Mon, 19/12/2016 - 09:36
Perhaps it is apt that Protégé Partners, LLC is located above the world-renowned Museum of Modern Art in New York given that its modus operandi is to find the best and most creative talents in the hedge fund industry.
Some seed investors look for portfolio managers with proven skills in investing, not running businesses or dealing with clients.
"We want them to do all three. We want them to be great portfolio managers/analysts, great at running a business, great at dealing with clients: we want the whole package. We are looking for Renaissance men and women who are multi-talented," says Jeffrey Tarrant, founder of Protégé and the firm's CIO and CEO, continuing the artist analogy.
Tarrant runs a highly talented team with extensive market experience, including Adil Abdulali, Senior Managing Director, and Michael Weinberg, Chief Investment Strategist and Senior Managing Director. Collectively, Protégé draws upon a highly evolved network that gives them the opportunity to source and invest in the most exciting hedge fund protégés.
Prior to founding Protégé, Tarrant ran money for numerous family offices including Sidney Kimmel and German family office, Thurn und Taxis. Weinberg has managed money at Soros Fund Management, Credit Suisse First Boston, and was instrumental in FRM Capital Advisors (FCA), the seeding business unit of FRM (now part of Man Group). Abdulali managed a mortgage backed securities hedge fund.
"We have a highly developed network that allows us to find these protégés. Because we've worked on the Street for such a long time in various portfolio management and risk roles, we have basically invested in a wide variety of funds throughout our careers. Across all generational levels in the marketplace, we know people: from the latest analyst raising capital for a new fund throughout the lifecycle to those who have been managing funds for many years," says Weinberg.
Since Tarrant established Protégé in 2002 the vision has been clear: to invest only in the cream of the crop within the small- and emerging manager firmament. As is widely documented (both in the media and academia), hedge funds tend to outperform when they are younger (in terms of track record) and smaller. What tends to happen, however, is that a manager will enjoy success exploiting a particular inefficiency in the market, attract the interest of investors, and there then ensues a virtuous cycle. The manager attracts more money, more investors, to the point where they become over-capitalised.
The result is that they often end up diluting their ability to exploit the very inefficiency that made them alpha generators in the first place.
Protégé is always mindful of this with every seed investment it makes. In short, it guards against this threat of ending up with asset gatherers, as opposed to alpha generators.
"Our approach is to work with the next generation of protégés, of top talent that have worked for and been trained by the best fund managers. We are not sourcing managers from databases," says Tarrant, who adds:
"There was one very large activist fund that we invested with who became too large for us. What happened in the end was that we invested in two of his protégés, one of whom we seeded and another whom we invested with at `arms length', even though we thought the activist manager was still a top-quality investor."
One of the differences between Protégé and a lot of other seeders is that firms will tend to invest seed capital and pull it after two or three years. This is because many seeders run seed funds that require them to invest and redeem more frequently in order to meet their investment targets.
Protégé does not do this. It is able to invest with a manager for as long as necessary. Weinberg confirms that there have been many seed deals where even though the capital has become unlocked after three years, "we have kept our capital invested with them for years beyond the lock-up."
"One of them is an opportunistic deep value fund. That fund, 10 years later, is still only running USD1.4 billion. Unlike some of the very large deep value funds that are running USD10 to USD20 billion, this manager decided to maintain a hard close for much of the fund's life and is trying to maintain that flexibility to still be able to invest in the small-cap opportunity set to generate outsized returns," explains Weinberg
Broadly speaking, when Protégé seeds managers it is done by way of a revenue share arrangement. This will run for a specified length of time, following which there may be a sunset period during which Protégé's revenue steadily diminishes.
The emphasis on every seed deal, says Weinberg, is to allow managers to remain fully autonomous.
"The revenue share is tied in to the manager's management and performance fee. We do this rather than an equity arrangement because we want a clean and simple formula. We don't want to get involved in the way the manager runs its business.
"We want managers who are motivated, aggressive and capable of running their own businesses. We want our seed targets to have a full team in place: a CIO, a CFO, at least one analyst and at least one marketing professional to raise their own capital.
"That said, we do occasionally provide introductions. If we think highly enough of the manager we will introduce them to our institutional clients; at the end of the day we are eating our own cooking so we are happy to this, under the right circumstances. To be clear though, we are not marketing on behalf of our seeds. We want them to be entrepreneurial."
