HF Start-Ups Face A New Reality

Date: Tuesday, June 17, 2008
Author: Emii.com

Part 3 of 3:

For most start-up funds without a marquee pedigree, the road to gathering assets among institutions will require the assistance of third-party marketing firms and seed capital firms. However, with the glut in the marketplace today and institutions’ preference for more established funds, it is unlikely that these firms will be of much help to a start-up fund in its first few years of operation. Today’s reality is that most start-up funds should expect to be on their own for two to three years. If they can reach the $50-100 million threshold in that period of time, then it makes sense to start looking at third-party marketers. As it is, however, the environment no longer exists in which a third-party marketing organization can go out and raise institutional assets for a fund with $25 million or less in assets and a limited track record.

“If you don’t have the contacts and the resume to find at least the first $25 million in assets on your own, you shouldn’t even start a fund,” Frank Duffy, head of business development at hedge fund service provider Price Meadows said. “Placing huge confidence in a third-party marketer as a savior for your fund is a big mistake,” he added, noting that it also would be a huge waste of money.

Third-party marketers can work with a fund at any level, but the smaller the fund, the greater the challenge. For example, Liability Solutions only works with a brand new fund when the fund has a particular pedigree and unique investment niche that would allow it to generate interest among institutions. However, that is the exception to the rule. “The buy side is overrun with funds trying to raise money, and the selection criteria will continue to get more and more difficult,” Patrick Keane, managing director of third-party marketer Liability Solutions said. Todd Goldman, principal in Rothstein Kass’ Bay Area office, concurred, adding that “the best marketers in the world can’t take a fund from $5 million to $50 million.”

The two other main options for start-up managers are traditional seed capital organizations and multi-strategy hedge fund shops that are looking to take stakes in new funds. While these relationships can be essential for start-up funds, it is critical to structure the deal in a way that does not force a first-time manager to forsake the entrepreneurial spirit that brought him or her to the hedge fund business in the first place. “Plenty of seed groups will give money to a $10 million guy if he is willing to give up a huge percentage of the business,” Chip Perkins, principal of third-party marketing firm Perkins Fund Marketing said. “Unless you have $100 million, these seeders have you over a barrel.”

Nonetheless, because third-party marketers are not a realistic option for the first two to three years of operation and because a start-up fund most likely can’t reach the $100 million threshold on its own, seeding arrangements are critical. “If you don’t have a legendary background or come into the game extremely well connected with investors at a large institution, it is really hard to be successful without the help of a seeding firm today,” Howard Altman, co-managing principal at Rothstein Kass said.

While many start-up funds worry about giving up the keys to the house when signing seed agreements, Altman emphasized that a seed organization should not just be viewed as a wallet. The best seeders are strategic partners that are positioned to help a start-up manager build a viable, long-term business with an institutional-quality infrastructure and not just provide some upfront cash, he explained. Furthermore, good seed organizations know it is not in their best interest to kill the entrepreneurial spirit of nascent hedge fund managers, so this hesitation should not be difficult to overcome through arms-length negotiations.

As the market becomes more saturated and third-party marketers find it more difficult to take brand new funds to institutions, seed organizations are evolving to meet the needs of start-up funds. One example of a seed organization that is bridging the traditional seed model with a private equity fund approach is Skybridge Capital. Skybridge will place between $25 million to $50 million of its capital in a group of eight to 10 funds in exchange for a percentage of the management and incentive fees during a three-year lockup. However, Skybridge provides more than just the initial capital push. It performs full-time marketing on behalf of its fund of funds, as well as operational support. For many start-up funds that do not have the time or expertise in marketing, this model can be very beneficial.

“The smaller you are in terms of fund assets, the longer the time frame in which to grow your business,” Scott Prince of seed capital firm Skybridge Capital said. “We can help by creating institutional legitimization for start-up funds and accelerating the fundraising effort,” he added, noting that most first-time managers do not have the expertise, time and resources to go on road shows targeting the high-net-worth and family office markets.

In its first fund of funds, Skybridge raised four times the amount of money it provided in seed capital from outside investors. For example, a manager that Skybridge funded with $50 million at the beginning of 2007 had raised a total of $250 million by year-end. For its purposes, the pedigree of the individual can be among the most important factors, which is why Skybridge focuses on talent that is coming out of an investment bank or larger hedge fund. It also will help managers who have not yet left the bank or hedge fund for which they currently work to start up their funds.

Many big multi-strategy funds that already see large asset flows and have full-fledged marketing arms are now serving a similar role for start-up funds: bringing them under their umbrella and leveraging their existing institutional marketing infrastructure. However, hedge fund executives caution first-time managers about actually becoming part of a multi-strategy fund shop. “It is best for a start-up fund to attempt to attract an allocation from a multi-strategy fund rather than actually join the shop,” said Adi Raviv, head of the alternative investments group at Northeast Securities. “It is difficult if you are actually within the multi-strategy hedge fund to reconcile its needs with your desire to run your own fund and build your own brand and track record.”

For their part, third-party marketers don’t have an investment in the underlying fund, according to Prince. Furthermore, the cost of hiring a seasoned full-time marketer would be prohibitive, as well as the fact that there is a scarcity of that talent available to start-up funds. Therefore, Skybridge believes its model combining the seed capital with marketing creates greater institutional legitimacy. “Capital alone has become somewhat commoditized,” he added.

Stable Start-ups

Whether a start-up fund decides to go it alone or work with a seed capital firm, a third-party marketer or a multi-strategy hedge fund manager, the final lesson for new managers is that marketing is an ongoing process. According to hedge fund executives, one of the classic mistakes made by new funds is to believe that their initial investors will be permanent investors. As in any asset gathering business, it is the ‘stickiness’ of assets that allows a viable long-term business model to be built. In the hedge fund context, this means that start-up managers must constantly be in the mindset of replenishing assets.

Initial investors may have needs that change over time and investment boards may reshape investment policy, leading to redemptions. Furthermore, if funds are not careful in the rush to raise assets, they may attract too much capital from ‘fast money.’ For example, many hedge fund marketers believe that funds of funds move in and out of single strategy funds rapidly, either due to the tactical nature of their investment allocation or the pursuit of the style du jour. A start-up manager that is too reliant on funds of funds as an investor base - or any one client type, for that matter - may place itself at a high risk of mass redemptions. It is important for new funds, and any partner organizations, to develop a diverse investor composition so that assets remain stable.

“I don’t necessarily believe that funds of funds are faster money than other investor types, but you do need to have a good balance between investor types and remember that marketing is a 24/7 job,” Keane said. An investor base will change over time, and those changes will not necessarily be a related to a fund’s investment performance, but rather to the complex nature of today’s investor base. “No investor is forever,” he added.