New wave of hedge fund start-ups find life is tough

Date: Wednesday, December 1, 2010
Author: Laurence Fletcher, Reuters

The hedge fund industry's proverbial 'two traders and a terminal in Mayfair' are back.

But starting your own hedge fund is likely to prove a much less lucrative venture for the foreseeable future, thanks to hard bargaining by investors.

Investor confidence is returning after the credit crisis in which clients deserted small firms. Some $42 billion of net inflows into the industry this year have encouraged managers to take the risk and start boutiques, just as in the pre-crisis boom years.

This year has seen launches such as Nightscape Capital, set up by former managers from Sandelman Partners and other firms, and Quiris Capital, founded by ex-Morgan Stanley algo managers.

But the rewards look set to be less lucrative, as still-nervy clients invest smaller sums than before the credit crisis. They often invest in return for a discount on charges, giving managers a lower asset base on which to earn fees.

"There is renewed confidence. The marketplace for start-ups seems to be fairly robust," said Andrew Rubio, chief executive of Throgmorton, which provides back-office services for hedge funds including Brevan Howard, one of Europe's biggest hedge fund firms.

"(But) it is not like it used to be -- a very, very select few start off with a lot of money."

The UK financial regulator authorised 28 hedge fund businesses in the three months to September, a 50 percent rise on the second quarter, according to corporate finance firm IMAS Corporate Advisors. Leavers from larger firms such as Polygon, Odey and CQS set up 12 of these.

In contrast, the number of approved persons employed by larger hedge funds with between 10 and 50 people fell 24 percent in the first nine months of the year.

"A DIFFERENT WORLD"

However, launches are often small so that reaching a target of $100 million in assets under management -- often seen as the level at which larger investors come in -- looks set to remain tough.

"It is a different world to launch a fund now compared with 2007," said Mairead Kenny, head of EMEA capital introductions at Bank of America Merrill Lynch BAML.L.

"It is a real challenge ... unless they are a big brand name. Many launches are in the $15-$20 million range ...A $50 million sized start-up fund is a good result though you do see $100 million."

Funds are increasingly having to offer lower fees to attract early-stage investors -- so-called "founders' shares" -- which will initially hit a firm's fee income.

"(Start-ups are) often (happening) with a founders' share class up to $100 million -- we are seeing more of that now," Kenny said.

The resurgence in start-ups follows nearly $300 billion of net outflows in 2008 and 2009, according to Hedge Fund Research, and a dash by investors for bigger firms, a trend that decimated start-up numbers last year and saw fund closures far outweigh launches.

COPING

But average returns of 20 percent last year and 7 percent so far this year -- performance on which they can charge fees -- and relief that European Union regulation has turned out less harsh than first feared have encouraged managers to look at start-ups.

"We are definitely seeing more people knock on our door and say they are thinking of doing something," said Martin Cornish, managing partner of law firm Katten Muchin Rosenman Cornish, which works with hedge fund start-ups.

Ken Heinz, president of Hedge Fund Research, said: "HFR expects a strong quarter for launches in Q3, as the quarter was better for financial markets...(and) investors' flows were the best since 2007."

However, more managers find themselves having to make do with asset bases that a few years ago might have been seen as too small, in the hope investor confidence will continue to recover and clients can be enticed by a couple of years of strong performance.

"You are seeing fund launches of smaller amounts, where it is almost viable and managers have got the seed, so they (build up) a track record and then go back and tap other contacts," said Katten's Cornish.

"It is almost a wind-back to where the industry stood in the late 1980s and 1990s, where $10-$20 million was a good-sized fund."