The costs of growing your own hedge

Since then, investors and regulators have become somewhat more demanding. Investors have stepped up the pressure for increased reporting and a wider range of prime broking relationships to spread the risks, while also squeezing fees in the hope of better returns. New regulatory burdens have piled on costs in compliance and monitoring, all of which mean start-up funds need a much bigger pot of money to get started.

One hedge fund manager said: “Post 2008, there was a lot of hope that when the big brands stuttered, investors would go down the food chain and look at smaller, more nimble funds which delivered better returns. The absolute opposite happened. Investors felt more secure with big brands, they wanted to focus on operational due diligence, and start-ups had to be institutional from day one.”

It takes at least $250m in assets for a hedge fund to be sustained on management fees alone, according to research last month from Citi Prime Finance, the US bank’s prime brokerage division. In the first half of 2012, the average new fund launched with just under $100m in assets under management, according to trade magazine EuroHedge. This is a historically high level and is more than double that of the average launch size of $44m in the first half of 2009. These figures cover both start-up funds and new funds launched by established managers, but it is an indication that start-ups are getting bigger.

Hedge funds with less than $250m were expected to have average costs of $2.5m in 2012, according to Citi’s research, which surveyed the opinions of more than 80 hedge fund firms representing $186bn in assets under management last year. The average size of the small funds responding to the survey had $124m in assets and spent 198 basis points to cover their expenses, excluding compensation for investment professionals.

Third-party expenses accounted for 63% of costs, largely due to the cost of setting up the fund and using external advisers. Small hedge funds on average allocate 40% of their expenses to operations and technology, while business management costs stand at 31%.

It means that costs associated with running the hedge fund are roughly equal to the 2% management fee collected by small managers, according to Citi Prime Finance. While some portion of that can be charged back to investors, the bulk cannot. With fees under pressure, these costs become even more challenging. According to prime brokers, the majority of start-up managers are offering fee concessions, charging 1% to 1.5% management fees and a 15% performance fee, rather than the old standard of 2% management and 20% performance fees.

Anurag Bhardwaj, head of hedge fund consulting at Barclays in New York, said that the average hedge fund with $100m to $1bn in assets only has an operating income of $2m after paying all expenses.

-- Mounting costs

Under new regulation, US-based managers running more than $150m must now register with the Securities and Exchange Commission and fill out Form PF, which means disclosing details on the funds they run and their assets under management.

Sandy Kaul, head of business advisory services at Citi Prime Finance, said that although the cost of SEC registration is not particularly significant, “the compliance programme you need to build within your organisation is significant: policy, procedure, monitoring, compliance and back-up systems”.

Bhardwaj said that filling out Form PF “can add significant additional costs which could include upgrading [a firm’s] infrastructure, hiring an in-house person or hiring consultants and vendors who can meet regulatory requirements”.

Compliance specialists report a big increase in business. Andrew Rubio, chief executive of Throgmorton, a third-party service provider for hedge funds, said: “Last year was a record year in terms of new business coming on board. We’ve probably seen about 15% growth compared to the year before.”

Institutional investors are also demanding hedge funds forge new relationships with service providers. Kaul said: “Post the 2008 crisis; institutional investors are starting to insist that hedge funds have more than one prime broker in order to diversify their counterparty risk. That puts tremendous pressure on infrastructure. Hedge funds used to be able to use a single prime broker technology platform. The minute they used more than one prime broker, they had to re-aggregate all the reporting information themselves, because no counterparty had a holistic view of the portfolio any longer.”

More due diligence means that the allocation process is slower. According to Deutsche Bank prime brokerage’s alternative investment survey last year, two thirds of investors take between three and six months to complete due diligence on a manager, whereas only a third did so in 2002. Rubio said: “Time is money and the level of due diligence has created more costs just by being a more lengthy process.”

-- A helping hand

Along with fee pressures, raising money has got tougher. Chris Goekjian, chief investment officer of Cheyne Capital, which manages $6.3bn, said: “In 2008, someone with a good background and pedigree could probably raise $200m to $500m on day one. All he or she needed, besides the investment team, was a chief financial officer and a compliance officer. Today, even people with great pedigrees are struggling to do launches of $100m.”

As launching has become more expensive, hedge fund managers are looking to seed investors, who offer money in return for a stake, for a helping hand. Kaul said: “Prior to the crisis, people looked at seeding as a sign that the manager did not have the confidence that it would be able to raise money on its own. Post the crisis it’s been seen as an indication that someone with an educated view actually sees the manager as a good opportunity to take a bet on.”

This has resulted in a buyer’s market for seed investors. Patric de Gentile-Williams, head of seeding at FRM Capital Advisors, says FRM seeds less than 1% of the managers it meets. “Before the crisis, capital was readily available. We met someone in 2007 who was moderately successful in their strategy before launching on their own and they received 11 written offers for seeding of their hedge fund business. Today, there aren’t 11 institutional-quality seeders out there.”

Other traders are opting for the security of a large platform rather than trying to make ends meet as a small firm. Last year Cheyne hired Christian Dangerfield, Calum Graham, and Robert Rowland to launch the Cheyne Malacca Asia Equity fund, formerly the Belvedere Malacca fund, managed at Battlebridge Investment Partners. Goekjian said: “We’ve had some instances where we have brought on board to Cheyne excellent managers who had their own businesses but had not grown fast enough.”

Despite mounting pressure for small start-ups, some have bucked the trend. OVS Capital, an event-driven manager, started with $8m just over two years ago and has grown north of $500m. And Hengistbury Investment Partners, run by Stuart Powers, a former partner at The Children’s Investment Fund, has grown to $700m after launching with partner capital a year ago.