Capital Raising is Now Survival of the Fittest for Hedge Funds

Terry Flanagan

Fund managers continue to trudge through a difficult 2012, posting first-half gains of just 1.26% as an aggregate while the S&P 500 added 8.31%. With performance playing an ever-vital role in raising capital and investors skittish about less-than-stellar returns, the fundraising environment for smaller managers has become more competitive than ever, as allocations increasingly flow in the direction of larger, more established funds.

Interestingly enough, the flow of investor money into hedge funds has trebled over the past four years, especially from institutional investors who see the alternatives sector as a favorable option. “Flows [into hedge funds] continue to do well as investors struggle with generating a certain rate of return,” said Don Steinbrugge, managing member of Agecroft Partners, a third-party marketer specializing in alternative investments. “Pensions must have a 7.5% return a year, endowments need 5%—if you’re just investing in fixed income and equities these days, it’s very hard to generate strong returns. With hedge funds, an investor can still expect a 6%-8% return, and that compares very favorably to expected returns from fixed income and equities.”

For smaller-to-mid-sized hedge funds, however, institutional allocations haven’t come so easily, as large hedge funds continue to earn the lion’s share of assets from institutions: in a recent KPMG report, 87% of funds with 100 employees or more reported an increase in pension fund assets since 2008, while 80% said “other institutional” assets had increased, too. Meanwhile, funds with less than 25 employees saw a less pronounced gain in institutional assets, with 65% reporting a rise in pension fund allocations and 60% reporting a rise in “other institutional” assets.

“Unfortunately, the reality is that the bigger you are [as a fund], the easier it is to get even bigger—money begets money,” said Patrick Fisher, senior research analyst at Prelude Capital, a fund of funds in New York focusing on long/short equity managers. “Large funds are the natural beneficiaries of investors moving into alternatives: they’re viewed as more stable, more reliable. There’s no business, reputational or job risk when investing in, say, Winton, SAC or Millennium. Large funds are considered safe, they’re a known quantity—and easier to find and conduct due diligence on.”

In an environment of sluggish returns and investors biased toward big funds, small-to-mid-sized funds must increasingly focus on differentiating themselves. “Our application of HFT derivative trading has made a number of big investors take notice,” said William Yeack, managing director of Golden Archer Investments, a New York-based hedge fund whose investing strategies revolve around volatility arbitrage and HFT. “Given the technological and computational complexity of our strategies, our operational infrastructure is much more advanced than most other funds. I think that this differentiates us.”

Yeack also emphasizes the eternal importance of performance, noting that “the first thing any investor will look at is [a fund’s] track record. If they don’t like what they see, the conversation ends there. If, however, they get excited by past performance, the rest of the process falls into place.”

Because the competition for fund allocations has become so tight, managers are advised to strengthen their operational infrastructure and to polish their overall presentation. Steinbrugge of Agecroft Partners recommends three key components in a successful fundraising effort. “First, a fund must have a strong product: good returns, a strong infrastructure, a smart investment team with pedigrees; second, it needs to cultivate positive investor perception. It doesn’t matter how good you are if you can’t present it clearly and concisely so that the investor knows how good you are. Finally, you must have broad penetration into the marketplace to differentiate yourself. Fundraising is not linear—it’s exponential. Once a fund is growing and others see it growing, it’ll attract confidence and investments.”

Nor are mid-sized-to-small fund managers advised to rest their laurels on the common industry saw that gives smaller funds a performance advantage over large ones. Instead, it seems that the burden of proof lies more heavily upon the smaller funds. “Everybody says that smaller funds perform better than larger ones,” said Fisher at Prelude Capital. “It really depends on how you look at the numbers. The very simple reality is that a lot of big investors don’t really care about a slight performance variation between a small and big manager—the safety of a big manager outweighs the perceived performance benefits of the smaller guy.” Nevertheless, Fisher gives smaller funds the same advice as Steinbrugge: maintain strong performance, a clearly articulated investment process and construct a solid overall product.

As the year marches on, the fundraising prospects for hedge funds remains murky, as intra-asset class correlation continues to render flat results. Both Fisher and Yeack maintain an ultimately positive outlook for the industry, however. “As markets continue to gain strength, additional capital will likely come easier to hedge funds,” Yeack said. “In the remainder of 2012 and into 2013, we are expecting to have a great deal of investor demand.”

Until then, it seems that mid-sized to smaller funds will have to compete for allocations. “The hedge fund industry is all about elimination,” Steinbrugge said. “An endowment fund, which gets contacted by about 2,000 managers a year, will be looking for a reason to knock you out, so if any question is answered badly, you’re gone…and the last man standing gets the money.”

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