$100 Million Question

As a member of the Capital Introduction team at HedgeCo Securities, I spend the better part of my day on the phone, playing matchmaker to hedge fund managers and investors.  We start first by initiating a dialogue with the investor in order to gain understanding of their various investment parameters.  When and where appropriate, we introduce them to a suitable product (namely, one of the funds offered through our broker-dealer).

Over the past couple of years, one of the more noteworthy trends I have seen has involved the “$100 Million Question”.  Simply put, I have observed that the vast majority of pension plans, endowments, foundations, and funds of funds (not to mention a growing number of high net worth and family office investors) refuse to even consider investing in hedge funds with less than $100 million in AUM.  In my experience marketing various hedge fund products, growing your fund’s assets beyond the $100 million AUM plateau signifies not just a noteworthy achievement in fund raising but as a catalyst of sorts, opening your fund’s floodgates to a sea of external allocators.  From my experience, there are three root causes for this AUM-inspired trend.

First and foremost, most allocators are constrained by their own size.  Often time, I hear from institutional allocators who stipulate in their bylaws that no single investment can represent more than a certain percentage of the targeted fund’s overall assets.  For example, imagine you are the manager of a $200 million fund of funds (FoF) that initially allocates $10 million per new managers.  If your bylaws state that any allocation cannot exceed 10% of the desired fund’s AUM, then your investable universe is strictly limited to funds with reported AUM north of $100 million.  In other words, if a fund has yet to reach $100 million, you cannot consider it, let alone invest in it.  As an institutional allocator, your time and money is better-spent conducting diligence on funds that have already achieved this 'critical mass.'

The second reason I believe investors adhere to the “$100 Million Question” boils down to business risk.  One common refrain that investors have shared with me is that once a fund approaches $100 million in AUM, they feel that the fund is better-positioned to withstand daily market and liquidity events.  In my experience, fund managers normally rely upon their own capital, seed investors, high net worth, and family office capital to supply the bulk of the fund’s first $100 million in AUM, or what is often referred to as ‘hot’ or ‘relationship money.’  Historically, these allocators are much more likely to stay committed to the fund during any market downturns or rough patches, helping reassure potential outside investors.  Along the same lines, this asset base helps to ensure that the fund can maintain a solid infrastructure.  By infrastructure, I am referring to the fund's engagement of top flight service providers (administrator, auditor, legal counsel), as well as the staffing of a support or back office team.  All of these pieces lend themselves to attracting additional institutional capital.

Last, eclipsing the $100 million AUM barrier signifies a shift in investor perception in my opinion. Once managers have surpassed $100 million in AUM, the perception is that they know what they are doing (of course, reasonable minds could argue that point).  Money starts to chase money.  Reaching the $100 million AUM sweet spot is like winning your first tournament on the PGA Tour.  While reaching the mark may not guarantee future success, it legitimizes your place on tour.  That big shiny trophy on your mantle very well may lend to your odds for success down the road.

Given the post-Madoff/Lehman/Oh-Eight world in which we live, one major trend I have observed is that potential allocators are much more stringent with their due diligence.  For the emerging manager, that means stomaching the “$100 Million Question” when the investors ask.  However, rather than treating this potential road block in a negative light, you can use it to zero in on the investors who will consider allocating to a fund of your size, giving you a much more targeted approach to marketing. After all, in this business, your time is arguably your greatest resource.    

Dave Reynolds

Changing the Prime Brokerage Pricing Landscape

Currently, and over the past nine years, I have been selling Prime Brokerage for almost all the major Mini-Primes and some of the largest Prime Brokerage houses.  I did not however work for these firms directly, nor did I 'sell' in the traditional sense.  My role instead is one a consultant.  I make introductions to what I believe is the right Prime Broker based upon the client's needs, even if I have no economic benefit in doing so.   In addition, I am most often able to actually lower commission cost of the client and get the value-added services that enhance their Prime Brokerage relationship to a level they have not experienced previously.  That said, I have made hundreds of introductions to Primes and Mini-Primes and have brought in over a billion dollars of assets that have been held custody and traded with Prime Brokers.

