Asset Management Intelligence - May 2015 - The New (and Difficult) Environment for Emerging Managers
Although emerging hedge funds have, on average, the best alpha during their early years, they find it more difficult than ever to raise capital. There are numerous challenges that they face today that pre-2008, did not exist.
In the Dow, S&P and other trading platforms today, volatility in the market place has begun to set off alarms in the institutional and retail investor world. [This was not helped by CalPERS withdrawal from its hedge fund positions.] Indeed, nearly every category of potential investor has begun to retreat from alternative investments because the prevalent question they seem to be asking is not if but when the six-year run-up in the present bull-market will end. Family offices have begun to hedge their portfolios by moving significant portions of their assets into cash. Hence, money that might have been available from these investors has evaporated.1
Infrastructure and Compliance
Due to increasing due diligence demands, emerging managers must be able to do more with less. Oftentimes, they are run by two or three people who may have a chief investment officer and chief operating officer. Indeed, the vast majority of the 8,000 funds that exist today are actually small businesses.
Because of Dodd-Frank, absent self-perfecting exemptions, they must now register as state registered investment advisors (“RIAs”) and have robust conflicts and procedures manuals in place. With their typically small staff, not only do they need to make savvy investments that set them apart from their competition, they need someone to act as their in-house chief compliance officer (frequently the manager) who needs to ensure their manual is strictly adhered with. This is in addition to marketing the fund.
To further complicate matters, the SEC’s Office of Inspections and Exams (“OCIE”) has increased its staff to enable it to visit over 1,400 RIAs (which will impact funds that are SEC registered). The OCIE will be reviewing a fund’s private placement memorandum, limited partnership agreement, subscription agreement and LLC operating agreements as well as the fund’s marketing materials. To ensure consistency, all the documents must be updated to ensure they’re each saying the same thing. While this may sound easy, given the above-described numerous responsibilities a manager may have, it is not. More often than not, the OCIE has found that the marketing materials have been kept current while the other documents have not.
The SEC has recently announced that funds must establish robust cybersecurity systems. While there is no “magic bullet” that a fund can buy, there are numerous IT firms that offer services to combat the latest threat. In the context of this discussion, however, it is yet another added cost that an emerging manager needs to deal with.
Potential Opportunities for Emerging Managers
While the discussion thus far has focused on the numerous obstacles emerging managers face, there are ways to deal with each problem.
First, hiring good professionals is key to attracting capital. The pedigree of a fund’s counsel, accountants, prime brokerage relationships, administrator and third party consultants is key to launching a fund. In today’s environment, when investors are doing their due diligence, the first thing (among many DDQ issues) they see are those providers. In addition, having fulsome term sheets are critical to that “first look” an investor sees. Because these are so many investment opportunities, having something that distinguishes your strategy and potential for success makes those choices critical at the outset of a fund’s inception.
Next, an analysis of whether a launch in the Caymans, British Virgin Islands or Bermuda (an increasingly friendly jurisdiction) is something a manager should look at. Does a domestic stand alone fund suffice or should a master feeder approach offer the manager more flexibility to attract investors? Indeed, many emerging managers have contacts overseas in Europe, Asia or Latin America; it is not unusual to pursue an offshore fund in advance of starting a domestic fund.
Another factor not to be overlooked is the “friend and family” approach. Because a fund’s track record over its first six months is so important, launching a fund with a de minimus amount “assets under management” (“AUM”) is, in the long run, not as important as starting that six month track record. If a manager can “knock it out of the park” for its first two quarters, it will be easier to pitch to family offices and other major investors.
Another opportunity for emerging managers is the JOBS Act (Rule 503(c) offering). While that Act is presently being revised, it is currently available to funds who wish to put their materials on-line for anyone to view (as long as a timely filing is made with the SEC and actual sales are made only to accredited investors).
So, despite the challenges enumerated above, if a fund manager believes he or she has a product that is worth pursuing, obstacles can be overcome. Don't forget even the most successful funds had to start with humble beginnings!
Richard Heller is a Partner in Thompson Hine’s Corporate Transactions & Securities and Investment Management practices as well as its Family Office Services group. (www.thompsonhine.com) Questions? You can contact Richard at 212.344.5680 or email@example.com.
Asset Management Intelligence - May 2015
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