When it comes to understanding the entrepreneurial spirit necessary to build long-term hedge fund businesses, seed investors are as dialled in as anyone. With an eye on identifying the next, best talent, and backing them with day one seed capital, they know that their reputations are on line, should they get it wrong.
This makes the issue of outsourcing an intriguing one. How far would a seed investor go in terms of allowing a manager to outsource certain functions? Do they prefer to control things and mould the manager into an institutional outfit? And what of the role of technology, in particular the rise of cloud platforms, which give start-up managers the potential to outsource everything, save for portfolio management?
Hedgeweek spoke to Stable Asset Management, one of Europe’s leading seed investment firms, on these issues.
Looking broadly at industry trends and the rise of the cloud, Tom Cheesman (pictured), Manager at Stable Asset Management, is in no doubt that platforms such as Amazon Web Services are changing the optics of hedge fund management.
“If you think about it from a disaster recovery perspective, the cloud works well. We had a CTA strategy that used Amazon Web Services and the consensus among our operations team was that AWS is excellent. They have a progressive team of quants that can keep up to date with cyber threats. I have spoken to various prominent US investors about AWS and they broadly approve of it. They don’t have any problems with it at all,” comments Cheesman.
There seems to be growing consensus among hedge fund allocators that outsourcing is an acceptable practice, provided the manager has robust oversight in place. A recent Emerging Managers survey by GPP*, produced in conjunction with AIMA, intimated that for non-core functions such as legal, treasury, investor relations and capital raising, allocators are overwhelmingly positive on them being outsourced.
For Stable, however, a little more control is still required.
“We like to be hands-on. We only seed managers in London and New York for that very fact. Because we have relationships with multiple service providers, the costs of our managers using them are significantly less – I would estimate a third of the price – than if they were to establish outsourced relationships themselves,” reveals Cheesman.
This is revealing in as much that for those managers lucky enough to receive seed capital – or indeed acceleration capital – the cost benefits can be substantial. It comes down to economies of scale.
Stable Asset Management makes a point of establishing a wide network of service providers, so that when they back a start-up manager, the burden of outsourcing – if one can call it that – has already been addressed.
“We certainly do look closely at the outsourcing issue. Unlike most seeders, who just hand over the cheque, we realise that’s where things have the potential to go wrong. As a result, we can have quite a large say in the service providers a manager uses although it is a two-way discussion with the manager depending on legacy relationships that they may have. We’ve seeded six managers and over the years have developed relationships with a spectrum of quality service providers. We use these selectively, depending on their strengths at supporting different types of strategies,” explains Cheesman.
He says that once a manager gets to a certain size of AUM, that is when they might suggest hiring key internal staff, while at the same time overseeing other functions to help the manager control costs. If it is a quantitative strategy, for example, Stable might advise on hiring a CTO, before hiring a marketing/IR person.
If providing acceleration capital, Stable can help guide emerging managers to grow better businesses, not necessarily by interfering with existing outsourced relationships, but advising on how contractual terms might be tweaked and improved. As Cheesman rightly states, hedge fund managers can be brilliant traders but that doesn’t mean they are necessarily great at running a business.
They might have had everything done for them in their previous role so oftentimes they don’t know if the price being offered in a service agreement is too expensive.
“That said, I do think core functions like the COO shouldn’t be outsourced. For those that are outsourced, choosing the right service provider and doing proper research on them is extremely important. My advice to managers is, ‘make sure they have a complete knowledge of your investment strategy’,” says Cheesman.
Cheesman offers a word of caution by referring to direct lending funds, some of which have had an awful lot of trouble: “Different fund administrators jumped at the chance to win their business, but when push came to shove they realised how hard it was to actually process the loans.”
Sean Capstick, Director and Head of Prime Brokerage at GPP, commented: “The survey report we produced in conjunction with AIMA shows there is a clear understanding from investors that emerging managers need to and should outsource more non-core functions, allowing managers to avoid high fixed costs in the early days and focus on their strategies. The quality of providers is the main issue for allocators and, as the survey shows, 78 per cent of them said that managers should only deal with recognised providers.”
Quality and appropriateness of the outsourced provider is therefore critical. Allocators might be becoming more amenable to the idea, but managers cannot get carried away and assume that outsourcing functions means outsourcing their responsibilities at the same time.
“The functions managers outsource will depend on the type of strategy they run, so a quant strategy isn’t going to outsource their CTO function,” Sean continues. “One clear disconnect that came out of the survey was the sentiment that hedge fund allocators have towards the marketing/capital raising role, compared to managers. An overwhelming majority of allocators surveyed (96 per cent) said that they were happy for this to be outsourced, whereas 79 per cent of managers confirmed that this role was kept in-house.”
“The reason why I think there is a discrepancy between the manager and the allocator is connected to the fees that third party marketers charge,” suggests Cheesman. “If you take private equity, it’s 1 per cent of assets raised, and a 20 per cent ongoing revenue share from the assets raised, which is expensive. Investors aren’t so concerned because at the end of the day they aren’t the ones paying.”
One could argue that there is a cultural difference at play. The use of third party marketers in the US is far more common among hedge fund managers compared to Europe, says Cheesman:
“In the US, third party marketers are arguably more involved with their clients. They’ll sit down with the manager to understand their strategy and might have the manager’s business card made with their name on it, to use at conferences and events to act as an ambassador to the fund.”
Maintaining control over how a manager raises AUM is understandable. They still need in-house expertise. But with the proliferation of technology platforms such as Murano, which disintermediates the marketing/capital raising process, roles like marketing, technology and compliance could be more widely outsourced by managers, and drive operating costs still lower.
And that has to be a welcome scenario, for both managers and investors alike, when it comes to building a successful, sustainable hedge fund business.
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