Some Hedge Funds, to Stay Nimble, Reject New Investors

Date: Thursday, September 8, 2011
Author: Azam Ahmed, DealBook

Since the financial crisis, big hedge funds like Paulson & Company, Millennium Management and Och-Ziff Capital Management Group have not turned away money, eagerly collecting billions of dollars from investors who have tended to stick with the industry’s marquee firms.

The situation makes Anthony Bozza all the more unusual. With assets swelling, the hedge fund manager is closing the door to new investors at his four-year-old firm, Lakewood Capital Management. In a little more than a year, his fund has grown from $200 million to $900 million, according to investors in the fund.

Small hedge funds were supposed to be the big losers in after the crisis, hampered by costly regulation and investors who flocked to the seeming safety of larger institutions.

But three years later, some small and midsize managers are flourishing, attracting assets at a rapid rate. Rather than risk their returns, they are just saying no to new investors.

RouteOne Partners and Point Lobos Capital, started by alumni of the approximately $21 billion fund Farallon Capital Management, stopped accepting new money. Brenner West Capital Advisors, which tripled its size to about $480 million in less than a year, did the same this month, according to people with knowledge of the fund. Jericho Capital and the Redmile Group raised hundreds of millions of dollars before turning away new clients.

“There was a period where the bulk of the money was flowing to the very largest players, and now it’s trickling down,” said Dean C. Backer, global head of sales and capital introduction at Goldman Sachs in prime brokerage. “From the manager’s perspective, there are folks who really just want to be disciplined in terms of how they build their business.”

Lakewood, RouteOne, Point Lobos and Brenner West declined to comment. Redmile and Jericho did not respond to requests for comment.

Their discipline stands in contrast to the hedge fund math. Most portfolios charge a management fee of 2 percent on the total assets, an incentive to welcome new investors.

But the credit crisis taught managers the perils of growing too quickly. Amid major redemptions, some hedge funds were forced to scale back their operations. Others suffered lackluster returns because of a dearth of good investment opportunities.

Chastened by recent history, some newer hedge funds are trying to temper their growth.

The allure of smaller funds is their nimbleness. They can dart in and out of investments with speed that some of their larger competitors struggle to mimic. They can also concentrate on their best ideas, experts say.

“What you see with small or newer managers is they are engaging in strategies that are different and new and haven’t been seen before,” said Meredith Jones, a director at Barclays Capital’s strategic consulting group. “In many cases, that’s where a lot of the innovation comes from and that’s what keeps the industry from becoming homogenized.”

The start-ups that tend to gain traction have two main characteristics: pedigree and performance.

Mr. Bozza of Lakewood worked at the hedge fund SAB Capital Management and as an analyst at the buyout shop Kohlberg Kravis Roberts. RouteOne was started by William Duhamel, a former partner at Farallon. The Brenner West co-founders Craig Nerenberg and Josh Kaufman spent time at MSD Capital, Michael Dell’s family office. Josh Resnick, the head of Jericho Capital, was a managing director at TCS Capital Management, a hedge fund.

The recent returns of these managers have also caught the attention of investors.

After a rough 2008, where the firm lost nearly 20 percent, Lakewood notched gains of 70 percent return in 2009 and 16 percent last year, according to investors in the fund. Its bets against stocks, known as short positions, have been particularly successful, earning the fund about 20 percent a year on average since inception in 2007, according to a person with knowledge of the fund who spoke anonymously because the information was private.

To assuage anxious investors, many start-ups are hiring white-shoe law firms, and top firms for prime brokerage, legal work, auditing and administration. Brenner West, for instance, uses Goldman Sachs for its prime brokerage and Citco for its fund administration, two of the industry leaders.

“Those kinds of things make the guys with the money feel a lot more comfortable now,” said Karl D’Cunha, a senior managing director at Madison Street Capital, an investment bank.

Smaller funds have a tougher time attracting institutional investors like pensions and endowments, which represent the majority of new money being plowed into hedge funds. These investors typically invest big chunks of money, sometimes as much as $200 million, and do not want to account for a large percentage of any single fund.

But many big investors are finding new ways to work around that issue. So-called seeding funds have proliferated in the last year. These firms come up with the initial capital to individual hedge funds that are just getting started in exchange for a piece of the business. Often, such investments serve as a marketing tool for funds, enticing other investors.

The Blackstone Group, Reservoir Capital and Goldman Sachs have all raised money to invest with start-up managers. Reservoir Capital, for instance, made a seed investment with Lakewood. Brenner West was seeded by Protégé Partners, another investor in start-up hedge funds. Major institutions like the Ohio Public Employee Retirement System and the California Public Employees’ Retirement System have started their own portfolios focused on emerging managers.

Still, the amount of money dedicated to small funds remains modest by industry standards. Gone are the heady days when unproven firms could raise $1 billion before making a single investment.

Now, success is limited to a more select group of managers with the returns and experience to back their business.

“You’ve had a very fast growing, entrepreneurial industry that needed to go through the Laundromat a little bit,” said Drew Chapman, a partner at Cadwalader, Wicksham & Taft. “The crisis weeded out the weak.”