Q&A with Frank Napolitani and Jaclyn Greco of EisnerAmper's Financial Services Practice
Last year witnessed a number of notable billion dollar launches, including D1 Capital. How would you sum up 2018 in respect of US start-up activity, generally speaking?
It was the year of the big launch, with ExodusPoint, D1 Capital, Kirkoswald Capital and the relaunch of Point72 Asset Management (formerly SAC Capital) – all listed in the public domain. From what has been published, these firms gathered approximately USD20 billion-plus of new launch capital from leading global investors in 2018. Beyond these large launches, the new launch space is slower than prior years given that so much of the new-launch capital has been allocated to these larger launches.
From your perspective, what are the main concerns/challenges facing the start-up community?
Fundraising remains one of the top concerns for the start-up community. Some of the major fund launches last year have monopolised a large amount of the capital being allocated to emerging managers. This has created a headwind for the rest of the new launch market, which caused a slowdown in the volume of new launches in 2018. These prospective portfolio managers have chosen to delay their launches and stick it out at their current firms into 2019 when, hopefully, new capital will be available from investors redeeming capital in 2018 from underperforming managers.
Another headwind that prospective new launches are facing is the prolonged underperformance of existing hedge fund managers, especially long/short equity, and the investor base that continues to remain less-than-positive on the space.
However, in terms of strategies, long/short equity managers still dominate the landscape of launches that we see: whether they are fundamentally driven or quantitative, generalist or sector specific (e.g. financial, TMT, consumer, etc).
Have you noticed a change in the dialogue you are having with start-up managers compared to five years ago? For example, are they more cognisant of the compliance and ODD requirements that need to be in place on day one?
The conversation has changed dramatically. Managers are very much aware of the changes in the market over the past five years, and more so since 2006; the heyday of hedge fund capital raising.
Conversations today focus on operational due diligence being performed by institutions and how dramatically it has increased post-Madoff, albeit the fact we are ten years removed. For fund managers who are hesitant to follow best practices to have an institutional quality operational infrastructure, they will have a difficult time garnering investment capital.
What gets you most excited about the hedge fund industry, and what do you regard as the biggest threat?
The most exciting part of our day-to-day is working with entrepreneurs who are either beginning or contemplating starting a new business. However, the market has changed significantly in the past ten years and we believe the biggest threats are the continued underperformance of hedge funds (overall) and the increased regulatory and infrastructure requirements from the regulatory agencies and institutional allocators, respectively. This increased burden has caused operating budgets to balloon and when coupled with lower fees the breakeven AUM level for a fund manager is considerably higher than it was 10 years ago.
The markets got spooked in December with the Dow Jones temporarily falling into bear market territory. Is this the volatility regime hedge fund managers have been waiting for and if so, could 2019 be a big opportunity for global macro managers in particular?
The lack of volatility and continued upswing in the US equity markets have created a difficult environment for hedge funds to outperform, given the challenge of successfully executing short trades. Additionally, the effect of ETFs on the market and how they influence trade volumes of individual names without regard for the individual stocks’ fundamentals has made it difficult for traditional stock-pickers.
These challenges have hurt the hedge fund market overall, especially long/short equity managers. However, when the volatility reared its head last February and in the fourth quarter of 2018, many managers were caught flat-footed and failed to capitalise on the volatility, suffering drawdowns. That being said, hedge funds have traditionally outperformed during periods of increased volatility and managers who adhere to their process should benefit.
What is the most important ODD consideration that you emphasise to your clients?
Many ODD professionals use the motto made famous by former President Ronald Reagan, “Trust but Verify”. It may seem obvious, but we emphasise being completely transparent when going through ODD with prospective investors. Omitting or misrepresenting anything from a background or reference check will come back and cause for an immediate veto regardless of how stellar your investment process/performance/operational procedures are.
To what extent is technology facilitating best practices?
We are big believers in technology and feel that the improvements in cyber risk, reporting and compliance have allowed fund managers to continue to focus on their investment process rather than allocating people to do things manually. With the use of technology, you are generally able to perform tasks faster, better and cheaper and gain operational bandwidth.
How should start-ups strike the right balance in terms of roles and responsibilities, when looking to attract institutional dollars? Is it still acceptable for someone to wear dual hats as the CIO and CFO, for example?
Institutional allocators look for a clear separation of duties between the “book and the business”. We do not recommend that any fund manager also manage the back-office aspects of their business while managing a portfolio. With that being said, the marketplace understands the need for single individuals to wear multiple hats. Those individuals, however, should not be members of the investment team.
Operational costs for a new manager can be daunting, which is why there has been an emergence of the outsourced model in the US. If a new fund manager is launching a fund with less than 100M in capital, the cost of allocating low to mid six figures to each respective back office c-level function can be paralysing. Couple that with technology and other infrastructure costs, it becomes extremely difficult for a fund to get off the ground. Which is why the outsourced model has emerged and why the investor community has accepted this strategy (up to a certain AUM level).
There is not a hard line in the sand as to what the AUM level is where it becomes expected to insource, but we would estimate it is approximately USD100 million to USD200 million of AUM.
Finally, what are you hoping to see in 2019? Are you hopeful that new talent will continue to spring out of existing hedge funds?
We feel that there are always going to be talented entrepreneurs looking to start new businesses each year. However, given the headwinds we’ve discussed, I think you’ll see an increased number of global macro and credit fund launches as the market volatility and interest rates continue to rise. Hopefully the increased volatility will allow hedge funds to outperform and coupled with the potential underperformance by long-only managers, hedge funds will regain their place in the financial services industry.
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