Being a start-up hedge fund in today’s market environment is mired with challenges. The institutional investor marketplace has undergone a seismic shift. Public and private sector pension funds, sovereign wealth funds and insurance companies are all increasing their exposure to hedge funds. These investors are allocating huge sums to hedge funds and it is no surprise that global assets under management (AUM) controlled by hedge funds are likely to surpass the $3 trillion mark for the first time by year-end 2015.
However, these allocators are investing predominantly into the largest managers. Many are contractually forbidden in their investment mandates from investing into managers below a certain AUM threshold. Deutsche Bank’s 13th Annual Alternative Investment Survey, published in March 2015, found AUM controlled by $5 billion-plus managers grew by 141% since 2008, compared to 53% for firms with less than $5 billion. The paper added that it was estimated 200 hedge funds accounted for more than two-thirds of industry assets.
In addition, swathes of new regulations are hindering start-ups. Regulation such as the Alternative Investment Fund Managers Directive (AIFMD) has introduced barriers to marketing and soliciting capital from EU institutional investors. Meanwhile, incoming rules such as the Markets in Financial Instruments Directive II (MiFID II) will ramp up reporting costs for some hedge funds, although the UK’s Financial Conduct Authority (FCA) said UCITS and AIFMs would be excluded from transaction reporting for now. Furthermore, the European Commission (EC) is likely to permit CSAs to continue, albeit with enhanced transparency requirements.
Smaller hedge funds therefore need to analyse and understand how they can effectively raise meaningful capital from the right investors in this challenging regulatory environment. Utilising a prime broker that understands their needs and objectives is crucial to growing into an institutional business.
The current predicament
The capital introductions teams at bulge bracket prime brokers routinely highlight their industry connections and ability to facilitate meetings between capital-hungry hedge fund managers and yield-hungry investors. Here lies the predicament. For established hedge funds, the need for a prime brokerage capital introductions group is somewhat nullified. These managers will usually have a steady stream of existing or prospective investors to whom their own marketing and sales teams can reach out.
Bulge bracket prime brokers certainly do play a part in facilitating meetings between large launch hedge funds and institutional investors. But the situation is less clear-cut for smaller to mid-sized hedge fund managers, many of whom will struggle to even get on-boarded by a prime broker in the first place. This is because the incoming Basel III capital requirements look likely to render these managers commercially obsolete from the perspective of investment banks who must be more mindful of their own balance sheet capital strength under the new rules coming into force in 2017.
For those small to mid-sized managers that are serviced by a bulge bracket bank, capital introductions can be a frustrating process, particularly as a growing chorus of banks view it as an ancillary service with limited commercial upside. It is, however, possible to operate with a boutique provider such as Linear Investments which has a look-through segregated account to the major prime broker. This could well be a solution for many mid-sized funds who need the major prime broker reference point for their investors, but also the support of a specialist boutique broker.
One London-based manager, which launched very recently, complained that the level of service at a number of bulge bracket prime brokers has fallen short, with priority often afforded to managers with scale and size. The manager thought that bulge bracket prime brokers simply facilitate introductions between hedge funds and the wrong types of investor. “The hedge fund investor base has changed significantly over the last few years," the manager said. "Nowadays, capital introductions teams at large banks are occasionally guilty of introducing small to mid-sized hedge fund clients to investment consultants, pension funds and endowments, who are more at home investing into larger hedge funds.”
A New York-based hedge fund chief operating officer (COO) highlighted his issues with bank-backed prime brokers: “Bulge bracket primes tend to do very little in way of capital introductions for managers with less than $100 million," said this COO. "Emerging managers are finding it hard to raise capital, which is a shame, because emerging managers tend to be the best performing hedge funds out there. There is a market for boutique primes, working with managers which are sub-$100 million, particularly those in the region of $10 million to $25 million.”
Introducing hedge funds to the correct client is critical. Investors which typically allocate to smaller managers tend to be funds of hedge funds, family offices or high-net-worth-individuals (HNWIs) as opposed to risk-averse institutions. However, some institutional investors are building their hedge fund analyst teams in-house so they have the knowledge to invest directly in to smaller hedge funds rather than use advisors or funds of hedge funds. A number of funds of hedge funds, who failed to differentiate themselves post-crisis and found themselves delivering correlated returns to end clients, have reinvented themselves, and are increasingly focusing on emerging or niche managers. Family offices and private investors, a historical bulwark of the industry, are also returning to hedge fund investing. Nonetheless, the New York hedge fund COO said boutique primes did have relations with consultants, which can sometimes facilitate investments from smaller pension funds.
It is here that boutique prime brokers, which have a strong focus on client relationship management, and a robust understanding of the needs of start-up managers, can assist. Boutique prime brokers such as Linear Investments recognise that smaller hedge funds need to be introduced to the correct investors. As such, Linear Investments routinely ensures its hedge fund clients are introduced to funds of hedge funds, family offices and HNWIs to help them raise early-stage capital. “Boutique prime brokers do have a track record of introducing smaller hedge funds with investors who may have fewer reservations about allocating to a manager with limited AUM,” said a London-based manager.
A routine complaint from smaller managers about bulge bracket firms is that they do not receive adequate client service in areas such as capital introductions or consultancy. This is forcing many to rethink service providers, and look towards the boutique prime brokerage model, which puts client service at the forefront of its offering. “Client relationship management at boutique primes is excellent," said the New York-based COO. "It is essential that when I call a prime broker, I can get through to an individual who knows everything about my business. If that individual struggles to answer one of my questions, then it is crucial they have a colleague who can. Strong client relationships for smaller to mid-sized managers is a key selling point for boutique primes.” Embracing the boutique prime model will enable smaller managers to develop and grow their business into an institutional offering.
Small managers must identify the right prime brokers, which have a deep understanding of the investor market and how it functions, in order to grow their businesses. Having a best-of-breed capital introductions team can make a huge difference, and enable managers to penetrate elements within the investor community they normally would not have known about or had access to. It is now possible for mid-sized hedge funds to have the best of both worlds, serviced by the specialist prime brokers such as Linear Investments, which has a look-through to the balance sheet of a major prime broker and a segregated account. Having the balance sheet and reference of a major prime broker with the service level of a specialist boutique to look after day-to-day business issues and key areas such as capital introduction is an appealing proposition for small to mid-sized hedge fund managers.