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The conundrum of investing in emerging managers

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By Marianne Scordel – A year ago, we explored what hedge fund investors might be looking to buy during the following twelve months, what their attitude towards managers at the smaller end of the spectrum was, and what investment strategies appealed the most.

This year, Bougeville Consulting and Global Prime Partners decided to team up in this survey produced for Hedgeweek to try and understand what has changed, whether plans have come to fruition, and what, in the light of recent events and as a result of more structural factors, would determine investors’ appetite towards emerging managers in the near future.
Global Prime Partners (GPP) is a boutique Prime Broker, focusing on servicing clients with AUM generally under USD100m. It is important for GPP to understand the potential for success of the firm’s clients and potential clients, not just in terms of investment performance, but also as far as business development is concerned: AUM growth and stability of assets – mandates they are likely to win as well as those they are likely to lose, as a result of opportunity costs or early redemption.
Bougeville Consulting assists hedge fund managers with their business strategies. This consists in providing the ground work – including research into the costs and benefits – to enable them to make decisions relating to the opening of new businesses, the making of a new product, or the development of a new strategy – albeit seen from the support and the commercial opportunity angles rather than directly from the perspective of the investment strategy of the fund. The ultimate objective is always to meet current and future investors’ legitimate expectations or alleviate potential concerns – hence our need to be, and to stay, aware of what our clients’ clients really want.
Last year our study was seeking to understand investors’ overall appetite, and, in doing so, we found that the evolving landscape for emerging managers was, in fact, difficult to predict. Among those surveyed, 70% of respondents pronounced themselves in favour of smaller funds – which, at the time, we had not defined precisely. However, many qualitative features – including survivorship bias, the “no one gets fired for buying IBM” rationale, and the diversity among smaller managers – were mentioned as potential obstacles to investing in those funds.
The resulting picture was uncertain; so, this year, we decided to drill down a little further into this aspect of hedge fund investing. We have articulated the findings around three main points:
•           Over 60% of those surveyed rely on third parties for their operational due diligence. While the extent to which they do so varies, this nevertheless sheds light on last year’s finding according to which internal resources had not been increased for the purpose of performing ODD. It also provides a clue as to why the resulting investment decisions are less likely to be in favour of emerging funds.
•           The environment – commercial, regulatory – has become more expensive and those costs are likely to have a relatively greater impact on emerging managers, thus adding to the risk of investing in a new venture. Having to bow to the pressure of lower fees, recently-established managers must now face the increased costs, and risks, relating to the new compliance environment.
•           Finally, investment timeframe and commitment to partnership seems to be of paramount importance when it comes to choosing investment targets, be it in relation to the size of the fund or to the investment strategy followed.
–          As far as the size of the fund is concerned, overall we have found that the longer the investment horizon, the more likely investors are to invest in emerging managers. This relationship becomes stronger when investors are managing proprietary assets rather than third parties. On the contrary, AUM is not a good proxy for target size preference.
–          As to the investment strategy, 50% of the respondents clearly said they wanted to increase their exposure to equity as an asset class, and 25% were planning to decrease their exposure to CTAs over the next twelve months – both of which could give rise to a few questions given this year’s market movements. Again here, data shows a positive correlation between investment horizon / investor type, on the one hand, and choice in asset classes, on the other hand.
The multi-faceted impact of the outsourcing of ODD
The investors surveyed manage or advise on asset allocation. Sizes at firm level range from USD200 million to over USD170 billion, with hedge fund investments of between USD200 million and USD2.5 billion. The average size is USD42 billion with hedge fund investments ranging from 1.5% to 100% of total AUM. Like last year, investors surveyed are from the UK, the EU ex-UK (including Germany, Spain, Scandinavia and the Netherlands), the Americas, Switzerland and the Middle East.
While last year 70% of respondents said they were broadly in favour of emerging funds, this year only 25% adopted a similar view. Where does the drop in numbers come from?
We do not believe that the change in individual respondents within our sample explains such a dramatic change in the results. The sample mean has remained fairly similar – USD42bn this year versus USD40bn last year – and the diversity of respondents – a balanced mix between wealth managers, superannuation (pension) schemes, funds of funds, multimanager funds, and family offices – is broadly identical. The main difference this year is that respondents are more concentrated around the mean in terms of asset size, however this is unlikely to have a negative impact on investment in emerging funds for the following reasons:
•           We have found that there is a weak correlation between AUM size and likelihood of investing in smaller funds.
•           If anything, some of the largest investors are less likely to invest in smaller funds because their investment sizes would immediately make them the main investors, which they want to avoid – unless they do seeding and can take an equity stake into the management company also.