When the Protégé team seeks out the next best talent they look for people who have already worked for some of the world's best fund managers. They are not looking for managers who could turn out to be exceptional: only those who already stand out from the crowd and have learned from, and traded under, the best in the business.
As such, Protégé prefers each manager they seed to already have a track record but there are some protégés working as analysts to portfolio managers who will also be considered from time to time.
"Ideally, we want to see a track record. We want to see evidence of the mistakes they've made in the market and learned from in someone else's time, not after they've launched; someone who has traded through both a bull and bear market and come out the other side.
"However, one of our seeds this year, Miguel Fidalgo's Triarii Capital, did not have a track record. Before we seeded him, Miguel had already put together an institutional-quality team and had been running a paper portfolio for six months. We ran due diligence on him for that entire six months. The overall process, from initial meeting to making the seed investment, was probably nine months in total," explains Weinberg.
Fidalgo, who features later in this report, formerly worked at Seth Klarman's USD28.5 billion Baupost Group.
As one might expect, Protégé's screening process involves extensive meetings with the portfolio manager, and indeed the whole team, to understand precisely what their investment strategy is and why it has the potential to succeed. Seeding managers is just as much about the people as the process. Protégé looks for the right chemistry in a seed target. Understanding what makes the portfolio manager tick, what motivates and inspires them, is just as important as being convinced by the alpha generating aspects of the strategy.
"We have an internal risk team here at Protégé. Chris Engdall ran Bear Stearns' prime brokerage risk team. As such, when investors allocate to one of our seed managers they have the added benefit of having an extra set of eyes on the portfolio, making sure the manager is not violating risk rules or doing things they shouldn't be doing. We consider this to be an important part of our value proposition," confirms Weinberg.
This year has been exceptional for Protégé, in terms of the opportunity set.
To put things into context, between 2010 and 2015 the firm did four seed deals. In 2016, Protégé has already done three deals; two seed capital deals and one acceleration capital deal.
Tarrant puts this down to a confluence of factors. Firstly, he points out that a number of the larger hedge funds have had a difficult 18 months and as a result the payouts haven't been as robust as they may have been historically. It comes to a point where if a portfolio manager is doing well but the hedge fund, overall, does less well and they don't receive what they consider to be the right level of compensation, they may leave and set up their own hedge fund business.
"Another reason is that many of our competitors have fully deployed capital in their seed funds so they are not active in the market.
"Whereas many seeders raise seed-specific funds, we do not. Our model is differentiated in that we don't raise seed-specific funds, ours are commingled with our arm's length investments. This means we don't have to forcibly deploy seed capital, whereas others might have to. For others, it's a bit like private equity in that irrespective of the market opportunities or valuations, GPs have to put their capital to work.
"One of the nice things about Protégé's model is we only have to put seed capital to work as and when the opportunity presents itself. Given that we see such a strong opportunity set, that's why we've done three deals already in 2016," explains Tarrant.
Aside from seed capital, Protégé also provides acceleration capital to managers. This year, for example, Protégé has provided USD75 million of acceleration capital to Cooper Creek Capital, a small- and mid-cap US equity long/short fund managed by Robert Schwarz.
The financial terms on acceleration capital deals are very similar to seed deals – a revenue share, a sunset and/or a trailer – but the obvious difference is that acceleration capital is deployed to an established hedge fund manager that has performed well and is looking to take its business to the next level.
"Cooper Creek was running around USD75 million and we've now doubled the fund's assets. The statistics we quote is that there are some 8,000 hedge funds out there. The 500 largest funds have 87% of the hedge fund industry's assets. So if there are 7,500 funds running 13% of the assets, you can imagine that there are going to be plenty of high-quality funds in that universe. But for some reason they haven't grown.
"There has been an unwarranted stigma attached to managers running smaller funds. Investors struggle to understand why they haven't grown their AUM, despite good performance, and it creates scepticism. But it goes back to the earlier point: institutions generally want to invest in the bulge bracket names to mitigate career risk; there is an inherent bias," says Weinberg.
Institutions also have constraints. If they want to write a USD20 million ticket to a manager but for fiduciary reasons are not allowed to be more than 10% of a fund's assets, that rules out a USD75 million fund, no matter how good the manager.
"Now, however, Cooper Creek is running almost USD200 million and that is going to help attract more institutional investors," adds Weinberg.
In addition to Triarii Capital and Cooper Creek, the third allocation this year has been in Mill Hill Capital, a structured credit RV strategy investing long in asset-backed securities – CMBS, RMBS, CLOs, equipment trust certificates – and short overvalued corporate credit.
