Sascha Klamp, CEO of CITE, reviews the shortcomings of the nascent fund manager distribution approaches and argues for a more widespread use of the holistic venture partner business model in asset management.
Investors globally suffered during and in the aftermath of the 2008 crisis and if they were invested in hedge funds post-Madoff their pain was likely leveraged. Whilst investors were licking their wounds, dramatic changes occurred in the fund of hedge funds space.
Initially, it took allocators some time to fully comprehend the implications of the market events and the impact it had and still has on the funds industry. But once the initial shock-and-awe moment settled, redemptions across the fund of hedge funds landscape accelerated. As a consequence, the number and size of funds of hedge funds (FoHF) are riding down an inverse S-Curve.
While the initial redemptions were sluggish and appeared to be a drop in the ocean, this trend has now accelerated as larger allocators adjusted their investment and operating models to focus on sourcing and building internal hedge fund investment capabilities. For the first time, many FoHF analysts were confronted with writing redemption tickets rather than filling in subscriptions documents.
The natural assumption was that single-manager hedge funds would suffer and follow the decline of their largest source of capital pre-2008. Far from it: after an initial phase of decline in assets under management, which was long overdue no doubt, hedge fund assets have now surpassed the pre-crisis levels (previous peak $1.95 trillion in June 2008 versus $1.97 trillion in November 2013, according to Eurekahedge, 2013).
Consequences for the hedge fund model
The result, one would think, is that all is back on track for the hedge fund industry. Looking closer, we see an increasingly significant rift in the fortunes of early-stage/emerging managers and their multi-billion-dollar counterparts. In essence, funds at ‘seed’ or ‘anchor’-stage are struggling to attract investors as the latter seek comfort in bulge bracket names. Further, the emerging manager universe (up to $500 million AUM in CITE’s definition) appears to be plateauing and struggling to find ways to move from start-up stage to institutionalisation stage. One of the main stumbling blocks on their path to “making it big” is access to affordable distribution. The industry still behaves like a “cottage industry”, a term that sounded endearing back in 2002 but a decade on leaves many observers puzzled as to why the industry has not matured.
It is true that we have seen a dozen or so fund launches that came off the blocks with several $100 million or even $1 billion plus. But (a) these are the exception to the rule and (b) there is no causality between their launch size and their ultimate survival, as performance remains the metric of choice for most investors. In fact, academics Getmansky (2012), Aggarwal (2010), Teo (2009), and Brown/Goetzman/Ibbotson (1997) have long made the case that smaller funds significantly outperform larger ones by AUM.
We observe further structural inefficiencies in the hedge fund market, with around 1000 hedge funds closing doors, and another 1000 launching annually. Looking ahead, we expect that the number of annual fund launches is likely to follow its historical pattern, as we see no reason for this to change materially.
The evolution in the role of distribution
On the back of redemptions following the 2008 crisis and the institutional investors’ Trendwende (change of beliefs) towards the emerging fund manager universe, placement agents and third-party marketers (TPM) have struggled to maintain going concern. Although changing the revenue model from a fee based solely on success to a combination of retainer plus success fee has helped somewhat, across the majority of third-party marketers revenues have dropped on average in excess of 50% since 2008. By raising the bar for their potential clients, we suggest that third-party marketers have not necessarily made their own lives easier.
Another challenge that they face is how to communicate to their investor base that their pre-screening method echoes investors’ due diligence standards. Finally, third-party marketers’ model has always struggled to circumvent the inherent conflict of interest as to the true independence of their product selection. As the hedge fund industry has undergone significant changes, so must the TPM universe evolve. Most likely, they need to refocus their service offering along with their message to the market, to ultimately make their service solutions and pricing both transparent and accessible again.1 So what can the industry do to enable a higher fund survival rate, and thus make the TPM model more sustainable?
Conflicts of interest in the incubator model
Whilst initially for many investors funds of hedge funds had been the vehicle of choice for accessing hedge fund investments, incubators recognised the opportunity in collaborating with managers at an earlier stage. With the exponential growth of the industry prior to 2008-2009, the successful formula seemed to be simply picking a few obvious talents, offering a platform and providing fund seed money in return for an equity stake. Although interesting and appealing, only very few incubators have actually succeeded. The reasons are many. Only the largest hybrid incubators, such as Blackstone, have had the benefit of being able to provide both significant seed capital for the manager and bulk distribution capabilities. The limited resources to provide the latter across the majority of smaller incubators is mostly what led to incubator model stagnation.
Many of the largest FoHFs did not have a reason to engage in the seed or anchoring stage prior to 2008/9. Instead, they could afford to portray an image of exclusivity by imposing arbitrary institutional requirements of minimum track record period and minimum assets under management. However, those criteria became quickly obsolete as FoHF investors rightly raised the question of the validity of using a FoHF in the first instance.
