Since the market correction of 2008, a vast majority of hedge fund net asset flows have gone to a small minority of hedge funds with the strongest brands, marking a change from the pre-2008 environment. A brand is an investor’s perception of the overall quality of a hedge fund based on multiple evaluation factors that evolve over time. A high-quality brand takes a long time to develop, but once achieved, it significantly enhances a firm’s ability to raise capital and retain assets during a drawdown in performance.
Branding is a critical issue for all hedge funds, because the marketplace has become increasingly competitive. Some estimates put the number of hedge funds at over 15,000 in the marketplace. Hedge fund investors are inundated with requests for meetings, with some receiving hundreds of phone calls or emails per week from investment managers. To filter through the overload of information, investors are turning more and more to a firm’s brand when choosing which funds to meet and with which to ultimately invest.
From the fourth quarter of 2008 through to the third quarter of 2010, most hedge fund inflows gravitated to the largest hedge funds with assets greater than $5 billion, deep operational infrastructure, large investment teams and an institutional client base. Performance became a secondary consideration. During this period a large percentage of the assets flowing into the hedge fund industry were driven by large pension funds making their first direct allocation to hedge funds. Their primary objective was increasing their exposure to hedge funds while minimizing headline risk. The large hedge funds that had developed well-known brands within the industry were perceived as providing a conservative approach to investing in this space.
Over time, the definition of a high-quality brand evolves and a greater emphasis may be placed on potential future performance. As an increased number of pension funds have gained more experience with hedge fund investing, some gradually reduced the minimum size of AUM of hedge funds in which they invest. Most of the assets continue to flow to the largest managers. However, many have begun allocating a greater portion of their assets to funds with $1 billion to $5 billion in AUM. Over time we expect this AUM limit to decline, but currently very few pension funds are investing in hedge funds below $500 million in AUM.
In the past several years, we have seen a re-emergence of more experienced and sophisticated hedge fund investors within the endowment, foundation, pension, large family office and fund of funds sectors of the market. Many of these experienced investors believe that the largest hedge fund managers have accumulated too many assets, which dilutes their alpha over a larger asset base and, increases the investment risk to investors because of the larger bets they were required to make in individual securities due to their size.
Unfortunately for a majority of managers this greater focus on smaller, more nimble managers continues to be concentrated in the small percentage of those small and mid-sized managers that have developed the strongest brands. The key question is, what are the firms that have developed the strongest brands doing differently?
For the small number of new hedge fund launches that are successful each year, their high-quality brand was typically created at their previous firm. This may include having held a senior position at another top-quality brand hedge fund, having spun out of a top investment bank proprietary trading desk, or having been seeded by a well-known investor.
For the hedge funds not fortunate enough to launch with such fanfare there are three critical steps involved in creating a strong brand and raising assets in today’s competitive environment. These include the quality of the fund offering, the investor’s perception of the quality of the fund offering, and their marketing and sales strategy.
It is almost impossible for sub-par managers to raise assets from investors outside of friends and family. The biggest mistake most of these lower-quality hedge funds make is not understanding the evaluation factors investors utilize to select hedge funds, andtherefore not creating a top-quality offering. These factors typically include an evaluation of a firm’s operational infrastructure, investment team and their pedigree, investment process focused on their differential advantages, risk controls, performance, service providers and fund terms. A weakness in any of these factors can eliminate a firm from consideration. In some cases a minor adjustment can significantly improve the marketability of the fund. Hedge fund performance tends to be a quantitative screen to eliminate a majority of managers, but once performance has reached a certain hurdle its weighting in the evaluation process is less important than most managers realize.
The second step in the process of building a strong brand is making sure the market’s perception of the firm is equal to reality. This requires a consistently delivered, concise and linear marketing message that identifies the differential advantages across each of the evaluation factors investors use to select hedge funds. Many high-quality hedge funds have difficulty raising assets because they do a poor job of articulating their message to the marketplace. Investors use a process of elimination in selecting hedge funds. This typically begins by screening the thousands of hedge funds in the marketplace, meeting with a couple of hundred and hiring a select few each year. It only takes one poorly worded answer to get a firm eliminated from consideration.
It is important that the marketing message is clearly understood by all employees of the hedge fund and that the message is consistently integrated throughout all the firm’s communication media, including the website, written materials, due diligence questionnaires, quarterly letters, and, especially, oral presentations.
The final step in building a strong brand is implementing a highly focused marketing and sales strategy that broadly penetrates the marketplace while being compliant with regulatory guidelines. Many investors exchange ideas on managers and, as a result, the more deeply a manager penetrates the marketplace the stronger their brand will become. Building a strong brand and raising assets takes time and cannot be rushed. The hedge fund industry is not transaction-oriented. In many instances, being too aggressive will eliminate a firm from the selection process. Many investors require a minimum of three or four meetings with a fund before they will invest.
One way to truncate the process is to utilize a well-seasoned, highly respected internal sales team, top-tier third-party marketing firm or a combination of both. Experienced and well-thought-of salespeople can have a large impact on a hedge fund’s success in growing their asset base. If their brand is strong, it can significantly increase the possibility of meeting with an investor and increase the initial credibility of a firm. Prime broker capital introduction areas can also be a valuable resource.
However, they should not be relied upon solely. As mentioned before, it usually takes multiple meetings for an investor to invest and it is very important to have multiple people focused full-time on the sales process.
The days of a hedge fund participating in hedge fund databases and then sitting back and waiting for the assets to flow are over. The firms that will be successful in growing their business in the future are organizations that stay highly focused on providing a top-quality offering, clearly articulate their firm’s differential advantage across the multiple evaluation factors investors use to selected hedge funds, and have a highly professional sales and marketing strategy.