduction services. While many of the introducing primes have exited the space, larger, traditional primes rarely focus on the smaller funds, contrary to much of the rhetoric on the street. Only the most choice (read: revenue generating) funds will continue to be courted by tier one primes and receive access to capital introduction services. Newer managers are forced to be extremely judicious when picking their service providers insuring they are getting a true value added service with a partner that has a vested interest in seeing them (and thus helping them!) grow.
One of the family offices we are currently working with stated, “We are very keen to put money to work this year with smaller funds; but we are looking for EVERY reason possible to AVOID putting money into them”. Any reason that they can “check the box” not to invest is used, and the first reason they cited was poorly done marketing materials and an incoherent vision. For the emerging and middle tier managers, success in raising capital in this tumultuous environment, beyond an excellent track record of outperformance, is largely dependent upon a clear vision and the ability to delineate it. Marketing pitches and materials should be reviewed and tested with outside eyes and ears, preferably with someone who has a vested interest in seeing them succeed. Funds need devils advocates, not cheerleaders.
There are numerous reasons to be bullish in this space. Funds with the ability to speak up clearly and say “here’s why were different, and here’s why we work” should reap the benefits of the renewed interest in this space. Without that clearly defined message, it might seem like a great time to go swimming, unfortunately it might be too late to realize you are only chum in the water…