The new JOBS Act, recently passed by Congress and signed by President Obama, is designed to make it easier for small businesses to raise capital and create new jobs in the current economy. An indirect beneficiary of this legislation is the hedge fund industry, as it will revolutionize how alternative investment managers can market their funds to the public. Until now, hedge funds have been banned from making general solicitations and advertising to the general public. This new legislation directs the Securities and Exchange Commission to eliminate the ban on general solicitation and advertising within 90 days; however, hedge funds will still only be able to accept investments from accredited investors. We may soon see newspaper, magazine and television advertisements from hedge fund organizations, which will have both positive and negative consequences for the hedge fund industry, institutional investors and the general public.

 

Benefits

 

The hedge fund industry will benefit from this new legislation as the SEC provides greater clarity regarding how information can be provided to the public and what type of information hedge fund managers are allowed to disseminate.  To date there has been conflicting legislation regarding what information hedge funds can provide, along with wide differences in the interpretation of these regulations within the hedge fund industry. The conservative interpretation of Regulation D of the Securities Act of 1933 pertaining to the ban on general solicitation has included 1) no communication on any subject to the media, 2) no participation in databases, and 3) no contact information on a firm’s website. Yet many of these same firms are registered with the SEC and must also comply with the conflicting legislation of the Investment Advisors Act of 1940, which requires these firms to submit a Form ADV to the SEC and state securities authorities.  Form ADV contains detailed information about their organization, which is available to the general public on the SEC website, and makes it impossible to be in compliance with both legislations simultaneously. Other hedge funds have been more liberal in interpreting these rules and believe it is appropriate to speak to the media regarding industry information excluding their firm and fund, participate in databases that are published in the media and provide some information on their website regarding their firm and investment process. The new legislation should help bring clarity and a more level playing field to marketing strategies among hedge funds.

 

SEC rules stemming from the JOBS Act should also benefit the hedge fund industry in reaching out to a wider audience, particularly with respect to high net worth individuals.  Until now, a vast majority of direct hedge fund investments have come from institutional investors or ultra high net worth individuals. High quality small and mid-sized hedge funds should benefit from the opportunity to build stronger brands in the marketplace in order to effectively compete with their larger rivals. Over the past 3 years, most net asset flows within the hedge fund industry have gone to hedge fund organizations with the strongest brands and not necessarily the highest quality fund offering. This is especially true for the hedge fund of funds industry, where many small and mid-sized funds have had a difficult time raising assets. For many high net worth individuals looking to diversify into hedge funds, a hedge fund of funds may be a more appropriate alternative due to the diversification benefits of investing in multiple managers.  We expect the hedge fund of funds industry to be a major beneficiary of this new legislation.

 

Institutional investors will benefit from greater transparency throughout the hedge fund industry. Currently it is cumbersome to identify top quality hedge funds, compare them to top competitors in the strategy, and perform appropriate due diligence. This is because of the difference in transparency between the mutual fund and hedge fund industries. In the mutual fund industry, a vast majority of firms provide information about their funds on their company websites and to leading industry databases.  This allows investors to quickly compare mutual funds based on style and rankings in a database, and then access more detailed information about individual funds on their websites.  In the hedge fund industry, many hedge funds elect not to participate in databases. In addition, US based hedge funds have password protected websites. As a result, analyzing hedge funds has been an arduous task that includes starting with hedge fund data bases and then leveraging trade publications, industry conferences, prime brokers, third party marketers and friends to help identify top hedge funds. This is followed by contacting the hedge fund directly to obtain information about the manager, which makes it a very inefficient process.

 

The hedge fund industry represents a significant number of the leading investment minds in the financial industry. This new legislation will benefit the general public because hedge funds should be more inclined to share their investment views on television and in print media.  As a result, retail and high net worth investors will gain valuable insights into a variety of hedge fund strategies and investment ideas.

 

Negatives

 

The negative aspect of this legislation is the potential for unscrupulous marketing activity by shady hedge fund managers who may be able to take advantage of high net worth individuals with a lower level of investment knowledge. The historical investor base of hedge funds have been Institutional investors and ultra-high net worth individuals who typically have a high degree of investment knowledge and use multiple evaluation factors when selecting a hedge fund. Unfortunately, some retail investors may be persuaded to invest in a fund based solely on high historical returns. The highest returning managers often are not the highest quality managers. Their historical performance might have been based on 1) a very small asset base, 2) taking significant risk, or 3) even luck. If these investors end up having an experience significantly below their expectations, it could create negative publicity for the hedge fund industry.

 

Hedge fund marketing strategy

 

This new legislation should prompt all hedge funds to re-evaluate their marketing strategy and determine the impact it will have on their firm. Most hedge funds will initially take a ‘wait and see’ approach to observe what strategies are being utilized by other hedge funds. Some of the questions that need to be addressed include:

• What other information should be made available on the company website, including appropriate disclosures?
• Should there be different password protected areas based on what country an investor resides in?
• Should the firm develop a public relations strategy?
• Should the firm develop an advertising strategy? If so, to what target market?  
• Should there be a conference strategy?
• Should the firm contact a broader universe of investors? If so, who is the target market and what is the most effective way of reaching this audience?

Not all hedge funds will modify their marketing strategy for some of the following reasons: 

• Their fund is closed to new investors.
• They view their process and firm information to be proprietary and do not want competitors to have access to their information.
• They are concerned about the risk that institutional investors will perceive a reduction in brand value for hedge funds that advertise to the general public.  This should be less of an issue for hedge fund of funds.
• They will not want to be distracted by retail investors, which is why many hedge funds have high minimum investments to begin with.
• They need to avoid violation of securities laws in other countries where some of their clients are based.   

Over the next 90 days the SEC has been directed to develop new regulations for the hedge fund industry, and once these regulations are finalized, we will begin to see many hedge funds start the process of broadening their marketing strategies. For those organizations that are bold enough to lead the charge in being the first to advertise, we expect them to enjoy a material advantage in building their brand not only through advertisements, but also the publicity generated by these ads. In order to be a first mover, these organizations need to start planning now.

 

Donald A. Steinbrugge, CFA, Managing Member
Agecroft Partners, LLC

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.

 

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

A lot of press has been given to the insider trading probe currently being conducted by US law officials.  There was only one arrest so far to come out of the FBI raids and all the subpoenas, which a lot of news releases and the public believe has more to do with the Galleon case.

I am not defending hedge funds, but could this be all about timing?

Back in September, SEC Inspector General David Kotz all but admitted that the agency announced its lawsuit against Goldman to deflect attention from his office's report, which happened to be released on the same day, criticizing SEC  for repeatedly failing to catch fraudster Allen Stanford.

On one hand, regulators are currently creating rules to implement aspects of the Dodd-Frank Act under certain timelines set forth by Congress, while on the other hand, lobbyists are working diligently to try and alter impressions of the provisions by these same rule makers.

Is it a coincidence then that US officials are being very agressivec with their tactics and painting the hedge fund industry with a broad brush and potentially ruining some hedge fund business's, therefore mitigating the chances of impacting the rulemaking process?

 

Eric Lazear, Head of Operational Due Diligence, FQS CAPITAL PARTNERS LP

Executive Board Member, HFBOA

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