Fund launch process hampered by rising volatility, allocator caution and capital-raising challenges – but emerging managers’ outlook stays buoyant
Fund launch process hampered by rising volatility, allocator caution and capital-raising challenges – but emerging managers’ outlook stays buoyant
Emerging and start-up hedge fund managers – defined in this report as firms managing assets of $250 million or under, with a track record of less than five years – say the current capital raising environment is tougher than a year ago.
Close to half (47%) of emerging managers globally surveyed by Hedgeweek said capital raising is now harder than this time last year. By comparison, a quarter (26%) of emerging managers surveyed said the capital raising environment is easier, while 27% said it was similar (see Fig. 2.1).
Mismatch
Industry participants note that Covid-19 made traditional onsite investor due diligence difficult, and so investors have tended to stick with managers with whom they already had established relationships, in turn putting the squeeze on start-ups.
“During Covid, many investors saw it as potentially riskier to give that allocation to a new start-up which has not had that level of onsite due diligence,” Donald Pepper, co-CEO at Trium Capital, says of the capital-raising challenge. “If there’s a pension plan with $500 million, for instance, the path of least resistance is to give it to the managers they have already conducted onsite due diligence on in 2018 and 2019.”
Pepper – whose firm seeks to attract talented and experienced portfolio managers and enable them to launch their own hedge funds, helping them to overcome the increasingly tough entry barriers from rising legal, compliance, operations and distribution costs – says investors are inclined to sit on the fence until a fledgling fund has built a two- or three-year track record, or reached a critical mass over $200 or $300 million.
He explains: “Investors look for track record in some shape or form. Regrettably, a real frustration in the European industry is the mismatch between portfolio managers who have a proven ability to run a hedge fund based on their talent, and investors willing to give them relatively early money.”
This stance has made life particularly challenging for start-up hedge funds. Portfolio managers tend to move around more now than in the past, observes Alyx Wood, chief investment officer at Kernow Asset Management, with the average fund manager’s tenure falling from seven years to three – which then makes it tough to construct meaningful track records in the eyes of investors.
Protracted
At the same time, the launch process for start-up funds has become more protracted over the past year, says Lucian Firth, partner at Simmons & Simmons, who notes the time between the initial conversations around a potential launch and the point at which there is money in the fund is now longer than ever.
Firth, who has a particular focus on start-up hedge funds at Simmons & Simmons, suggests that a greater risk aversion, stemming from the sustained upheaval of the last few years, has potentially dented emerging manager confidence when it comes to getting things right at launch.
“A few years ago, it felt like we saw more people who were willing to launch a fund that was well below the viable size, knowing they either weren’t going to make money initially or were subsidising it for a while,” Firth tells Hedgeweek. “Now, though, because of that uncertainty, more managers want to get a seed deal in place before they will launch. They want to have a seeder, or at least some decent amount of committed capital, before they will the start.”
Ant Bennett, head of sales and client development, ACA Mirabella, says recent start-ups tailed off towards the end of last year and into this year, driven by investor caution over resurgent market volatility, which has calibrated focus around higher-quality launches.
“There are quite a few managers spinning out again. There had been a hiatus towards the back end of Q4, where a lot of fund launches from some talented managers – credit, global macro, distressed managers – were queuing up and waiting to go.
“They were not having the best of times in terms of getting the first seed investors onboard – a lot of those seed investors, in anticipation of the final wave of Covid, dropped off and the conversations were kicked into the long grass.”
Bennett suggest investors were remaining on the sidelines as a result of considerable market volatility, underpinned by rising interest rates and inflation and the instability surrounding the Ukraine war, as well as the tapering off of quantitative easing.
“They didn’t want to start writing cheques in Q1, and the start of Q2. We’re only now just starting to see some of those launches kick off, and you are now seeing more separately managed accounts as different seed investor money comes in.”
“The decision to set up on your own isn’t one made lightly. There are fewer and fewer people out there who want to do it on their own nowadays,” adds Alyx Wood, whose UK equities-focused long/short contrarian strategy launched in 2019.
“If you care about building a long-term, sustainable track record, and compounding your own cash, then you go down the emerging manager route. To do that successfully you have to own the majority of the company, which allows you to trade through the ebbs and flows. Conversely, if you want to make money fast for the highest bidder, then going it alone is not the right option.”
Optimism and opportunity
Still, despite the assortment of challenges, a degree of optimism continues to underpin the emerging hedge fund manager space.
Surveyed on the performances of their flagship fund during the first half of 2022, one-third of European emerging manager respondents to Hedgeweek’s poll said performance was in line with expectations, while another third said performance exceeded expectations. On the flipside, just 17% said performance fell short of expectations in H1 (see Fig. 2.3).
Looking ahead, European emerging managers are optimistic on their performance prospects for the rest of the year: 67% are ‘somewhat positive’, and 17% are ‘very positive’, compared to 17% who forecast performance to be ‘flat’ (see Fig. 2.4).
Delving deeper, industry participants maintain that start-up managers running nimble, niche strategies have the potential to successfully generate uncorrelated alpha in a competitive field dominated by long-running brand-name hedge funds.
“Large is safe; large feels warm and fuzzy. But, weirdly, asset management is one of the few industries where you get diseconomies of scale,” says Alyx Wood. “Studies show that, without a doubt, emerging managers – the hungry ones, the ones that have an edge – outperform. That’s where all the alpha is. It moves around, but that is where it is at.”
He continues: “The allocators who frame themselves by performance, or finding niches or boutiques, have much better records by a staggering amount, for a reason, and that’s their selling point. Boutiques outperforming on average is not even in question here. What you do get, though, is a wider dispersion – bigger wins, and bigger losses. That’s where the smart allocators come into their own.”
But while newer funds can often outflank their more established blue-chip competitors in terms of performance with more nimble and agile trading styles – and industry participants point to data indicating the incremental returns of newer managers typically ranges between 170-190 basis points – investor appetite often remains frustratingly mixed, with allocators often preferring bigger, more established funds.
“There’s a well-known adage in the hedge fund market that size is the enemy of performance,” adds Donald Pepper. “However, it’s fair to say if you’re only running $15 million, that can affect performance because there are certain fixed costs within a fund, and if those amortise across a small investor base this will lower returns, somewhat offsetting the lower management and performance fees.
“Another issue that investors worry about is if someone’s running, for example, a $35 million fund, will they have the resources to be able to deliver optimal returns? Will they be able to hire that analyst, or will they be willing to bankroll build-and-they-will-come by having the right level of resources? This has led some such managers to join firms like Trium who will pay for these upfront costs.”
Key Takeaways
- Asset-raising – a perennially-tricky task within the emerging hedge fund space – remains difficult post-Covid, as renewed market upheaval and geopolitical uncertainty appears to have dented confidence among both managers and investors, with prospective start-ups taking longer to roll-out
- Despite the caution, smaller and emerging managers appear generally satisfied with their investment performance this year, and a majority remain buoyant heading into the second half of 2022