All three managers will be profiled in section 2 of this report.
To conclude, Tarrant says that for 2017 one key initiative for Protégé is to invite investors to participate in co-investing opportunities in the seed deals that it embarks on; think of it as the syndicated loan model used by investment banks.
Rather than investing in fund-of-funds or a group of seeds, an institution might only want to invest in a single deal.
"We will make this possible next year. And that is quite unique. We are not aware of that typically being done in the market," remarks Tarrant.
"An endowment I recently spoke to is interested in doing a seed deal but doesn't have the expertise. They could participate in one of these syndicated deals and enjoy the seed economics without the complexity of having to structure the deal themselves. This is a huge opportunity for us. It's a big part of the future for seeding and acceleration capital.
"The seed pipeline already looks strong for 2017," concludes Weinberg.
Manager perspectives: Triarii Capital Management
Miguel Fidalgo, a protégé of Seth Klarman's USD28.5 billion Baupost Group – where he spent seven years – and Farallon Capital, founded Boston-based Triarii Capital Management in 2015.
Triarii has a strong security-specific short credit book coupled with its long book and using a global mandate seeks to buy debt and equity in companies facing reorganisations, restructurings or difficult-to-analyse situations. It pursues a value driven, opportunistic philosophy very much in keeping with Baupost, seeking out investments that have significant downside protection coupled with equity-like expected rates of return to deliver an asymmetric risk reward.
"We tend to spend a large chunk of time looking at deeply out of favour industries and geographies. For example, currently we are invested in industry sectors such as refiners and in geographies such as Greece. It's very much a bottom-up investment approach," says Fidalgo.
Upon leaving Baupost in early 2015, Fidalgo embarked on the process of becoming a business entrepreneur, confirming that Triarii officially launched with external capital on 1st May 2016. The long-term plan, he says, is to take this opportunistic philosophy and implement it as a boutique.
"We firmly believe that in order to compound capital at greater risk-adjusted rates of return you have to be nimble. Our vision for the business is to constantly retain the ability to look at smaller capital structures and to concentrate our best ideas in the portfolio and hunt out these mispricings," says Fidalgo.
Having spent more than a decade learning from great mentors like Klarman gave Fidalgo the confidence to strike out on his own. The idea of being an entrepreneur and being self-motivated was, he says, "very appealing". "Moreover, I firmly believe that the opportunistic value driven philosophy that I follow is best done at the smaller, boutique scale without layers of management and a large capital base."
He says that the most surprising aspect of becoming a fund manager has been the fund raising process. Given that Fidalgo had been historically insulated from this process working at large hedge funds with tens of billions in AUM, he had not needed to go out and build relations with endowments, family offices, etc.
"Understanding the length of that process and how time consuming it is was probably the most surprising aspect of becoming a hedge fund manager," says Fidalgo.
He confirms that the Protégé Partners relationship originated when a friend at Harvard Business School found out that Fidalgo was heading to New York to speak with prospective investors and advised him to go meet with Michael Weinberg and Jeff Tarrant.
During those initial meetings, Fidalgo spent a lot of time talking through risk controls, the investment philosophy, team backgrounds, and what the long-term objectives for the business were.
"It was not too dissimilar to the conversations we were having with prospective investors at the time. By the time Protégé and I sat down, the business side of things was reasonably far advanced. We had topline answers prepared on our choice of service providers, roles within the team, what the plan after launch was going to be, etc. This allowed for a fairly smooth conversation with Protégé because we had already thought out a lot of the business elements in ways that were in line with how Protégé tend to think about how best to launch a business," explains Fidalgo.
There were two early signs that discussions were going well: Protégé's desire to look for precisely the kind of opportunistic strategy that Triarii was set to run, and Fidalgo's focus on keeping the business boutique and right-sized to maximise the strategy's performance.
On the first point, it is important for any manager looking for seed capital to partner with someone who fully believes in the investment strategy. Other institutions might be more rigid in terms of how they think about managers "so to have a partner like Protégé, who is as flexible as we are, is absolutely essential," stresses Fidalgo. "Especially when that investor is performing an anchoring role in the relationship. They fully believed in our approach and that was a significant plus point."
Secondly, there are some seeders who provide meaningful early stage capital but take a view that they want the manager to amass as much AUM as possible.