As a result of my experience as a prime brokerage consultant, I have become quite good at understanding the strengths and weaknesses of the various Prime Brokers, especially the mini-Prime Brokers in the industry.  Some can have great prices, others great software or research, better execution platforms, robust reporting, fixed connectivity, faster co-location, soft dollar administration, capital introduction, stock loan, bond desks, international equity offerings, better financing costs, enhanced leverage, futures, currencies, the list goes on and on and on.  Point is, choosing a Prime Broker can be much more difficult than just figuring out who can give you the lowest commission rate. A wrong move could cost you more than thousands or millions in commissions, it could inhibit you from growing your fund and firm to the appropriate levels.

However, with all the above in mind, there is a large percentage of hedge funds that are long/short equity or options strategies that simply use a screen to execute their transactions.  These funds may not utilize any of the afore mentioned services or even care about them, outside of having a good order management system (OMS) and a safe, high quality custodian for their fund assets.  These types of traders can be the most commission sensitive, and turn over their portfolio the most often.  For these traders, every fraction of a penny matters.  So if the service was the same, and the custodian was the same, and the platform was the same, why would a hedge fund pay .01c if they could pay .005 or .003?  The reason are plentiful, frankly, and include:

• Inability to negotiate properly with their Prime or executing broker because of their lack of industry knowledge (ie: where the industry is priced currently for their size, volume, etc.)
• Insecurity about upsetting the relationship with their current Prime or executing broker. 
• Feeling they may lose potential value added service they currently enjoy
• Laziness

There is no reason a fund has to be overpaying for a service that has been commoditized like screen-based trading, and I spend a good deal of my day re-working potential clients Prime Brokerage or straight execution arrangements in efforts to save them and their investors as much as possible. This is especially easy when you are moving a client from one brokerage firm that uses XYZ for custody, to another brokerage firm that also has a clearing relationship with XYZ.  They both have the same OMS, same reporting, etc.; usually the only difference is usually cost.  What continues to surprise me is how even some of the largest hedge funds still don't pay as low of a price as they could be paying. Their posture possibly attributed to what was mentioned in the bullets above.

So all of this got me thinking, "What if there was a place where fund managers and traders could go to simply name the price they wanted to pay, detail the services needed, and see if there were any takers?" In a tough economy where brokerage firms are fighting for execution business, and fund managers have been put in the driver's seat, they need to be able to seize the opportunity.  But what vehicle? And how would they drive it?  That is why I, and my team, came up with ThePrimeline.com.

Shameless pitch below:

ThePrimeline.com is the first service available to the hedge fund and trading community where customers can name the price they would like to pay for execution.  ThePrimeLine.com utilizes a multi-factor comparison algorithm to find the perfect match between prime brokers and investment Managers. By working with the information submitted by the investment manager, coupled with internal data and research, the HedgeCo Securities team suggests a list of prime brokers relevant to the hedge fund or manager.

Utilizing ThePrimeline.com may allow hedge funds and traders to anonymously shop their prime brokerage and execution needs and ultimately bring down their pricing without any sacrifice in quality.  That was my goal in creating this site. I truly hope if your firm is one that can benefit from the site, that you take advantage of the opportunity to potentially decrease your costs and improve your returns.

Separately Managed Accounts - Blessing or Curse Part 2

In my last post, I discussed the benefits of Separately Managed Accounts (SMA’s) for Investors.  So, the next step is to talk about some of the drawbacks.  The first problem you run into is the larger minimum investment size in order to obtain an SMA over a traditional LP investment.  There’s not a hard and fast rule, but typically the minimum investment for an SMA is roughly five times larger than the minimum investment into the actual fund structure. 