Among the respondents, 15% said they have “concentration limits”, as a result of which they cannot own more than a certain proportion of AUM – a 10% and a 20% limit were indicated as ceilings. The respondents who put forward that argument “against” investing in emerging managers were wealth managers, dealing both with wealthy individuals or endowments. With ticket sizes in the range of $10m to $30m,the ceilings could be reached fairly easily as far as the smallest managers are concerned. “We do not want to be caught with our pants down”, said one investor, to support his employer’s decision to avoid emerging managers, “so such an investment would be ok only if we believe a fund’s AUM will increase quickly”.
Investors with an increasing amount of AUM find investing in emerging hedge funds not so much dangerous as expensive: “Small funds make it difficult for us to achieve scale”, says one respondent.
•           Conversely, some of the smallest investors tend to rely on the fund’s service providers for the purpose of Operational Due Diligence. Since smaller funds have less money to spend on outsourced functions – e.g. on a Prime Broker – the result is that smaller investors may tend to stay away from the space.
What explains the drop in numbers seems to be linked to that fact that this year, we asked the question in a more concrete way. Investors have not fundamentally changed their minds about emerging funds and overall still say they are open in principle. However, they pointed to a number of reasons as to why they are not planning to do so in practice. Most of those reasons have to do with the way emerging managers deal with the operating / business side of their ventures.
It can be argued that relying on service providers to perform ODD is a way of outsourcing that part of the investment process. Smaller investors tend to do this almost by default: they do not have enough resources to look into the (all important) details and, instead, tend to trust that a “big name” (e.g. in the Prime Brokerage area) in itself means that a fund is fit for purpose. Those respondents who invest via managed accounts or into UCITS – funds of funds primarily – also tend to rely on platform providers, a process that is made even easier for those who recently built in-house platforms for outside managers. It has to be noted though that most of those surveyed do take the way managers outsource key functions into consideration – albeit to a greater or less extent and often in combination with other factors.
The most important points respondents made about emerging funds and their service providers are as follows, starting with views which are the most strongly-held and ending with those where comments did not constitute respondents’ primary concerns:
•           To outsource or not to outsource… is this really the question? – The overall comment is that “small funds do not have the means to have solid, scalable infrastructure”. They have often recently come out of banks and are faced with the challenge of managing a business in addition to concentrating on their investment strategy: they find it hard to multitask and lack the expertise to deal with all the various areas relevant to their businesses; however, they often cannot afford hiring the talents required – whether to perform the work as a permanent member of staff or as an outsourced service provider.
•           Prime Brokers and Compliance – These are the functions that seem to matter the most to investors, and some respondents say that these are “weaker at smaller funds than at larger funds, which, as far PB is concerned, can create a financing risk”. While some investors “prefer an outsourced compliance function”, which, at least gives some guarantees that the job is being done professionally, resource constraints result in investors passing on smaller funds because these two key functions are not dealt with appropriately.
•           Documentation and marketing material – “Still a lot of people are using boilerplate documents, which allow managers to do anything”, says a respondent. While similar comments come up spontaneously after a few minutes of speaking with a few hedge fund investors, one respondent, whose operations fit into the higher end of the sample in terms of AUM, volunteers to say that “fact sheets and presentations are sometimes incomprehensible even for larger funds! The difference is that [the larger funds] listen to us because they have marketing personnel internally”. Smaller managers, who may be more likely to use third party marketers, find this exercise more difficult, and, according to another respondent who goes further in criticising funds’ information he regularly reviews: “Emerging managers have little to lose; we do not know to what extent we should rely on their presentation”. The nuance to this is the fact that documents coming from more established funds are sometimes old and… outdated.
•           Corporate governance – Some investors complain that they do not see enough board independence, with director oversight often qualified as “poor”.
•           Conflicts of interest – “Larger firms have the resources to hire more back-office staff with segregation of roles and responsibilities, which is important in building appropriate checks and balances”, says one respondent.
•           … and why sometimes it just does not matter – Finally, one respondent indicated that while back offices must be “appropriately funded”, they must first and foremost “have conviction about person”. They explained such an approach was in-keeping with their value and long term model, which result in a partnership with the investment target and hence they are prepared to accept that a fund’s operations will develop, grow and improve as the AUMs themselves also grow over time.
Additionally, some of the biggest investors, who also admit “ODD is not [their] strongest point”, have recourse to dedicated ODD service providers on which they rely for at least part of the process – with the remainder sometimes being done by their internal compliance teams. Based on our sample, the split among investor type is as follows:
•           Family offices and funds of funds are the most reliant on external providers – either as providers they specifically mandate to do this job or via Prime Brokers’ introduction and implicit recommendations.
•           Wealth managers tend to “mix and match”, trying to reach a balance between what is done in-house, on the one hand, and input from a specialist third party, on the other hand.
