“It’s a patience trade”: Hedge Fund Veterans’ Advice to Emerging Managers

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Emerging hedge fund managers remain resilient in the face of numerous challenges, with a recent survey finding breakeven rates have fallen and that most allocators would consider investing in managers with less than $100 million in assets under management.

These were some of the headline findings revealed by the Alternative Investment Management Association (AIMA) and global investment bank Cowen in the Emerging Stronger: Emerging Manager Survey 2022 – The next generation of hedge fund firms.

In an AIMA fund manager briefing webinar, attended by a large audience from across Asia, Cowen brought together two veterans of the continent’s hedge fund community to discuss the survey’s findings and to offer aspiring managers the benefits of their experience.

Sandeep Mand is Managing Director of Wolver Hill Asset Management Asia, a hedge fund platform offering services to emerging managers in the region.

Ronnie Ho is COO of Hong Kong-based East Eagle Asset Management. His derivatives-focused multi-strategy fund started up in 2018.

They were in conversation with Ortwin Gierhake, Hong Kong-based Director of Prime Brokerage sales for Cowen. He said the survey showed that, as well as the fall in the breakeven rate since the previous survey in 2017, management and performance fees are essentially flat at about 1.4 percent, and average headcount has slipped from eight to seven.

In a positive sign for emerging managers, two-thirds of allocators said they would consider investing in a manager with less than $100 million in AUM although they had very little tolerance of operational flaws, meaning operational due diligence (ODD) had taken on greater importance.

No one doubts that founding a hedge fund requires an enormous commitment of time and effort, especially in the early days when the emerging manager might have to make personal financial sacrifices just to keep the lights on.

Mand’s advice was to build carefully, mindful that the fund will not be in its ultimate form from the start.

Start Simple

“It’s a patience trade – that’s the first thing I say to people – and you’ve got to be able to fund yourself for that patience trade. You don’t have to do everything on day one.

“Start simple. Incubate for six months to a year, then you can start adding people. That shows good risk control.”

Mand added that the early self-funding period can be tough not just for emerging managers, but for their families too.

“On a few occasions, we have asked, ‘Have you spoken to your wife? What does she think? How many kids do you have at school? Have you budgeted that into not only your fund business, but your whole-life business,’ because it’s a big commitment.”

One finding of the survey was that scaling up a new fund was taking longer than in 2017. “You need to plan for more working capital and you need it for longer,” Gierhake said.

Ho also takes the long view. “You need patience, it’s a people business.” His fund started with $20 million and a team of three and faced set-up costs for fund administration and legal support.

The next step was building a track record, demonstrating to investors that the fund had an edge and could deliver their planned returns.

“When we first approach investors, we don’t just show them a one or three-year track record, we can look further back, 10 or 20 years, to when we worked in banks, and explain how the market, the industry, the alpha, is different compared with after the global financial crisis or as a result of Covid.”

In the early days of the fund, the original team put in substantial amounts of their own money. “Investors do appreciate this as it is a perfect alignment of interests. If we lose money, it’s not only clients’ money. We suffer as well.”

Ho also thinks emerging managers have an advantage over their bigger peers in talks with investors. “We are more nimble, we have to be more reactive to changes in the market, because we are relatively smaller. This is a chance to showcase how we can deliver some uncorrelated returns.”

He echoed Mand’s view on the benefits of technology, insisting that the increased use of online tools during the pandemic had been a boon. “Technology helps us to work more efficiently but also to save costs.”

Your Are Not Alone

It’s tough but emerging managers are not alone and Gierhake urged them to seek help. Outsourcing opportunities are multiplying in everything from compliance to trading, while the expertise of service providers can be bought in for a fraction of the cost of an extra employee.

Asked if the $20 million fall in breakeven rates to $64 million was a surprise, Mand said the conventional wisdom was that the rate was $100 million or more. “But I think the fall is reflective of the fact that there is a lot more outsourcing.”

“The view used to be that if you wanted to be successful you had to take everything in-house, you had to own responsibility for the whole business. Outsourcing has been around and accepted a long time now and recently we’ve only seen that trend strengthen.

