A Paradigm Shift For Hedge Fund Stars

Date: Thursday, April 17, 2008
Author: HFN Daily Report, Guest Article, Adam Herz

During the last year, a new standard has emerged for hedge fund start-ups. Prior to 2006, when market conditions were ripe, it was common for superior investors to leave their well-known, established funds, raise $100 million or more in capital and start their own hedge fund. At that time, $100 million was considered the hurdle needed to convince the market of a viable business. Today's economic environment, along with the maturing of the business, is changing the analysis for star investors as they consider starting their own fund. The current marketplace is creating compelling reasons for these investors to reconsider moving to a large fund versus doing it on their own. Skilled investors are increasingly joining large platforms or turning to emerging manager platforms as the barriers to entry for new hedge funds continue to rise.

Historical Context
Up through 2005, the hedge fund landscape was significantly different than it is today- fewer hedge funds meant less competition as well as a larger role for fewer institutional investors. In the beginning of 2005, there were approximately 175 firms with $1 billion of assets or more. As of January 2008, there were more than 260 firms managing $1.65 trillion. Although the absolute number of funds is not much greater than it was in 2005, assets have risen dramatically and the distribution of those assets is highly concentrated. The largest 20 funds in 2005 had an average capital base of $12.9 billion under management (compared to $24.41 billion in 2007), and were near capacity, scrambling to build out an infrastructure capable of taking in new money. Therefore, the capital base for investment professionals at these large funds prohibited the ability of multiple investors to make large bets, limiting the number of people who could generate outsized returns and, consequently, outsized payouts.

The above factors, combined with the limitations on big payouts, paved the way for hedge fund stars to venture out on their own with a comparatively small pool of capital. A single investor could be up and running without many of the burdens associated with managing a large fund (i.e. fundraising professionals, large staffing requirements, expensive real estate, complex back-office functions, extensive compliance etc.). A bull market, coupled with the relative novelty of hedge funds (few of which failed) fueled investor appetite and made the start-up route a perceived risk worth taking. The initial capital base was seen as a very temporary moment with lofty expectations of asset growth and high returns. The psychology of the market has changed such that growing asset bases and higher returns are not a given in investors' minds as they had been several years ago, therefore making investors more reluctant to invest in new funds.

A New Environment: Bringing it In-House
Conditions have changed considerably in just a few short years. A combination of factors has dramatically altered the universe for entrepreneurial hedge fund superstars. The "large" funds have now become behemoth, $20 billion plus funds with fully built out global operations. Costly back-office and operational controls efficiently manage investor concerns. A larger capital base enables some managers to take substantial,concentrated bets of between $400 million and $500 million. More recently, the proliferation of hedge fund IPOs at these large funds presents a defined and lucrative exit strategy for these investment professionals.

Significant obstacles exist for today's star investment professionals who are considering launching their own funds. The investor base has become increasingly selective and cautious, mandating sophisticated back office functions in order to maintain sufficient quality controls. The investor base has also widened to include pensions, foundations and endowments, requiring more non-revenue generating staff to interface with these newer investors. Compounding these issues is the resulting increased demand on a portfolio manager's time to manage investor expectations. This obligatory involvement in fundraising, investor relations and management detract from what is most important for a star investor: investing.

All of these conditions and the present credit crunch contribute to an environment where fundraising is far more difficult. These are persuasive reasons for investors to bring their talent in-house to large funds rather than venturing out on their own. This creates a win-win situation for both star hedge fund investors and the large funds. Analysts can focus on investing and take highly concentrated positions. This frees them from running portfolios that generally consist of a large number of investments, including some ideas about which they have less conviction. The significant capital base and increased number of high conviction names yields higher payouts. Similarly, funds reap the benefits: they leverage the fixed costs of infrastructure, get talented investors and put large sums of money to work while monetizing their brand. This allows them to raise more money and potentially get a higher equity value should they IPO.

The "Emerging Manager Platform"
For those investors who are still determined to run their own fund without the capital base to support today's more stringent requirement, a viable alternative is the "emerging manager platform." In exchange for equity, firms provide nascent funds with infrastructure and support, incubating them until they can stand on their own.

Historically, "emerging manager platforms" had been perceived as less impressive, which deterred some of the most talented managers from even considering them as an option. Recently, this model has been much more attractive to higher quality investment professionals due to the increased hurdles of launching an independent fund.

On the Horizon
Going forward, there will be an acceleration of higher quality investors opting to move to "emerging manager platforms." As emerging managers attract new top-tier talent, this reinforces and strengthens their image in the marketplace, thereby further drawing talent. As a result, there will be a repricing of those services as it becomes a larger, more competitive market.

On a broader scale with regard to larger funds, expect to see an emphasis on more thematic types of trades. Fewer individual stocks will be able to provide a compelling risk/reward worth deploying significant amounts of capital as an increasing number of firms have the ability to take on these large positions. Additionally, with the increased flow of top tier investors back into larger hedge funds, a greater number of mid-level professionals may leave those firms as the opportunities for them get ahead internally are hampered.

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Adam Herz is the founding partner of Hunter Advisors Corp., an executive search firm. Hunter Advisors, founded in March 2003, specializes in the recruitment of investment professionals for clients globally within the hedge fund community.
Adam brings to his clients a vast breadth of experience dealing with all aspects of human capital for premier hedge funds. He helps to advise clients with strategic decisions related to management and growth issues. Additionally, he has helped provide capital introductions to seed nascent funds and then works closely with these funds and other firms as an advisor.