"We firmly believe that to do a great job for our clients we have to limit our asset aggregation and Protégé was perfectly aligned with that. Our partnership is aligned in such a way that it preserves that vision of running a boutique business. The idea was to launch with institutional scale while preserving a flexible mandate. Start-up managers need to be at least USD100 million at launch to have that institutional scale, and ideally they should have a capital partner that is likely to be around for the long term."
Triarii looked at a number of options to help it meet its objectives and Protégé offered by "far the best combination". The fact that it has a history of investing in managers for the long term, believe in the boutique opportunistic business model, and were not looking to dilute Triarii's ownership, were key considerations. Fidalgo believes that having a high calibre seed investor on board is also beneficial in terms of reducing potential concerns among other prospective investors.
"By having scale and being cash flow positive on day one allows us to provide comfort to prospective investors. Not only that, but we can demonstrate that the majority of that day one capital is in steady hands with a seed investor that is going to stick with us over the long term; that is a powerful proposition when we do investor meetings," states Fidalgo.
His advice to start-up managers is: "Start building potential investor relationships early, and by that I mean years before you plan to launch."
Manager perspectives: Cooper Creek Partners
New York-based Cooper Creek Partners Management LLC was founded by Robert Schwarz in May, 2008 having formerly been Managing Director at JL Advisors, where he built the team from scratch. Its hedge fund, Cooper Creek Partners, is a US small- and mid-cap focused equity long/short fund with an average 10 per cent net exposure to the market. Unlike Triarii Capital and Mill Hill Capital, Cooper Creek has received acceleration capital from Protégé Partners and represents the firm's third deal this year.
"We are a catalyst driven hedge fund that operates under a low net framework. We're looking for catalysts to drive upside in out-of-favour investments. We have a full portfolio of stock specific alpha-driven ideas on both the long and short side. We're not using any hedges or baskets; every long and short must have its own catalyst," explains Schwarz, who oversees a five-strong team.
Schwarz enjoys training investment professionals from scratch and wanted to create a "unique culture" and a fund that had a team-focused approach to hedge fund investing, "which I didn't think existed in the market at the time. My father was an entrepreneur and I always dreamed of running my own business one day," he remarks.
It is fair to say that launching Cooper Creek – or any hedge fund business for that matter – on 1st November 2008 was a challenging time, as the world's financial plates adjusted to the tectonic forces of the global credit crash. Trying to raise capital was far from straightforward but over the years Schwarz has built a hedge fund that has gone through the stress of that economic period and can demonstrate a consistent eight-year track record.
"I initiated a relationship with Protégé in February of this year to help us build scale both for the offshore fund an also to eliminate fund size as an inhibiting factor for future investors; that was the main goal behind the relationship. I knew Michael Barron (Head of Research and a Protégé Managing Director) from a former firm and had seen him at various fund conferences.
"I started the process of speaking with Protégé at the end of Q3 2015. We had a seven-year track record to show them, and a differentiated, unique investment approach that they found interesting," recalls Schwarz.
From the get-go Protégé liked the team, the investment process and the overall business operation that Schwarz had built since inception. Crucially, says Schwarz, Protégé did not ask him to make any changes to the way he was running the fund.
"They wanted to be helpful at all times in terms of being available, making suggestions, but they didn't want us to make any changes whatsoever to the way we were operating. And that was key to me. We are different to a normal seed investment, given that we've been in business for many years," states Schwarz. He confirms that with Protégé's acceleration capital Cooper Creek went from being a sub-USD100 million fund to approximately a USD200 million fund today.
This acceleration capital has, in Schwarz's view, opened up the door to larger pensions and endowments in the US "and has accelerated their due diligence process on us". The fact that the fund is up 15% this year with single digit net exposure to the market is certainly helping as well.
Investors have been monitoring Cooper Creek since it launched and as Schwarz recalls, "many of them would always say to us, `When you cross the USD200 million mark we can take you to the next level'."
That is now starting to happen.
"I think besides the assets," says Schwarz, "the Protégé investment is an institutional sign of approval. That puts us in a good light when we go back to talk to these investors because they know that the Protégé team will have scrubbed our back office operations, compliance procedures, etc. It's been a big positive."
Manager perspectives: Mill Hill Capital
David Meneret is Chief Investment Officer at Mill Hill Capital, a structured credit relative value hedge fund strategy investing long in asset-backed securities and short overvalued corporate credit. It is the second hedge fund manager this year seeded by Protégé.
