Flexibility key to striking the right balance
Investors are pushing their hedge fund managers to deliver better returns, and to revise their terms to better align with the specific needs of investors. This is leading to changes in fund terms and more dialogue with clients. Among other things, these adaptations include an increased use of hurdle rates among emerging managers as they aim to give their investors what they want. It is also a symptom of the growing need for flexibility in the startup arena where investors, managers and service providers must find that crucial symbiosis.
“The use of hurdles has always been there but whereas historically we would see the odd fund using one, now a good portion of them include a hurdle relevant to their strategy. Investors have expectations of their managers and they want the assurance of hurdle, so that managers are only compensated when they go above and beyond market beta,” explains Leanne Golding, Director of HTC Fiduciary Services (“Harbour”) in the Cayman Islands.
She says now more than ever, emerging managers need to have flexibility in their fee structures: “The cookie-cutter fee structure of 2 and 20 doesn’t really exist anymore. Specific nuances beyond investment strategies, with more options in fee terms, duration, or co-invest opportunities are starting to catch investors’ attention and helping to boost startup funds’ success.”
An example of this distinction is building a profit class into a fund. This means a fund will allow a specified percentage of net gains to be allocated into a redeeming profit class. Through this, investors have the opportunity to take some of those gains out on an annual basis without breaking lockups and without being subject to any redemption fees. Another example is the continued use of Founders share classes for startup funds, giving early investors preferred terms and capacity rights, in exchange for a longer lockup of their capital.
Dialling up the dialogue
The Covid-19 pandemic has also meant emerging managers need to up the ante on the dialogue they have with their prospects and strategic partners. Golding stresses: “They need to collaborate as much as they can with their existing contacts and networks. It involves more than a one time zoom call, it’s about building a relationship. Startups need to work on building trust and find other ways of having regular contact with potential investors. Now is the time to not be shy – reach out to all contacts you have, whether they’re investors or even a centre of influence with their own contacts.”
In Golding’s view, there has been some benefit to conducting due diligence virtually: “A greater proportion of each organisation on both sides of the deal can participate in the process, which is a good thing. Investors can also make more use of the information they get through this virtual format.”
Being as forthcoming as possible with investors and providing them with as much access as they can is how emerging hedge funds can make up for the lack of in person contact. Golding advises: “Take advantage of the fact that you can give investors a robust view of how you operate. Involve different areas of your firm to really get that message across.”
This is something that has been made possible through this virtual medium. Historically, one person or a small team would host the on-site visit with investors only making meaningful contact with that single touchpoint.
Golding does highlight however: “The one thing investors miss out during the virtual experience is the gut feeling upon meeting a manager. However, an overall decision is never based on one gut feeling whether it’s positive or negative.”
Operating a lean business
Another by-product of the virtual shift is the opportunity to re-think costs going forward, particularly operating costs. “The cost to start a firm has risen sharply, whether it is to cover regulatory compliance or to keep up with technology. However, this new environment we’re operating in allows managers to think about what their physical footprint needs to be and how much they’re going to invest in physical space. They also need to consider the technology they’re going to employ and how they are going to use these capabilities to attract the best team to work at their firms,” Golding comments.
When considering their infrastructure and how to operate efficiently, Golding says: “Managers want to create a roadmap to be able to grow and not have to re engineer things halfway down the road. They need to have the right framework from day one. They can also look at what portions of that framework can be outsourced, be it permanently or until they reach a critical mass.”
Investors are now quite comfortable with managers outsourcing some aspects of their business operations including IT, compliance and reporting. However, Golding stresses: “Managers need to make sure they have a plan when they choose to outsource. They need to have a procedure or process at the outset detailing how they’re going to monitor and oversee those various providers.
“Outsourcing allows you to delegate some of the operating burden and infrastructure to other providers, but ultimately you, as the manager, are the one responsible to make sure that they’re doing what you’ve asked them to do. From my position as a director, I would advise startups to have the right procedures in place to make sure any outsourced providers are meeting the standards they require.
“You can operate a lean but efficient firm, as long as you’re thoughtful about where you place certain responsibilities and where your cost centres are located, whether they’re there within your firm or with a third-party provider.”
In Golding’s experience managers just starting out appreciate having some extra support to get them through their launch – this includes advice from their legal counsel, directors or their prime broker for guidance on the best fund structure, what fee terms to offer, and selection of service providers, for example.
“We’ve been a bit more involved in some of those early-stage decisions than we might have been in the past. This is hugely beneficial because we’re having more contact with our clients through this process. Hopping onto a virtual call is easy and helps to ensure that things are set up properly from day-one,” she outlines.
Leanne Golding, Director, Harbour
Leanne Golding is a Director of HTC Fiduciary Services Limited and an officer of The Harbour Trust Co. Ltd. (together, doing business as “Harbour”), and is responsible for providing fiduciary services to Harbour’s fund clients, including serving as an independent director for such funds. Leanne previously worked for Goldman Sachs Administration Services (GSAS), where she was Vice President, Global Investor Services managing the Investor Services team in three jurisdictions. She joined the Harbour team in 2009.