The venture partner model
We believe that we offer a solution to the obvious fund management companies’ conundrum of engaging investors on a corporate governance level, and as a result failing to raise the appropriate assets to ensure fund management company survival. We try to facilitate the dialogue between a network of distributors and the fund management companies by alleviating frictions in the hedge funds’ go-to-market process. As a venture partner, and an evergreen corporate structure, we focus on “The next 10”2 percent. The “Next 10” are those funds that are unable to launch or scale based on their own resources (human, technical, capital) but have the potential to build significant franchise value. We aim to enable their growth by horizontally aligning fund manager, distributor or placement agent and institutional investors. In return for our alignment with the manager, we take an equity stake in the management company. This is a truly long-term arrangement and our outcome is essentially binary. Ideally we want to own our stakes on a perpetuity basis akin to Petershill or Affiliated Managers Group (AMG) to maximise our returns and cash-flow capabilities. In contrast to Petershill or AMG, we focus on the ‘venture’ end of the fund management companies (sub $500 million in AUM). We will only endorse those funds in which we have taken an equity stake. Therefore, we act akin to a venture capitalist which means that we screen a lot, interview a lot, but ultimately only can work with a selected few.
Valuing corporate governance
It is no secret that the fund of hedge funds industry is consolidating (e.g., closures of Tremont, Ivy Asset Management, and Fairfield Greenwich Group; Fauchier Partners’ acquisition by Permal, EIM and Horizon acquired by Gottex, etc.). We expect further consolidation. Alongside the changing landscape, new solutions are likely to become an important element of the new value chain. The winner-takes-all mentality implicit in the standard 2%-and-20% model is likely to be a thing of the past. Furthermore we expect the fees not only to compress but ultimately to be shared with a wider range of players, akin to the argument that the entrepreneur will retain a smaller share of a growing pie.
It is not doomsday for managers yet, nor do we think it will ever be. If fund managers can credibly argue that they are building a business and ecosystem around their fund solutions, based on solid corporate governance, many institutional investors will take note and are likely to pay for such credibility.3 It certainly is in the investors’ own interest to ensure that the fund management company is sufficiently capitalised and has strong corporate governance, including an independent board of directors. Investors know that having the right structural attributes and cultural attitudes towards investor transparency comes at a price.
Engagement with nascent fund managers
We embrace the distribution puzzle wholeheartedly. As strategic investors in a fund’s management company, the anchor investors have a vested interested in supporting the managers’ assets under management growth. To enable a higher probability of fund and firm survival, we work jointly with the management team to present a fund’s proposition in the best possible format.
To that end, we spend significant time with the management during the initial due diligence period (some eight weeks of engagement) and subsequently take a board seat to ensure swift execution of the business plan. In this model intense engagement is vital, separating it from most seed and anchor investors who simply do not have the capacity, capabilities and/or resources to commit to a team at this level. Our decisions to engage with fund managers are made by an experienced team that has partially worked together in a family office/endowment environment.
In return for providing such intense, and often on-site efforts, we require an equity stake in the fund management company. Over time, our portfolio of holdings will mature and we are mindful that some managers may want to buy back their equity interest.
Subsequent to our engagement with the fund manager(s), we collaborate with many distribution outfits who have agreed to review and potentially work with some of our fund managers. No doubt, our model is about co-creation in that all parties are aligned: fund managers, CITE and our distribution partners. If all parties are working towards the same goal, that is providing an environment to enable emerging managers to grow, the collective ecosystem will play a huge part in the success of our funds.
Owning general partner equity
We can point to a number of positive effects of a shareholding over a fund investment (see Table 1): (i) limited investor capital at risk, i.e., less dollar-amount required to build a single position or a portfolio of holdings – and in case of default lesser amount of capital being lost, (ii) the fund management company gets access to patient, long-term capital, (iii) there is no need for managed accounts to avoid co-investor risk (liquidity, NAV), (iv) only annual mark-to-market rather than monthly NAV volatility, (v) investment horizon matching both CITE’s endowment/family office-type shareholders and manager expectation of true long-term partnership, and (vi) less total investor capital required to build diversified exposure to the funds industry.
Furthermore, we are not conflicted with the underlying fund performance, with no investment in the fund, and, therefore, no pressure to deliver short-term performance. In fact, CITE takes a fiduciary view of working with the fund management company to ensure that the ‘noise’ that the market sometimes creates is assessed in a wider context of building a business and thus going-concern.
The benefits of being a direct investor in the fund have been well documented but are mainly (i) direct exposure to market, (ii) expected, absolute capital return higher compared to owning shares in the fund management company unless the value of the fund management company experiences a liquidity event that prices the shares fairly, (iii) mostly monthly, quarterly or annual liquidity, (iv) less time to build ‘momentum’ exposure to market, as an investor can add capital to a ‘functioning’ thesis or ‘double-down’ if short-term performance does not yet reflect an investment trend, and (v) limited risk of total loss of capital as redemption requests can be handed in at any time with the standard liquidity provisions (barring fraud, of course).
Unlike incubator or dedicated seeding vehicles, CITE operates as an evergreen structure. The benefits to fund managers are plentiful in this model as the seed investor is truly a long-term partner, which should matter in a world where investors are ever more short-term and liquidity-driven. Our team, for instance, has run an endowment-style investment vehicle previously and our shareholders can be confident that we are mindful that we cannot spend more money than our investment programme generates. We need to see distributions from our portfolio companies in order to organically grow our fund shareholdings. This enables us to be patient in identifying the Next-10.
CITE is a venture partner to fund managers and the extended corporate governance arm of the investor in the fund management company. Sascha Klamp, CEO, founded CITE Investments after advising the interests of Lord Jacob Rothschild in London.