Outsourcing, budgets, and the quant-vs-discretionary debate loom large over the US start-up process, with seeders, platforms and pods becoming increasingly important for fledgling funds.
Outsourcing, budgets, and the quant-vs-discretionary debate loom large over the US start-up process, with seeders, platforms and pods becoming increasingly important for fledgling funds.
The institutionalisation of the hedge fund industry over the past decade is making launching independently with friends and family money extremely tough for prospective new managers, according to US hedge fund industry participants.
“Everyone’s looking for institutional-grade quality now, and that’s one of the biggest challenges for a smaller fund,” says Wayne Yu, CEO and chief investment officer at BCK Capital, a long/short global equity-focused special situations manager which launched in 2015.
Pushback
His comments chime with Hedgeweek survey data that shows attracting investor flows is now the biggest single challenge for emerging and start-up hedge funds during the initial launch stages.
Almost two-thirds – 64% – of all hedge fund managers polled said securing allocator capital was the biggest barrier for emerging managers (see Fig 1.1). Meanwhile, a fifth of respondents – 22% – cited a lack of established track record and/or industry name recognition as the primary challenge for newer funds, while close to 10% named regulatory and compliance burdens as the largest hurdle.
Anecdotal evidence suggests that launches are being pushed back by a month or a quarter, while managers who can open with $100 million or so of their own money may initially opt to launch as a family office before securing more capital to formally roll out.
Bloomberg data shows launches of equity long/short funds – traditionally the largest hedge fund sub-strategy and often seen as the cornerstone of the industry – have fallen sharply over the past year, down from 50% of all new launches in Q4 of 2020 to less than a fifth (18.2%) in Q1 in 2022 (see Fig. 1.2).
Amid this tricky capital-raising environment, the expansion of boutique mini-prime brokers, compliance consultants, and specialist law firms focused on the next generation of managers can help hedge fund firms keep a lid on spiralling start-up costs, industry participants say, while the arrival of cloud software and remote working services have nixed the need for costly HQs in the well-heeled districts of Connecticut or Mayfair.
Hedgeweek’s survey found that close to 77% of North America-based emerging hedge fund managers – with assets under $250 million and a track record under five years – are satisfied with their current balance between outsourcing and in-house expertise when it comes to operational functions. About 15% are planning to outsource more, while less than 8% intend to outsource less (see Fig. 1.3).
Pointing to the proliferation of infrastructure-focused third party service providers spanning accounting, compliance and tech, Faryan Amir-Ghassemi, co-founder of Epsilon Asset Management, which fuses bottom-up stock selection with systematic investment processes, says decisions over whether to develop (often costly) infrastructure in-house or instead outsource back-, middle-, or front-office functions to third parties carries far-reaching implications for emerging managers hoping to build early momentum in a fiercely competitive market.
Barriers to entry
Budgetary priorities are also shaped by fund strategy type, with computer-based quantitative funds depending on a larger amount of technology, and traditional discretionary long/short managers meanwhile more focused on research and analysis.
With a nod to the hedge fund industry’s ongoing discretionary-versus-quant debate, market participants observe how the quant fund operating model is markedly different to that of a traditional asset manager, requiring considerable amounts of infrastructure comprising systems and platforms that support machine-readable trading models and codes – potentially heralding sizable costs for budget-constrained start-ups.
“The germ which allows a discretionary manager to bloom is centred around the human capital – their experience, their ability to implement their process, the tools that they need. Even if they came from a very large established firm where they had access to a huge amount of resources, their skills and resources are largely transferable,” Amir-Ghassemi says.
“I think there is a higher barrier to entry with quants – there’s a trade-off in terms of resource allocation when you’re a start-up quant – you have to make a build-versus-buy decision across the board with data sources, models, and infrastructure providers.”
Underlining this point, Amir-Ghassemi says start-up hedge funds must define their ‘circle of edge’, noting how this influences decisions around order management, execution, trading and more.
“We call it the ‘circle of alpha generative competence’,” he says. “You focus a lot of your build on that, and from there you really try to buy everything that orbits around that. The build-versus-buy decision comes down to whether the implementation is ancillary to your process within that circle of alpha generative competence, or it is something that you can build on your own to float yourself to a point where you can then commit to that spend.
“If you are high frequency, for example, you need to have your circle of alpha generative competence around your execution. If you’re low or medium frequency, this might be the type of thing that you can partner with a service provider to get you 95% of the way there before getting to a meaningful scale where you can invest the resources to build out that last 5%.”
Taking the temperature
If the independently-launched shop – characterised as the ‘two men and a Bloomberg’ set-up which helped define the industry’s pioneering spirit during the late ‘90s and early 2000s – is becoming increasingly rare in today’s institutionalised landscape, across the spectrum there lies an increasingly diverse range of fund hosting platforms, seeding and incubating solutions and multi-strategy pod structures offering various degrees of financial and operational support for new roll-outs.
Pioneered by the likes of Millennium Management, the $47 billion multi-strategy hedge fund giant established by Izzy Englander in 1989, the pod model can provide slugs of capital – together with operational infrastructure and regulatory support – to fledgling funds struggling to raise funds elsewhere.
On the flipside, launching on a platform means portfolio managers ultimately ceding a degree of control over their business. While platforms can meet managers’ operational requirements, not every fund – particularly contrarian or estoeric strategies – will be a suitable fit for the platform or pod model, owing to platforms’ risk parameters, which often tend to be low net exposure and market neutral.
“There are advantages to being a smaller fund – there certainly is the ability to trade in and out of things much quicker,” says Yu. “In terms of the emerging manager environment, it’s definitely a changing landscape – I think at this point it’s very difficult to launch a fund without some strong initial backing – launching with a big partner is a stamp of approval.”
Key Takeaways
- As the US hedge fund industry’s turn-of-the-millennium ‘golden age’ recedes further from view, the days of ‘two men and a Bloomberg terminal’ appear to be over. As investors demand institutional-grade infrastructure, start-ups are looking to launch with stronger backing, increasingly from seeders and platforms, as two-thirds of emerging managers say securing investor capital is their biggest burden
- The expansion of outsourced services is bringing a degree of comfort to newer hedge funds, especially quantitative-focused managers who face particularly acute operational and tech challenges
