As the founders of the first generation of institutional hedge funds reach the twilight of their careers, allocators are beginning to think about “retirement risk” in their hedge fund portfolios. For the better part of two decades, backing early movers in the space and staying for the long term proved to be a fruitful investment strategy. As a result, the preponderance of capital allocated to hedge funds today is invested in funds whose very talented leaders are likely to either return capital or attempt a succession plan in the coming years. In either case, allocators will be compelled to address change by making an active decision with unfamiliar patterns to recognize.
A number of early allocators to hedge funds have taken steps to address this retirement risk by turning to small and emerging managers. As a first step, allocators have backed spinouts from their existing managers. Although logical and comfortable to endorse, these launches comprise a tiny subset of the investable universe.
When allocators look beyond the familiar, the breadth of potential opportunities is overwhelming. It’s not terribly difficult to meet a few credible funds and pick one or two, but gaining confidence that this sample set is representative of a wide investable universe is far more challenging.
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Now a dozen years in the making, our accrued experience, mistakes made, and lessons learned seem relevant to the many issues faced by our evolving industry. Academic studies suggest that the returns of smaller and emerging managers outpace those of their larger, established competitors. At the same time, the law of large numbers dictates that many of the small funds will generate below-average results. Recent research and experience indicate that both are true: Higher highs and lower lows await and collectively aggregate to a slightly better result. When allocating to an industry predicated on protecting the downside, developing a process likely to result in more successes and fewer disappointments seems a wise prerequisite to getting started.
Whenever competition for a scarce good exists, timing can be essential to winning the game. We believe the best opportunities among emerging managers often arise when we are either the first to arrive or among the last to enter. To better appreciate this dynamic, let’s consider the process for acquiring another scarce good — space at a hot nightclub.
There’s nothing better than showing up at a quality nightclub before anyone else arrives. Anticipation builds for what the crowd will bring, the maître d’ gives you a hug, and the bartender has all the time in the world to impart nuggets of worldly wisdom.
When an investor is among the first prospects for a new hedge fund, the manager has as much time as needed to fully explain every facet of its history, team, investment process, portfolio construction, and ideas. Unlike at larger funds, the manager has a lot more time for the investor than the investor has for the manager.
When it comes time to start buying drinks, the early bird often finds great value for his money. Happy-hour discounts, free hors d’oeuvres, and even an occasional free drink get passed his way.
In a world where fee scrutiny has increased, investors in new funds find a level playing field for negotiation. Whereas large funds set a price for the masses long ago, small funds are often willing to negotiate a reduced price for their services in the early going. Depending on the balance of power, investors may engage in discussions about economics in the new enterprise, fee discounts, capacity rights, or incentive fee clawbacks.
For the patron with foresight, the benefits of arriving early remain, even when her chosen watering hole becomes the hottest ticket in town. The bar staff don’t forget which customers put them on the map, and the regular still finds it easy to catch the eye of the bartender for a round of drinks or of the maître d’ for a table to impress friends.
Many of the allocators’ best relationships are with the funds they entered in the early stages. Allocators who devote sufficient time and attention to understanding what could happen, make an early bet on the firm’s success, and stay in regular, productive communication throughout their investment period build significant goodwill, regardless of how big and successful the manager becomes. These relationships may benefit the investor via enhanced returns (through reduced fees) or indirectly from the manager’s desire to ensure the investor’s continued success (through referrals and investment ideas).
For every fund that starts and thrives, many more fail to get traction. Without a keen ability to scout talent, allocators may decide that the opportunity cost of capital and time or the risk of looking foolish is too high a price to pay for the potential benefits of early investing. Industry statistics indicate that most investors come to this conclusion; very little capital is allocated to startups, and the capital that is available comes from a small number of participants.
All is not lost for those allocators who prefer to see tangible evidence of an emerging manager’s success before taking the leap. It turns out that for those who pass up the happy-hour special, another opportunity awaits in which the odds of success are favorable.
No self-disrespecting New Yorker can make it through his single years without experiencing the “velvet rope.” When a popular bar gets crowded, a sizable bouncer stands outside the front door while potential customers line up alongside a velvet rope that prevents access. Partygoers must wait for those guarding the entrance to grant them access.
When not investing early, most of our investments have been at the opposite end of the emerging-manager spectrum — at closing time. For small hedge funds that come out of the gates well, the allocation community tends to catch on and pay attention. More often than not, strong investment returns result from a sound process run by a deeply passionate, highly motivated team that is navigating difficult markets far more nimbly than its larger competitors. If the manager stays disciplined about asset growth and continues to play in markets that the larger competitors cannot, the fund may epitomize the outperforming small manager that allocators seek for many years to come.
The hot spot in the New York night scene changes with regularity. Without much in the way of competitive differentiation, bars struggle to keep up with the fickle tastes of their patrons. After experiencing a fantastic night inside a hot nightclub one month, the ill-informed New Yorker may find the same spot both easy to access and not worth the cover charge a short time afterward.
When reviewing short track records, allocators need to consider whether the initial drivers of return are repeatable in the future. The investment window may be relatively brief for an emerging fund dubbed a star by the market. Astute allocators must keep their behavioral biases in check, making sure that the strong performance had more to do with the manager’s skill than with a cyclical tailwind for the manager’s strategy. In that moment when the door is about to shut, envisioning what might happen if a market cycle shifts could save allocators a few bucks.
It’s not only the velvet rope that becomes fodder for “remember when” stories later in life. Just as often as a velvet rope creates exclusivity for a chic venue, savvy promoters erect the rope to create the perception that the club is rocking. After a long wait outside on a cold, rainy night, a wide-eyed customer may finally gain entry only to find a surprisingly empty house.
A prerequisite for an attractive investment at closing time is that a fund must close its doors to new capital. Some managers use “closing” as a catalyst to raise more money, holding out one hand with a stop sign while waving through new investors with the other. As more investors enter, the once nimble fund may lose its step and no longer hold the benefits of exclusivity.
A Great Night Out
After conducting sufficient homework to confirm the quality of an apparently great nightclub, getting in early or late usually offers a memorable evening. Should the club close its doors to protect its franchise, the rewards of membership may be well worth the effort to gain access. Once the nightclub is full and rocking, the velvet rope disappears. The next enthusiastic customer who approaches may hear the loud noise but will see only an iron gate over a steel door, offering no hope of joining the party.
Whether identified early (“first in”) or late (“last in”), an investment in a successful emerging fund may prove a valuable asset for many years to come, especially if the fund becomes inaccessible to new investors. “Last-in” funds close, and “first-in” funds evolve from early to open to closed as well. An investor who keeps the winners and rotates out of the losers can build an irreplaceable asset and one of the hottest tickets in town.
This was previously published on Inside Investing at the CFA Institute.
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Ted Seides, CFA, is the president and co-CIO at Protégé Partners, LLC, a leading alternative investment firm launched in 2002 that invests in small and specialized hedge funds on an arms-length and seed basis. Ted began his career under the tutelage of David Swensen at the Yale University Investments Office, where he focused on external public equity managers and internal fixed-income portfolio management. Seides spent two years investing directly in public and private markets before co-founding Protégé in 2001. He has written investment pieces for Institutional Investor, Harvard Business School Publishing, CFA Institute Conference Proceedings Quarterly, FT Alphaville, and the late Peter L. Bernstein’s “Economics and Portfolio Strategy.”
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