A major industry report shows emerging hedge funds are finding new ways to be profitable despite a challenging environment. One key to their success is close collaboration with their service providers.
Charles Dickens famously began ‘A Tale of Two Cities’ by stating it was the best of times and the worst of times. We would not go to either extreme when talking about today’s environment for emerging hedge fund launches, but the idea at least captures some of the mood during a tricky but also promising first half of 2023.
And for those funds wondering what will get them into the best of times category and keep them there, we have a message to deliver. Strong planning and close collaboration with service providers can make all the difference. That’s one of the takeaways in a major new report by Hedgeweek.
The report – ‘Ones to watch 2023: the year’s 20 most exciting hedge fund launches,’ which TD Cowen sponsored – explains why emerging funds have cause for optimism despite the challenges they face. Fee compression is real and is ongoing, but industry dynamics are creating opportunities for closer collaboration with service providers. That can increase the likelihood of smooth and successful launches.
Jack Seibald, Managing Director and Co-Head of Prime Services & Outsourced Trading at TD Cowen, noted that the prep time for launches was getting longer. Some of that was due to funds recognising that it paid to take time to get both their investment strategy ready as well as their infrastructure. Another reason was that many managers spinning out from established funds had non-compete clauses that led to longer lead times.
Either way, the result is that hedge funds can work more closely with service providers to maximise the chances of success.
“From our perspective as a service provider, this helps – it means more time to have an impact during the process, whether that’s via consulting or capital introductions,” Seibald says in the report.
Driving down breakeven points
Given the strength of the competition and the downward pressure on fees, a strong planning phase is more important than ever. For instance, the report finds that competition among equity hedge funds looks particularly daunting.
That means hedge funds need the lowest possible breakeven points if they want to have the time to develop and realise their ambitions. And that’s where strong relationships with service providers can also come into play.
The report offers evidence that breakeven points for emerging managers had come down. Hedgeweek suggested that despite some cost rises and lower fees, hedge fund founders had found more ways to manage costs.
The report said the outsourcing trend over the past decade made it easier for emerging hedge fund managers to build their businesses, with sizeable numbers of funds revealing that they were outsourcing half or more of their business infrastructure.
“Even though the business environment has been difficult, and continues to be difficult, outsourcing has helped reduce overheads,” Seibald says.
Achieving such results requires planning. The TD Cowen executive says there is one piece of advice they give to new managers, which is that it takes time to plan. “Don’t be afraid to ask for help, don’t be afraid to ask for criticism, and take that criticism as it’s intended: constructively. Because it’s hard to get a redo,” Seibald says.
That advice was the same he received when he and a partner launched a fund.
Business propositions and beyond
It’s a given that funds need a strong investment strategy and process. But success also comes from putting extra care into developing and articulating the business proposition. A host of questions about the operations and the roles of those at the fund need to be worked out in advance, and they need to make sense for investors.
Early on, the focus with investors will inevitably be on the portfolio manager as family offices and other smaller investors are making a bet on that person’s abilities. But as time goes on and a fund looks to attract more research-intensive institutions, the attributes in demand include the sustainability of the fund.
“Here, the importance of the support around that portfolio manager – the wider team and business infrastructure – becomes infinitely more important. These allocators are concerned with scalability,” Seibald says in the report.
Hedgeweek says a majority of managers with AUM under $250 million and track records of less than five years are detecting more interest from institutional investors and private wealth investors compared with year-earlier levels.
Also, conversations with founders and COOs of funds that made it onto Hedgeweek’s 20 “ones to watch” list of funds point to even more cause for optimism as they focus on finding long-term partners for their business. They say they have been encouraged by the response from investors to fundraising efforts.
While there is no question that some funds have felt the need to exercise caution and put off launches until the second half of this year or later, a key takeaway from the report is that there are also reasons to be bullish.
That also jibes with our vantage point. From TD Cowen’s perspective, we know from experience that we can help funds to make the most of even the most challenging of environments. No one can guarantee it will be the best of times, but we think that with close collaboration between funds and providers, there’s every reason it can be profitable, both in the early years of a fund and beyond.
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