Specifically the strategy focuses on US credit, in line with Meneret's previous roles at UBS and Macquarie, where he was Head of Securitized Debt Trading. The team seeks to identify asymmetric trades across securitised and corporate bond markets, specifically concentrating on CLOs, corporate financials, non-agency MBS, corporate transportation, esoteric ABS and credit indices.
"In terms of the investment process we use a combination of asset level fundamental analysis and market-implied cash flow models to help us identify long and short opportunities. Overlaying that is a systematic process for risk and portfolio management. What is unique about our philosophy is that we are agnostic as to where we try to generate alpha from; both long and short positions are equally important," says Meneret.
During his time at Macquarie, Meneret launched and operated the Macquarie Credit Nexus Fund, effectively building a business unit within the bank from scratch. Alongside him were Robert Perdock in the role of CFO/COO and Hongwei Cheng, Head of Credit Product Quantitative Modeling. Perdock and Cheng are CFO/COO and Chief Risk Officer respectively at Mill Hill.
Speaking about why he set up his own firm, Meneret reveals that speaking to investors "we realised there was a lot of interest in our approach. Although a highly positive experience at Macquarie, it was the next logical evolution in my career. Entrepreneur at heart, I wanted to run the strategy under a standalone hedge fund umbrella."
Mill Hill Capital was subsequently established in February 2015 although the fund is not due to commence trading until later this month, having secured the seed capital from Protégé. Meneret explains that it was important to take the requisite time to properly build out the investment model and the internal infrastructure. The fact that Meneret had the experience of building everything to run the strategy at Macquarie – the systems, the infrastructure, with some support from Macquarie on the legal and finance side – meant he was well placed to understand the unique demands of setting up a hedge fund.
"When we set up the Credit Nexus Fund in 2012, we had to go through all the usual legal documentation process that we've subsequently gone through at Mill Hill," says Meneret. That there was clear continuity with the investment team put Mill Hill in a strong position when they first met with Protégé and removed a lot of the risk.
"We were a team that had been working together for many years, with great experience investing across corporate and securitised markets during that time, and this was a huge advantage. I knew Michael Weinberg already having met him previously at a SALT conference three years ago. Protégé has always been one of the top seeding names so we stayed in touch. We met to discuss the Mill Hill strategy about 12 months ago," he adds.
Although still boutique in nature, Meneret does not envisage this remaining the case indefinitely. That's not to say Mill Hill has grand designs on becoming a USD5 billion hedge fund but as Meneret points out, "we have a lot of room to grow the strategy before we reach capacity". For now, he says, the plan is to find dislocations in the US securitised and corporate credit markets and stay nimble as the team builds longs and shorts in the portfolio.
"It is a niche strategy. There are few hedge funds that trade across securitised and corporate credit products in any meaningful way and even fewer that target market neutral objectives," states Meneret. He confirms that finding a seed investor was a key consideration during the pre-launch phase.
"Having been a hedge fund manager at Macquarie," says Meneret, "I knew that if you want to do something properly you've got to have a robust infrastructure; especially for a strategy like ours that relies on large volumes of data. I also wanted to have a cohesive and experienced team to run the operations to minimise risk and maximise efficiency. We are proud of the fact that we were seeded by such an experienced hedge fund investor.
"You have to have critical mass at launch, especially for a credit hedge fund, and early on Robert and I were intent on building an institutional platform to mirror what we had been doing at Macquarie. If you want to grow a business you have to have strong foundations and it was pretty obvious to us that seeding was a requirement."
Meneret confirms that the entire Mill Hill team has found the process of working with Protégé hugely beneficial. Collectively, they appreciate the depth and precision of analysis conducted by Protégé because it demonstrates how serious they take their role as a seed investor. "Their expertise in the hedge fund industry is absolutely invaluable to us, particularly in relation to thinking about fee structures, discussing business issues such as which service providers to work with; these are all helpful areas for a start-up hedge fund manager. It's still early days but we are excited about the relationship we have with Protégé," says Meneret.
Seeding, he says, is like a marriage: "Protégé asked the right questions about how we would respond during tough times and periods of poor performance; this showed us that they would be a partner willing to stick with us during the good times as well as bad."
When asked what advice he would give to start-up hedge fund managers looking to attract seed capital, Meneret concludes: "The first thing I would say is don't rush. You've got to build the right team to run a business for the long term. Don't have a short-term mindset of thinking once you've got seed capital it's off to the races. It's about creating a structure that will stand the test of time."
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