Kevin Cook, a founding partner of hedge fund advisor Autumn Capital Partners, has looked closely at the main reasons why emerging managers don’t get to the next level. In essence, it is a failure to raise assets to a sufficient level to support the day to day operation of the hedge fund as a business. Cook argues that mistakes in three broad categories – capital raising, business and strategy – account for the failures that litter the emerging manager landscape. His account of why emerging managers fail was sketched out in a session at the 2nd Emerging Manager Forum in London on June 28.
Underestimating the challenge
Hard though it may be to believe in the investment climate of 2012, it is the case that some emerging managers will fail because of underestimating the challenge of getting a successful hedge fund up and running. Underestimating compliance standards as well as the time and expense of registering with the Financial Services Authority can also trip up inexperienced managers.
Added to this is the well documented difficulty of raising investor capital. On the one hand, high net worth investors have retreated from backing hedge funds of all sizes. This leaves institutional investors. Many, particularly in the US, are increasing their allocations to hedge funds. But this support is very much conditional since the vast majority still need to see a one to three year track in order to back a manager.
One particularly mistaken belief, according to Cook, is that many emerging managers believe that investors will ignore the lack of a track record if the portfolio manager has worked at a prestigious firm. Allied to this is another fallacy, namely that a track record, perhaps on the prop desk of an investment bank, will make someone a good hedge fund manager.
Owing to the very great difficulties in the current environment, Cook said it is a short sighted decision for an emerging manager to forgo seed capital in order to maintain full ownership of the economics. In addition to capital, a seed relationship can often contribute know how and infrastructure to a new firm. It is also important to be realistic. Too many business plans base revenue to run the operation on exponential capital growth during years one through three. The reality is that most emerging manager businesses will be loss making in the first three years. There is also danger in thinking that running a small hedge fund is glamorous, when it fact in is back breaking, hard work.
Lack of definable alpha
The winnowing of the hedge fund industry post-2008 has seen the big get bigger, the medium-sized run to stand still and small firms finding the business economics very tough indeed. There is a key message in 2012 for emerging managers who want to grow and prosper: you must have a definable alpha proposition.
For Cook, it is a truism that 2 & 20 for beta plus products won’t sell any more. The flip side of having a definable alpha proposition is that too many managers are doing the same thing. Being unable to differentiate on strategy is likely to make it difficult for an emerging manager to get traction with enough investors to make the business economics viable. The message here is simple: emerging managers must listen to messages from the market. Build it and they will come had happy consequences in ‘Field of Dreams’; with a hedge fund, however, it is a dangerous illusion.
Equally, it is an error, according to Cook, to put profitable strategies with unprofitable strategies in order to build scale for the business. “Investors,” he says, “prefer a simple alpha proposition.”
Inability to communicate
Any number of investor surveys show one simple fact: the biggest reason for an investor to refrain from making an allocation is not being able to understand what the managers are doing. This can extend across the investment process to risk management and to the partners own responsibilities in the business. On some occasions, a prospectus may be unclear on detail or lack focus on the key elements of the emerging manager’s investment proposition.
This is particularly prevalent with commodity trading advisors, according to Cook. With CTAs the investment proposition may well embrace complicated technological processes. But that is no justification for leaving investors befuddled.
If a fund’s principals don’t consider themselves to be good communicators, the advice from Cook is to find someone who is. Get them to focus on articulating the value proposition. Then listen to investors and adapt. Finally, be able to explain succinctly what the emerging manager offers that is superior to rivals in that part of the hedge fund market.
Investors view business risk as among the biggest challenges facing emerging managers. Thus having an inappropriately structured team is a frequent cause of firms failing. To avoid this, emerging firms must have a clear organisational dynamic from day one. A chief investment officer or chief operating officer shouldn’t be entrusted with, for example, heading sales.
The timing of launching a fund is especially crucial now. An emerging manager with poor performance is extremely unlikely to attract investors in this market. Unless the strategy, team and capitalisation of the fund are right, a launch probably won’t work.
Many emerging managers under estimate the amount of capital needed to put infrastructure in place and offer an ‘institutional feel’ to their business, Cook says. Under investing will make it much harder for an emerging manager to get traction with institutional investors.
With limited resources it is better to out source rather than manage all aspects of the firm internally. Thus it can be better to use some emerging manager outsource specialists who can be surprisingly cost effective and let the principals focus entirely on the key investment operation.
“Spending too little is the main area in which we see people making mistakes,” says Cook. “But we also see misallocation of resources.”
Assuming investors are equal
Piling it high and selling it cheap is the opposite of what hedge funds should do. Selling hedge funds is not a volume business and emerging managers must have a concise understanding of their investor target market.
Good sales results require a clear process. Emerging managers should have a deliberate, staged capital plan, Cook says, adding that creating and maintaining momentum is vital.
Pressure from investors for transparency is on managers, big and small. With the providers of capital likely to have the upper hand for some time, transparency is essential to mitigate investors’ concerns on fraud risk and style drift.
Being greedy and rigidly sticking to 2 & 20 will most likely hinder fee income, according to Cook. The more a fee structure is performance driven the better. Emerging managers also need to accept that every strategy will sometimes lose money.
“Have humility,” says Cook. “It plays a lot better with investors than arrogance. Marry humility with confidence, ambition and belief.”
Mistakes to avoid in developing a hedge fund business
Originally published in the July 2012 issue