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

George Roeck
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…

I recently came across the attached white paper* from Merlin Securities which highlights, in part, the distinction between managing money and running a hedge fund business. This is an concept that I have been emphasizing whenever someone asks me about forming a new hedge fund. There are numerous examples of talented money managers that attempted to go their own way and ended up closing their shops. They failed, not because they didn’t know how to make money for their investors, but because of operational collapses. The challenges in building a sustainable hedge fund business and raising external assets cannot be overstated. This may be a bigger issue for individuals leaving investment banks or mutual funds than prior hedge funds. Given the financial rewards achievable by successful hedge fund managers, the better a foundation you build, the greater the chances for success for your investors and yourself. Starting with the right team (both internal and external) is just as important as partnering with quality investors.

Please feel free to add your thoughts to the discussion.

*Reprinted with permission from Merlin Securities.

George Roeck, Chief Operating and Financial Officer, Charter Bridge Capital Management, L.P.

Executive Board Member, HFBOA

Expert networking firms are now a target of the SEC, along with traders who act upon any inside information. So far expert networking firms that provide information via channel checks have not been subject to SEC inquiry. However, a concern in the future is at what point does information gathered become inside information. Asking a pharmacist at the local Walgreen’s how much of a drug is prescribed is ok. Asking the same question to the regional Walgreen’s VP could be an issue. Speaking with operations and sales people of companies is becoming a questionable area. There is huge uncertainty in this area. Be careful if the expert used to work at the company you are discussing, or if he or she were once a consultant for the company.

The Galleon case is the first insider trading case that has relied upon wiretaps for information gathering. Wiretaps remove the circumstantial nature of evidence gathered in insider trading cases and have the potential of turning civil cases into criminal cases, as the Department of Justice has authority to request wiretaps, not the SEC.

Officers of foreign companies may not be subject to equivalent insider trading or full disclosure requirements as their US counterparts. However, any information obtained from the foreign company must be treated in the same manner as information obtained from a US company.

A CCO can protect their firm by emphasizing training of its professionals at least annually. Also, know the firms experts, what steps does the expert networking firm take if the firm thinks it has received insider information? Create and document policies and procedures and make sure they are followed. From an SEC standpoint, not following written policies is nearly as egregious as having no policy at all. Look at the source of information in determining a trade. If it is at the least suspect, put the company on the do not trade list.

Kurt Koeplin, Chief Financial Officer, RAIL-SPLITTER CAPITAL MANAGEMENT, LLC

All HFBOA members are invited to download a copy of the presentation from the January luncheon - featuring topic experts from Rothstein Kass!

Click here to download:

www.hfboa.org\pdf\sas70hf.pdf

The hedge fund universe is entering a new post credit-crisis era of increased institutional flows resulting in demand for greater Investor transparency and increased regulation & oversight. In this new environment, organizational maturity - a hedge fund's ability to match its operational and infrastructure needs with its size and scope - is becoming a key differentiating factor. The maturity of a fund's organizational structure, the robustness of its operational controls, and the resilience of its technology infrastructure are becoming determining factors in the allocation of capital.

In the second Prime Finance publication of 2010 this key topic has been explored through over 75 in-depth interviews with COO's, CFO's, and heads of strategy, from a broad cross section of hedge funds from start-ups and spin-outs, to emerging funds and institutional size firms, up to the franchise heavyweights of the industry. These interviews provide the foundation of views put forward in this article.

Findings of these interviews have been translated into a Hedge Fund Maturity Model that details the organizational, operational and technology characteristics of hedge funds across four stages of maturity linked broadly to the size of their AUM. This maturity model provides a framework for the industry to discuss organizational "best-practice" and forms the foundation for the Citi Prime Finance Business Advisory team to partner with our clients and help them shape their evolution and growth.

To view the full report please go to:

https://primebroker.citigroup.com/public/PlanningforChange_Dec2010.html

*this was reposted with permission from Citi*

The HFBOA interviewed several experts in the UCITS arena, following its well-attended conference on the topic held November 8.  The HFBOA and Financial Research Associates are planning another UCITS event March 30-31 in New York.  To read what our experts had to say about questions related to UCITS such as, "Is the demand for UCITS going to last?", download our latest newsletter today!

A recent white paper authored by Haim Mozes and Jason Orchard appears to set forth the proposition that smaller hedge funds (under $750 million in AUM) are less risky than larger hedge funds, and tend to generate greater alpha.  "Alpha is an important source of hedge fund returns, and that alpha decreases as AUM grows.  Thus, the larger a fund's AUM grows, the higher its systemic exposure and the lower its alpha generation and ability to exploit volatility, the worse it is likely to perform in a poor environment for equities and hedge funds.  It is hard for hedge funds to find enough liquid, yet misunderstood assets to generate alpha."  Mozes and Orchard seek to build upon the earlier work of Ammann and Moerth, which posited that hedge fund performance is negatively related to the amount of assets raised in the prior period.  Interestingly, Mozes and Orchard's conclusions are directly contrary to the recorded capital flows throughout 2009-2010, which have been strongly in favor of the largest hedge funds.

