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Comment: Why start-ups need a platform to create alpha

Steve Williams, chief executive of London-based full-service hedge fund investment management platform Harbour Capital Partners, says start-up managers now more than ever need the backing of an infrastructure platform if they hope to obtain seed capital.

In the past few years, the alternative investment industry has become mainstream. What was once a cottage industry of a few hundred funds and an investor base limited to high net-worth individuals or family offices has become a USD2trn colossus that attracts the bulk of its assets now from institutions such as pension funds and endowments. But as hedge funds have become more acceptable as an asset class, the expectations of investors, particularly large allocators, have risen to new heights.

A recent survey by KPMG says that more than half of pension schemes will require the hedge funds they invest in to comply with best practice standards within the next three years. The survey, covering investors with around USD400bn in assets under management, found that pension managers were particularly concerned about governance and disclosure.

This isn't entirely new. Institutional investors have long demanded higher standards from the hedge funds they allocate to in terms of compliance, risk management and transparency. At the same time, financial authorities have been increasing the regulatory burdens on hedge fund managers. It's fair to say hedge funds are no longer unregulated, or even lightly regulated; they now receive the full panoply of official busy-bodying, as well as fairly nitpicky oversight from their investors.

Meeting the demands of regulators and institutions has created new, higher barriers to entry for nascent hedge fund managers. Best practice is a cost issue. So is dealing with regulatory requirements. Hard-pressed fund managers will not necessarily have the skills to take care of the myriad tasks now expected of them. The obvious solution, hiring a team with compliance, risk management and legal experience, is hugely expensive, and only possible for the most extravagantly funded start-ups.

Partly as a result of these new hurdles (and partly, of course, as a result of volatile financial markets and the credit crunch) the number of hedge fund launches in the first quarter of the year has fallen to the lowest level since 2000, according to Hedge Fund Research. For the few and the brave who are still planning to launch, the reality is that no one will allocate any more to a two-man-and-a-dog start-up, where risk management and valuation are plotted on an Excel spreadsheet and infrastructure consists of a Bloomberg terminal.

Well, perhaps someone will - family and friends, for instance - but the big allocators and the seeders won't. And in these investment-challenged times, it's essentially institutions and seeders who have the money.

We know from our own experience in this office that some seeders have made being on a platform a condition for backing a new hedge fund. The platform offers seeders peace of mind. They know, first, that a platform such as our own can hire very experienced senior people in compliance, risk management and legal because we can spread the cost among the funds.

They also know that we're there on a day-to-day basis, taking care of the mundane but essential office management tasks while the fund manager gets on with what he's best at - making money. Finally, seeders are aware that we will already have done a whole swathe of due diligence on any fund on our platform, which means they have the comfort of knowing that the fund is, in a sense, pre-approved.

The requirement by some seeders that new funds join a platform is an interesting development in itself. It represents a huge change in attitude. A few years ago, investors on the whole were indifferent at best to platforms. Some felt the criteria for success with a start-up was the galaxy of investment stars the new hedge funds could attract, and everything else - infrastructure, governance, even seeding - was secondary.

Now, as barriers to entry have risen, so have start-up risks. It's not enough now to rely on investment stars; they also need to be able to run a business. According to a survey in 2003 by CapCo, half of hedge fund failures can be attributed exclusively to operational risk. This is what a platform can mitigate: we can take away all the time-consuming office management chores; we handle operations, risk monitoring and business development.

A fund manager just starting out probably doesn't want to deal with such mundane tasks as writing a pitch book, organising a road show or dealing with audited accounts. But all these things are necessary to attract investment. A good platform takes care of all that; its key function is to give pre-vetted managers the best opportunity to create alpha.

And alpha, of course, is what this is all about. Numerous studies demonstrate that young funds outperform more mature vehicles by a wide margin. To take one study at random, data compiled by PerTrac Financial Solutions showed that the newest hedge funds returned an average of 15.02 per cent in 2007, while older funds averaged 9.53 per cent.

Over the longer term, there is an even bigger gap between the young upstarts and the older sluggards. According to PerTrac, on an annualised basis, over the 12 years from 1996 to 2007 the average new fund returned 18.33 per cent, while the average older fund returned 12.84 per cent.

The usual reasons given for this are that new managers are hungrier, more entrepreneurial and driven by the desire to create their own businesses. It's probably also true that newcomers perform better than more established funds because they sometimes make riskier investments that pay off - which brings us back to the whole question of risk management.

While investors want the chance to earn alpha, they don't necessarily want it at the cost of the fund blowing up. It's the platform's job to provide a robust risk management system that meets the investors' expectations of best practice.

It's not a viable option for large allocators, such as funds of hedge funds or institutional investors, to put USD5m or USD10 into a small emerging manager. But without a leavening of newer, more nimble funds in their portfolio, their chances of uncorrelated returns go down.

They will, however, consider investing in a platform. Over the past three years, institutional investors have looked with increasing favour on platforms because they know we offer best practice to new funds. It is therefore viable for a large allocator to invest in a range of funds on a platform, taking on a measure of risk they would be unable to take investing in single funds. There is an element of self-fulfilling prophecy in this; as the large allocators restrict their investments to platforms, funds on platforms outperform their independently-organised counterparts.

In this new climate, with increased regulatory burdens and rising expectations from investors, hedge fund infrastructure platforms now offer new managers the best, most efficient and most cost-effective way to set up. We help managers find the point where risk and opportunity in their fund are most balanced, and then we let them get on with it.

Steve Williams is chief executive of Harbour Capital Partners, a hedge fund investment management platform based in London that provides new and existing managers with comprehensive, flexible infrastructure including compliance, risk management, operations technology and marketing.

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