Emerging hedge fund firms facing many roadblocks

New hedge fund launches are declining in one of the most difficult fundraising environments managers have faced since the global financial crisis.

The rising cost of running a small money management firm, fee pressure from potential investors, demand for differentiated strategies and a dearth of anchor investors all are dissuading hedge fund managers from setting up their own shop, observers said.

"Fundraising is extremely tough for hedge funds in the ninth year of a bull market," said Andrew Saunders, senior managing director at Castle Hill Capital Partners Inc., New York, a specialist consultant to hedge funds.

Mr. Saunders said hedge fund fees are being pushed down and it's hard for a small manager to "keep the lights on" when the desired fee formula from investors is no management fee and a 10% performance fee.

"Seeding at 2% and 20% is much different than zero and 10%. Managers could always model their expenses at 2% and figure out how to stay in business, but how do you model zero?" Mr. Saunders queried.

The volume of new hedge fund launches in the quarter ended June 30 — 148 — was the lowest since the fourth quarter of 2008 when just 56 funds began operation, showed data from Hedge Fund Research Inc., Chicago.

Since the financial crisis, the pace of hedge fund introductions peaked at 1,113 in 2011 and has been on a steady downward trajectory ever since, according to HFR data.

With just 306 hedge fund debuts in the first half of this year and if the pace of fund launches continues through year-end, 2018 will be the worst year for new hedge fund generation since 2000, when just 328 funds started trading.

Current conditions are extremely tough for hedge fund manager launches, partially explaining declining levels of funds hitting the market, sources said.

"It's one of the most difficult environments I've seen for new launches. The cost of launching has risen dramatically due to new regulations, enhanced focus on operational due diligence," said Jacob Walthour Jr., CEO and partner of Blueprint Capital Advisors LLC, New York, which offers a platform for investment in small, niche-focused credit hedge fund managers.

Investor preferences have changed, and "you can't rely on finding a substantial anchor investor, particularly family offices," which for many years were the main source of startup capital for hedge fund managers, Mr. Walthour said.

Blueprint runs a total of $1.1 billion on its investment platform, of which $360 million is under advisement.

Recognition pays

Name recognition and a resume that includes time spent at a large hedge fund help a lot when it comes to attracting assets to a new hedge fund.

"Unless you have a big name and a pedigree coming from having worked at a very well-known hedge fund company" or run a differentiated, diversifying hedge fund strategy, fundraising is very difficult, said Daniel Stern, a New York-based senior managing director and head of hedge fund research at alternatives consultant Cliffwater LLC.

Among the very few large launches in 2018 was the summer debut of ExodusPoint Capital Management LP, New York, co-founded by CEO Michael Gelband, who was global head of fixed income at hedge fund giant Millennium Management LLC.

ExodusPoint reported assets of $4.4 billion as of June 1 on its ADV filing with the Securities and Exchange Commission. ExodusPoint Partners Fund, the firm's flagship multistrategy hedge fund, started trading in July. Among its investors are the $52.6 billion Maryland State Retirement & Pensions System, Baltimore, which allocated $300 million, and the $23.6 billion San Francisco City & County Employees' Retirement System, which invested $175 million. Both funds made their allocations in September.

Marquee-name managers like Mr. Gelband find it much easier to attract significant day-one capital from established hedge fund managers investing their own money, wealth management firms and institutional investors, leaving more obscure managers with a smaller pool of potential investors, said Alifia Doriwala, partner, managing director and multiasset portfolio manager for The Rock Creek Group LP, Washington.

"For investors of all kinds, you can't be the only investor," Ms. Doriwala said, stressing "the question is whether a hedge fund manager with $50 million from a single investor has a sustainable business."

The Rock Creek Group manages $13.9 billion in hedge funds of funds and customized hedge fund portfolios. About $3 billion of its assets under management are invested in emerging hedge fund managers.

Slow starts

Even for high-quality small managers, there can be a long period of low asset levels.

Boardman Bay Capital Management LLC, New York, for example, launched its first long/short equity fund focused on technology, media and telecommunications in 2012.

Six years on, AUM is at $100 million and the company also is running two very concentrated, technology-themed, opportunistic hedge fund portfolios focused on the "software as a service" and optical sectors, which are getting a lot of attention from investors, said William Boardman Graves, managing member and the firm's chief investment officer.

"Institutional money doesn't come quickly. You have to take a very long-term approach," Mr. Graves said, noting that from the outset "you have to be confident that you have a product that's differentiated."

Boardman Bay needed to charge a 1% management fee, he said, because "every investor knows hedge funds need management fees to run the fund," but the firm instituted a sliding performance fee that doesn't kick in until the hedge funds return at least 5%. If the return is high enough, the firm will refund the management fee.

"We're more nimble, can make smaller, more impactful investments than larger funds, and we are passionate about tech investment," Mr. Graves said.

The Boardman SAAS Opportunities Fund returned a net 53.3% in the year ended Dec. 31 and a net 44.97% year-to-date Aug. 31.

That kind of return is what institutional investors increasingly are looking for from emerging hedge fund managers to juice up alpha generation in their portfolios, sources said.

Established programs

Many large pension funds have well-established emerging manager programs across traditional investment strategies. The $29 billion Employees Retirement System of Texas, Austin, is among the first to establish a dedicated emerging hedge fund manager program.

The fund hired Pacific Alternative Asset Management Co. LLC in June to provide an emerging hedge fund manager investment platform — Launchpad — that will enable asset owners like Texas ERS to provide seed capital to hedge fund managers from day one through the early stages of fundraising.

The Texas pension fund has had a $1 billion emerging manager program in place since 2010 and invests another $1.6 billion in hedge funds total, but it has been looking for a way to invest in very early stage hedge fund companies for some time, said Panayiotis Lambropoulos, ERS' lead hedge fund portfolio manager.

ERS' focus is squarely on the ability of early stage hedge fund managers to produce alpha, said Sharmila Chatterjee Kassam, deputy chief investment officer, who noted historical performance data prove the point.

For example, data from researcher Preqin Ltd. found that first-time hedge funds with less than $300 million under management and those with track records of three years or less on average outperformed the full universe of hedge fund managers in the one-, three- and five-year periods ended May 31, 2017.

ERS also increases the likelihood of outperformance from its small hedge fund managers because the pension fund will share the revenue of the new hedge fund managers, get reduced management and performance fees and a profit when the manager moves out of the Launchpad program and repays the fund for its investment.

ERS hasn't determined the size of its Launchpad investment, but Mr. Lambropoulos said he already is doing due diligence on early stage hedge fund managers and likely will invest in three managers over the next two or three years with the goal of having "the ideal farm system" of between five and 10 small hedge managers running money.