Assuming that you agree with Mozes, Orchard, Ammann and Moerth, how does one go about finding smaller more nimble hedge funds? Investing in hedge funds with shorter track records and limited resources can be a bit of a gamble, so perhaps one could look to horse racing to offer some lessons.  When it comes to wagering on horse racing, it seems that everyone has a system.  Some folks bet on the Horse and some folks bet on the Jockey.  I suggest that you look to place your bet on the best combination of Horse and Jockey, or "Hockey".  Investors can't always be sure that the track record of an individual portfolio manager is wholly related to the investment acumen of that individual or the result of an institutional environment or team effort.  Newer and smaller hedge funds where both attributes are present may offer the best chance for success. 

When I hear someone ask, "Is this a good time to invest in hedge funds?", I view this as roughly equivalent to trying to time the market which no one has been able to do consistently.  You will never know for sure whether it is a good time to initiate an investment, but you will definitely know it when you have missed the next upswing in the market or alternatively, caught a downdraft.  The standard investment advice regarding diversification and dollar cost averaging also holds true regarding investing in hedge funds.   

George Roeck, Chief Operating Officer & Chief Financial Officer, Charter Bridge Capital Management LP

Executive Board Member, HFBOA

"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to heaven, we were all going direct the other way - in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only."

-Charles Dickens, A Tale of Two Cities, English novelist (1812-1870)

When we look back to 2010 hedge fund start ups, will we be quoting Charles Dickens? Despite the enormous challenge of raising investor capital in this post-Madoff environment, many other aspects of starting a hedge fund have rarely been more favorable.  The pool of available talent (both front and back office) is wide and deep and can be accessed at a lower cost than just a few years ago.  The Volcker rule is pushing entire teams out of investment banks and many are looking for a new home.  Service providers (administrators, prime brokers, attorneys and accountants) are hungry for business and agreeing to take on newer and smaller firms just to get their foot in the door.  Real estate is more plentiful and less costly and lessors are willing to cut better deals.  There is a lot of available space already built out which saves precious dollars for new hedge fund managers.  Technology is also more readily available and cost-effective when accessed through a hosted (ASP) environment. 

Looking forward, allocators (pension funds, life insurers, endowments, etc.) have made promises to their constituents which they will not be able to cover in a low interest rate/return enviroment and will need to seek out the higher returns that alternative investments are known for.  I have seen some commentary forecasting a 2-3X increase in AUM for the alternatives industry over the next 20 years.  Firms starting up now will have a chance to build a track record in advance of the coming needs.  Speaking of needs, while it is clear that the largest hedge funds are attracting the lion's share of the assets currently being allocated, I am hearing an increased din of unhappiness with the largest firms.  Feedback along the lines of the larger firms are too correlated with the markets (and each other) and that returns have decreased as AUM increased.  This has lead many investors to seek out newer and smaller firms with good pedigrees. 

We will not know for some time whether 2010 was such a great year to start up, but as the saying goes, "You have to be in it to win it". 

George Roeck, Chief Operating Officer & Chief Financial Officer, Charter Bridge Capital Management LP

Executive Board Member, HFBOA

In this post Lehman era, the question I continue to grapple with is: How many prime brokers do you need?

Given that our fund is one of the more plain vanilla Long/Short equity funds, I think more than two is really unnecessary.  We launched our fund in the end of 2008 with three prime brokers and a segregated cash custody account (when I was hired, our initial thought before Lehman was just one prime broker and no cash).

The problem I run into with multiple primes - other than the hassle of additional reporting. reconciliations, etc - is being able to spread my balances to each.  I don't end up with significant assets at any one area to use as leverage for cost savings.

I understand being able to spread counterparty exposure over multiple primes is definitely something investors are thrilled with - I get it - but there has to be a happy medium to it.

I pose the question to the website from an investor and hedge fund prospective.  What is the right number? 1, 2, 5??

Do we still need to have our free cash in a segregated cash account, and if so what percentage of NAV are investors happy with? You have to remember that performance is affected in these situations - not enough balances, can't negotiate down financing rates.  Need to have x% of NAV away from PB - might be borrowing from Peter to pay Paul.  In the world of uncertain market performance, the last thing any hedge fund manager needs is additional basis point hits to an already weak 2010 performance number.

With all of this in mind, having multiple primes does have advantages above and beyond minimizing counterparty exposure, such as free competition to get locates on hard to borrow names.  Letting the brokers fight it out can actually save some significant performance depending on how long you hold your positions.  They also can go in and borrow stock from you and then you can use the other brokers as a benchmark for rates.  This enables a manager to more effectively manage the financing game.