Second, sometimes too much transparency and liquidity can actually be a bad thing.  You might be asking yourself how I could say that after I have been touting the importance of transparency and liquidity over the past few years.  Imagine an investor who is seeing intra-month volatility two or three times greater than the monthly volatility he is used to seeing.  Or imagine if his portfolio was down ten percent intra-month.  Investors with a quick trigger finger might close out too soon on a manager and miss the upside after seeing the negative performance.  Investors may not understand the strategic position of the portfolio manager, who might even be expecting intra-month drawdowns.  In fact, many option strategies do consistently drawdown leading up to expiration before going positive as options expire worthless, and many managers might be down 5 to 10 percent in the first half of a month and up that same amount in the second half.

Lastly, many strategies might be negatively affected by the SMA structure, and the fund manager might feel encumbered by using the investor’s broker.   He may not have access to the research he needs with the new broker.  He might trade hard-to-borrow stocks that aren’t readily available with one prime broker and prefers to utilize a multi-prime broker model.  And, of course, some assets can’t be traded Parri-Passu in different accounts. 

So, we know not all funds are appropriate for SMA’s, but not all funds are willing to take on SMA’s either.  Many of the larger, more established managers don’t want to deal with SMA’s, and quite frankly, don’t have to.  Actually, it is much easier to have an investor in the fund as opposed to in an SMA; that’s why they invented hedge funds in the first place!  After speaking with Brent Gillette over at Investment Law Group, he mentioned that legally a manager will have more fiduciary responsibilities and thus more exposed to liability.  Brent also pointed out that the performance fees in an SMA are subject to ordinary income taxes as opposed to capital gains taxes for a fund’s performance fee.  Also, some fund managers are very “secretive” about their strategies and wouldn’t be willing to let investors see live trading in the account. 

While some fund managers avoid SMA’s, let’s talk about the recent increase in the use of Separately Managed Accounts.  As the financial markets melted down in 2008 and investors were pulling out money as faster than Elin Woods at a divorce hearing, fund managers began to find out how hard it can be to raise assets.  The power in the industry shifted in the favor of investors, and many fund managers were willing to bend to investor demands.  Also, as technology has improved, prime brokers are more equipped to handle the logistics of SMA’s. 

So, now that fund managers are taking on SMA’s, let’s discuss how they benefit from Separately Managed Accounts.  The obvious reason for taking on SMA’s is attracting investor capital.  SMA’s allow the investor more control and can ease his mind about committing capital to a fund manager.  Also, smaller managers now have access to institutional capital that was normally only available to large and established managers due to SMA’s.  For instance, a $2 billion pension isn’t going to want to allocate less than $50 million to any one fund manager.  There are due diligence and human capital costs in making allocations, and anything smaller than $50 million isn’t worth it (I wish I had that problem).  Well, $50 million funds are not going to bring in $50 million allocations.  Typically, institutional investors only want to be, at max, 10% of the fund’s AUM.   But, they will allocate via an SMA.  Also, institutional investors prefer Separately Managed Accounts since they severely reduce the chance of fraud. 

Yet another benefit for a fund manager that allows SMA’s is the ability to actually grow their fund.  That's right, I said "grow their fund."   Increased ‘strategy’ assets under management in a Separately Managed Account increase the manager’s credibility.  This is the snowball effect of raising assets.  Increasing AUM makes the fund more attractive to other investors and will lead to other allocations.  Once the fund manager has raised a decent amount of assets under management through SMA's, investors will start to care less about the total fund AUM.  Specifically if the manager raises their minimum further for future SMA's or cuts out the offering of SMA's entirely, thereby making a fund investment the only way to get involved with the strategy.


So in summary, are SMA's a blessing or curse to today's hedge fund industry?  In my opinion, there is no doubt they are a blessing.

Separately Managed Accounts - Blessing or Curse? Part 1

More than ever, I am seeing investors utilize separately managed accounts as opposed to direct hedge fund investments.  The question however remains, is this a benefit for hedge fund managers, or will it lead to the death of the traditional hedge fund structure?