•           The two pension funds interviewed are the only respondents saying they perform a very thorough ODD in-house, with dedicated teams working on this, which somehow confirms a point a fund of fund manager also made as part of this survey exercise: “The problem is that we are doing for our [pension fund] clients what they now know how to do”, thus highlighting the fact that several pension funds of large companies or organisation now have in-house alternatives teams that do everything, including in some instances more of the ODD that many funds of funds no longer really do.
The environment: how much is it costing?
Investors say emerging funds may not have the appropriate level of resources to hire or to outsource properly, and this is compounded by the fact that the cost of doing business has increased over the recent period.
•           AIFMD – Last year, the AIFMD was already on the cards, however it is not until late in the day that some of the players started to realise how expensive this would be. In addition to the direct cost of compliance comes the regulatory risk, and potential fines imposed by regulators, as a result of areas of uncertainty, such as those relating to marketing. Several respondents indicated that they are no longer sure as to what extent funds unknown to them – hence, many of the emerging funds – are allowed to approach them; some have taken the conservative approach that reverse enquiry might be preferable for now.
•           UCITS – European conservatism really started with the beginning of the global financial crisis but was enhanced by the recent regulatory developments, which is paradoxical if one considers that one of the stated intentions of the AIFMD was to protect investors and restore confidence in financial markets. While US investors are still adventurous, the tendency for Europeans is to demand more of the UCITS type of structures, which is creating more costs and constraints on hedge fund managers.
•           The “F… word” – At a time when, even in the best case scenario, capital is scarce, it appears the “fee question” is creating an additional hurdle for emerging managers: several respondents say they would only consider investing in smaller managers if they are offered lower fees. A respondent even said he wanted different fees at milestone AUM, starting very low and increasing as the manager becomes more successful.
•           How small is small? – Finally, last year we had not provided respondents with a definition of emerging managers, instead preferring to leave to door open to a qualitative discussion. In our conclusion, we had said that “several investors supportive of smaller funds say that they are now prepared to lower the minimum size of the funds into which they would invest. While this may sound like good news, the numbers provided ($100 and $200 million, both by private wealth managers) still seem rather high for a manager starting up”. Again this year, one of the respondents explained that “clear winners start with $200m anyway”, to justify he would not consider any fund with less than that amount in AUM.
Timeframe and percentage of “skin in the game”
While the above does not present an optimistic picture of the market for emerging managers, we did, throughout our investor survey, notice an interesting trend, namely the positive correlation between investment horizon and willingness to invest in emerging managers. The relationship is further strengthened when investors have a greater sense of ownership of the assets they manage.
Respondents made the following comments in relation to emerging funds and investment timeframe:
•           “Long term viability of smaller funds may be a problem,” said an investor, adding that “two-third of the new hedge funds fail”. Yes, all agree that the potential returns are higher over time, provided one is prepared to stomach the risks involved: “we do not invest in emerging managers because of the huge level of uncertainty, however we are aware that we are missing out on alpha,” says a respondent, echoing one of his counterparts who says they are now doing some work internally to relax the concentration rules mentioned above, which, in some cases, prevent investors from owning too high a share of AUM.
•           While long term investors managing a proprietary portfolio may be prepared to bear that risk, others, in charge of assets coming from a greater number of third parties are faced with the question of reporting on short term performance to clients who may be “less educated”
•           This explains why 50% of the respondents say they want to increase their exposure to equity, which has performed well so far this year, while CTAs, who suffered this year in terms of performance, are not as much in favour as they were last year, with over 25% of the respondents planning to decrease their exposures to this strategy in the next twelve months. “This is very backward looking,” admits an investor – even though those buying equity include investors committed to specific strategies, such as event-driven, rather than to the asset class itself.
•           Finally, as a point of methodology, it should be noted that last year’s sample included two seeders, which, by definition, do invest in emerging managers and do have a vested interest in the business, due to the equity stake. This year, these investors are no longer in the sample, however they have been replaced by another type of investor who does not have an equity stake but, instead, has adopted a “partnership approach” with the managers in whose fund they invest. Participating in the growth of a fund is no doubt rewarding, requires striking the right balance between proactive support and inhibiting interference, and takes, well, time…
The landscape for emerging funds does not look as rosy as one might like, past the initial enthusiasm that comes quite naturally with novelty. The one optimistic note though is that the investors committed to smaller managers look at the long term and, thus, provide a stable and strong base from which to grow.
Marianne Scordel founded Bougeville Consulting to assist alternative fund managers with their business strategy. This includes providing assistance to hedge fund managers in finding cost effective solutions to compulsory changes (e.g. those pertaining to the regulatory environment) and in enhancing commercial opportunities – adapting products, structures, or the marketing thereof. Prior to this, she worked for Nomura and for Barclays Capital. She is an Alumna of St Antony’s College, Oxford.

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