What are your thoughts? What stories do you have recently? I would love to get a lengthy blog going on this topic.

Marc Abel, Chief Financial Officer, Dabroes Management LP

Executive Board Member, HFBOA

It’s not like me to be quite a salesman for anything,　but I thought I would give my views regarding the HFBOA conference and why I believe it will be beneficial to hedge funds CFOs such as myself.

In quick review, here are the topics of the conference:

• Regulatory updates: At home and abroad
  • Regulation at the state level: New implications for private fund managers
  • The future of offshore jurisdictions
  • what you need to know about the European Alternative Investment Fund Managers Directive
• Accounting, auditing and tax updates
  • the impact of the new carried interest law
  • Updated disclosure requirements for ASC 820 (Formerly known as SFAS-157)
• Managing your third party relationships more effectively
  • cleaning up your prime broker arrangements
  • New trends for administrators: asset verification and price verification reporting
• financial management for the fund and fund advisor
  • compensation challenges: from high water marks to deferred compensation plans
  • what can I legitimately charge to the fund?  Legal and ethical considerations
• Managing investor relationships: From due diligence to fundraising
• How do investors' approaches to due diligence differ? Investor Panel Discussion!
• terms, liquidity, and fundraising: A look at varying expectations

 Given the market environment these days, I am always facing different questions and I believe this year is one in which going to the conference will be of most value.

I am very concerned about the EU directives because my fund is primarily invested in western Europe.　 Of particular interest is short bans by country: There is going to be much more compliance required in certain countries (which will require monitoring position size on shorts to say the least) and I am curious what the panelists will say are "more likely than not" to stick once the books are written.

As far as the new carried interest law, we are generally a short term capital gain shop, but everyone wants to be able to get as much capital gain vs ordinary, especially since the elimination of all those offshore deferral compensation plans that were so popular a few years back.　 The combination of the new carried interest law and the elimination of the Bush tax cuts (or what looks to be possibly amendments with Obama’s stamp, but again favoring tax treatment away from the hedge fund managers) should make for some interesting discussions, both at the conference and going forward in the months before 2011: How managers will operate as tax-efficiently as possible.　 Are we going to need to accelerate capital gains to take advantage of lower tax rates? 　What will happen with all these dividends that were getting preferential treatment that will no longer apply?　 Are swaps still going to get around all that offshore withholding?　

The pendulum for prime broker agreements are swinging more in favor of the managers again.　 The collapse of the world back in 2008 (when I launched our fund) dictated that funds needed to 　take on multiple prime brokers as well as a cash custody account for free cash.　 That put hedge funds at the mercy of the brokers and banks and terms for hedge funds were very unfavorable.　 　I think now is the time to really push back and renegotiate agreements and possibly eliminate the need for four or more prime brokers and discuss terms that favor funds a bit more.　 I think this particular conference session will provide significant value to hedge fund manager CFOs, though will probably benefit all attendees to some degree.　 Another key question: What will administrator’s agree to in their new agreements for 2011 and beyond?　 Can we as an industry apply enough pressure to renegotiate what is currently in place regarding price verification?　 Can we get them to agree to pricing the portfolio vs. a price verifier?　 I would love to hear what my peers think.

As for income and expenses of the funds moving into next year, what will the trends be to the following?

1.  High water marks-what will we as an industry be expected to make before we collect our 20% (if it stays there)

2.  What is going to be the industry standard for management fees-i.e. is 2% acceptable anymore?

3.  What about expenses that funds feel comfortable charging to the fund, given a downward trend away from the 2%?　 IF we charge less to the funds can we stay at 2% or if we go to say a 1% benchmark will investors "expect" to pay for more and have the manager pay for less?　 OR is there such a paradigm shift that will require into 2011 and beyond (dare I say) 1% fees and also very little fund expenses?

4.  As to liquidity terms, we are looking to see what PPMs will look like going forward-what will investors "expect" to be given in addition to fee terms, specifically liquidity?　 At our fund, we have bounced that around a lot recently to figure out whether you can have a hard lock, just a soft lock, some combination of lock or (if the fund is liquid enough) really not have any lock up at all?　 I am curious where investors stand on this as they need to appreciate that managers are looking for long term partnering relationships.　 Although it’s important to give on some liquidity, especially if the fund is liquid, we don’t want to be managing our fund quarter to quarter or month to month if it ever gets to that point.　

 These final areas of the conference I think will really leave people with some thoughts to consider.

Again, not being a salesman, I nonetheless hope I sold everyone on the need to attend and get ready for a very exciting few days.　 Attendance has grown year over year and I think this is the perfect time to join your peers for what I feel are strong sessions on key issues as we head into next year.　 See you there.

Marc Abel, Chief Financial Officer, Dabroes Management LP

Executive Board Member, HFBOA