First, for those unfamiliar with the term 'separately managed accounts' (SMA), an SMA is basically a brokerage account that is held in the investor's name as opposed to the fund's name, and is not intertwined or co-mingled in any way with the fund (separate).   The fund manager is typically the 'sub-advisor' for the account, and has limited power to simply trade the account, and not make any withdrawals or money transfers.  The sub-advisors are typically paid on a quarterly basis (a bonus for fund managers that normally take fees annually) and usually get paid the same fees they would with their hedge fund.  The SMA is typically traded the exact same way as the hedge fund, with no time or selection bias, essentially Parri-Passu (hand in hand/equal footing) if the strategy allows.   There are certain strategies where this is simply impossible, and therefore SMA's are simply not appropriate and fund investments or pooled vehicles are the only proper way to allocate and diversify the portfolio.

Now that we understand what an separately managed account is, let's talk about the benefits.  Assume strategy permits SMA's of course.

For the investor, utilizing SMA's is a much more effective method of allocating.  SMA's allow the investor benefits like:

• Transparency
• Liquidity
• Decreased Costs (no admin/audit/other fees bringing down returns)
• Ability to properly weight their overall portfolios
• Ability to individually leverage accounts and tweak exposure
• Choice of custodian 
• Control over commission/finance costs 
• Prohibit/Severely Inhibit fraud from occurring

These benefits are huge in my opinion.  An investor can shut a manager down and liquidate their account at anytime if they see things like position concentration or 'style drift'.  They can utilize software to monitor all their accounts at one time and quantitative tools that help them effectively manage their risk moment by moment.  They can use notional exposure from one account to fund another and actually (for once) get back the ability to leverage their hedge fund holdings. (key for fund of funds, a dying breed that needs any edge possible to produce additional alpha) Investor's can hire their own administrators if they even deem them necessary, and not have to share in expensive audit bills. They can't steal any money from the account, OR post fake returns, because the investor gets all the statements! I can keep going....

Obviously all these factors are compelling reasons to invest via SMA, but of course, there usually is a catch.  In this case, the catch is often that in order to obtain a managed account from an established fund manager, you have to have a minimum investment of anywhere from five to fifty million dollars.  So, as amazing as the benefits of an SMA structure are as opposed to a traditional fund investment, usually only the institutional or super wealthy family office types are able to meet the minimums required to establish the accounts.

I will continue with the potential problems for an investor with the SMA structure and why the structure will not work for all products in my next post.  In addition, I will discuss the benefits/caveats for fund managers that allow the use of SMA's, and I will conclude with whether I think SMA's will be death of the traditional fund investment, or instead be the tool that helps bring trillions of additional capital into alternative investment managers coffers.  

Quick housekeeping item, I have been away from writing on the blog for far too long!  When I started writing my capital introduction blog the hedge fund marketing/capital introduction industry was still thawing, and so it gave me some time to express my thoughts and share my experience with the public.  However as an active marketer and manager one of the larger capital introduction teams in the industry, once the ice did thaw, we found there were still plenty of sweet smelling flowers available underneath.  As a result, myself and my team have been extremely busy raising assets almost exclusively for emerging managers over the past year, and I am proud to say from experience that money has definitely returned to the alternative space.  We have had tremendous success over the past year and as a result, it has severely impacted the time I had available to write on Cap Intro blog.  That said, I am making a conscious effort to try to write at least a few entries a week going forward.  I have a ton of new topics that have been bouncing around in my head for months that I must share.  So get ready for some new entries shortly and thanks for your patience and continued reading and following of www.capitalintroduction.com.

New Registration Requirements for Investment Advisors

On, July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Act").  The Act has several potential impacts on those within the investment management community.  This article is an attempt to explain the important aspects and the impact this new legislation will have on Investment Advisers.

Unless otherwise stated, any changes in law discussed herein generally are effective July 21, 2011.