“For example, tech is used much more profusely in providing solutions. Some providers will say that if you take their IT solution, because they understand the system, they can do the daily trade matching and processing and supply staff and support that way, which is definitely something to be looked at.

Asked what can be outsourced and what shouldn’t, Mand drew the line at outsourcing investment.

“The manager owns the investment side of the business; it’s their skill, their IP, their reputation. The team is leveraging themselves and how they think and how they execute and you cannot outsource that.”

Trading and compliance could be outsourced “but it is double edged. You do save costs, but you need to make sure you kick the tires hard on whoever you partner with, to make sure they’re giving you a robust and a meaningful solution for the price that you’re paying.”

Also, as ODD had grown in importance “you do need someone to take ownership of it”, Mand said.

As outsourcing proliferates, questions arise about how the outsourced services are supervised. “That’s where it’s crucial to have a strong COO, head of operations or business manager,” Mand said.

Gierhake urged managers considering outsourcing to talk to the people who will be working directly with the fund, not just the relationship manager. Also ask them about staff turnover and how they deal with it.

Platform Incubators

Alongside outsourcing, emerging managers are increasingly using platforms that will “incubate” a fund until it is ready to go out on its own. In this case the platform will take over the funds regulatory responsibilities.

“There are more platforms like mine that can give more robust support. So you’ve got managers launching with a head of operations or COO and outsourcing as much as they can to help them with the day-to-day functions,” Mand said.

Gierhake asked how investors react to a fund that sits on a platform such as Wolver Hill’s. Mand said there had been mixed signals.

“Some allocators totally understand the necessity that we provide. The more institutional the allocator and the bigger the ticket, the more they’ll be asking the CIOs and the portfolio managers to take responsibility for their business,” he said.

“It’s more acceptable. It’s a cost saving but it’s that fine balance between cost and responsibility.”

There is a debate among managers about whether an emerging fund needs a dedicated investor relations person. Ho said that when his fund started, ”everyone wore multiple hats” meaning each staff member covered IR, among other roles.

Talk to Investors

What happens when things go wrong? What if the emerging manager has a bad month or, despite creating a sound business model, his or her strategy is simply not “flavor of the month”?

“You can’t sit there and think investors will come,” said Mand. “I wish it was like that. You’ve got to commit time. First thing in the morning, last thing at night, to get on conference calls and you have to make the same presentation 50 times. It takes longer than I think some people expect to get an introduction.”

Asked if allocators had ever suggested improvements were needed in the fund, Ho said it had happened in the first year. “We worked with external providers on how to beef up and improve our infrastructure. And, over time, I think the allocators were actually helping us grow and become more institutional.”

Ho added that communication with investors was crucially important “Investors want to hear not only how we generate returns, but also how we will grow the team. How do we divide the work between the investment and non-investment side? How would we take back ownership of some of the outsourced activities?”

“We were able to attract some early stage investors that were very patient and helped us to not only provide capital, but advice. Our seeder has also been very supportive in helping us to grow from just a $20 million manager. Hopefully we bring 100 million down the road and become a more institutionalised platform.”

“Transparency is very important and it is something emerging managers can provide to attract more capital and speed up the fund-raising process.”

The Bright Side

It’s clear that the emerging manager still faces years of hard graft to launch a hedge fund, but that has always been the case. At the same time, there has never been more expert help available to help turn the manager’s dream into reality.

Mand even sees a bright side to the flat 1.4 percent management fees, saying they left room for an emerging manager to build a fund. On the average breakeven AUM of $64 million a year, 1.4 percent brings in $75,000 a month. Assuming the principals sacrificed their salaries for the first two years, that could fund a fully functioning two-to-five-person business.

He also offered a money-saving tip he said is often overlooked – amortizing the fund formation costs. “Your legal, fund admin and other setup costs all add up, but you can amortize them over five years.”

Both Mand and Ho pointed to potential savings on office space, one of the biggest costs facing hedge funds. Mand said We Work was an option for nascent funds while Ho said that by renting an office on the south side of Hong Kong instead of in the Central district, his firm had saved 60 percent on rental costs.

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