ADVISER REGISTRATION

1. If you manage any separately managed accounts and have assets under management ("AUM") in excess of $100MM, then you must register with the SEC (even if you only have one account /client).
2. If you have separate accounts and AUM of $25MM - $100MM, then you must register with your home state unless exempt under state law, in which case you must register with the SEC.*
3. If your only clients are investment funds and you have AUM of more than $150MM, then you must register with the SEC. 
4. If you are a non-U.S. adviser with any separate accounts, or with fund assets over $150MM, then you generally must register with the SEC UNLESS you have (1) no place of business in the U.S.; (2) less than $25MM in AUM from U.S. clients and U.S. fund investors; (3) fewer than 15 U.S. clients and fund investors; and (4) do not hold yourself out generally to the public in the U.S. as an adviser.
5. If you have AUM of less than $25MM or are exempt from SEC registration, then you must be registered or find an exemption in any state where you have a place of business or more than 5 clients.*
6. If you are a "Family office" or an adviser solely to one or more "venture capital funds"  (both terms to be defined), then you are exempt from SEC registration.

*It is not clear what state exemptions may change as a result of the Act.


INVESTOR CERTIFICATIONS


You must immediately amend your fund subscription agreement's definition of accredited investors to exclude primary residence from an investor's net worth.  For now, this change seems to apply only to new investors or additional subscriptions from existing investors with no need to expel any existing investors.  This change is effective immediately and requires your prompt attention.


If you are a registered investment adviser ("RIA") and charge performance fees/allocations to any investor in a 3(c)(1) fund, you will need to amend to adjust for inflation the "qualified client" certification obtained from each client/fund investor next year.


SWAPS


You may need to register with the National Futures Association ("NFA") as a Commodity Pool Operator (CPO) if (1) you buy commodities and currently rely on an exemption based on margin and notional exposure percentage limitations because you will now need to include any swaps when determining compliance with such limitations, or (2) you are defined as a "major swap participant" when new rules are adopted.


You may need to report (1) pre-enactment swaps if applicable regulators issue related interim rules, and (2) future swaps which are not accepted for clearing.


MISCELLANEOUS


A.  Reporting:  If you manage funds (whether or not you are a RIA), you WILL be required to maintain records and file reports to the SEC.


Such reports will include a description of funds':

1. amount of AUM
2. use of leverage, including off-balance sheet leverage
3. counterparty credit risk exposure
4. trading and investment positions
5. valuation policies and procedures
6. types of assets held
7. side letters
8. trading practices
9. any other information that the SEC deems to be “necessary or appropriate

B.  Custody:  Future rules under the Act may require RIAs to take further steps to safeguard client assets.


C.  The "Volcker" Rule:  If you are affiliated with a bank, then you generally must not engage in proprietary trading activities 
or sponsoring or investing in a hedge fund, private equity fund or similar entity.


D.  "Bad Boy" Provisions:  If further rules are adopted, then you will be disqualified from using Rule 506 Regulation D offerings if your firm or principals have engaged in certain improper conduct in the past.


E.  Securities Lending:  Within two years, the SEC will promulgate rules designed to raise the transparency of information available to investors with respect to the loan or borrowing of securities.


F.  Shorting and Arbitrage:  The SEC may adopt further reporting rules and restrictions on such activities pursuant to the Act.


G.  Mandatory Arbitration:  The SEC may adopt rules and regulations restricting or prohibiting the use of mandatory arbitration agreements by advisers.

Quick Note on the New Financial Reform Bill

I just wanted to give everybody a quick update about the new Financial Reform Bill signed into law by Obama.  The most important change for me was the update to the accredited investor definition, which is now defined as having $1,000,000 net worth without including the primary residence.  Some pundits are tagging this bill as the largest financial reform act since the Great Depression.  For a full overview of the new reforms, please see the article written by Alex Akesson on HedgeCo.Net.

Update: Trends in Capital Introduction 2010

Here is the link to the published research report, Capital Introduction Trends in 2010, written by Daniel Golyanov at Carbon360.