What are the 3 Characteristics Emerging Managers Need To Attract Institutional Investors?

Founder’s Note: We are excited to offer you our first blog post! As a company and by way of our Global Emerging Manager Incubator program, we deal very heavily with emerging managers and emerging manager institutional investors. In today’s environment amidst the rise of outsourcing, fee pressures, product curation and compliance considerations it is not easy setting up shop and running a hedge fund in 2019. But we hope our first of many posts showcasing interviews and our insights will help shed light on what it really takes to attract not just any investors, but institutions to your fund.

According to data from Hedge Fund Research (HFR), there were just 306 hedge funds that launched in the first half of 2018 it means that 2018 was the worst year for the new hedge fund generation since 2000, when just 328 funds started trading.

So what can hedge fund emerging managers do to better their chances of long-term success?

Breaking ground as an emerging manager is no easy task. In a sector that has suffered outflows and poor returns over the last few years, convincing investors to put money into new funds is increasingly difficult. It has prompted a shift in the types of hedge funds now being launched and even how they are invested in.

One of the obvious reasons for this is securing investment. Funds who are struggling to receive inflows may unknowingly have a broken element in their business. This could be their team, investment strategy, their investment process, general operations or just that the general appeal is lacking. Not only are flows rare, investors now expect more from their managers and managers are increasingly being asked to ‘tweak’ their strategies to suit wouldbe investors.

Tony Griffiths, Head of Research for HFMInsight told CreativeCap Advisors: “Demands on emerging managers are changing. Investors feel empowered by the fact that there has been a level of underperformance from hedge funds. It means that the way they use them [hedge funds] in portfolios and the expectations of them are changing.”

But attracting assets is not just about flexibility or even performance. Institutional investors looking to invest in emerging managers want to see experience, integrity and thoughtful managers who are building a sustainable business.

“They are being asked to tweak their products by investors. Whether it’s strategy, liquidity, fees or fund structure, we see that managers are getting requests to make these changes. Even if they don’t agree to all of them, they are certainly sitting down and having a conversation,” Griffiths said.

Investors also like emerging managers to have set up their own fund and typically have had a solid year of performance under their belt. However, from our team’s discussions with early-stage focused investors, this is not always an exact science and sometimes investors are even open to managers with as little as six months of track record in certain instances.

However, difficulties sometimes arise between an investor’s conviction and a manager’s ability to not only build a portfolio, but also a business concurrently over the long-term. Investors look at pedigree because it acts as a signifier of potential future success although they recognize that this may not always be the case.

There are several platforms and programs designed to facilitate new funds. Ones such as Blueprint in the US is a platform for investment in small, niche-focused credit hedge fund managers. Another is PAAMCO’s Launchpad, the co-investment platform for seeding and supporting emerging hedge funds launched in the middle of last year. Additionally, Texas Teachers recently hired Kirk Sims last month to further bolster its emerging manager program.

One investor we spoke to noted: “For an emerging manager to stand out we like to see that they are able to commit to the business. A lot of the time we see managers running away from their current situation. For example, they got fired from a large platform shop or they became tired of reporting to someone else. We view these as running away from something as opposed to running toward something.”

Another challenge emerging managers face is how much experience they have. This boils down to whether emerging managers have had to withstand big market corrections such as 2008.

Investors see starting a brand new hedge fund without enough working capital to fund the business as an immediate red flag because they do not have the appropriate runway to build a business. The process of building a hedge fund takes much longer than many managers realize and requires a team and resources. Despite this, the current market environment remains fairly hostile for emerging managers and a shift to offering customized solutions is looking key to growth and success of the industry.

Griffiths notes: “Customized solutions are the future.”

This is where the strength of emerging managers lie. They can be more flexible and focus on smaller deals in markets. They have also outperformed larger managers in the past few years.

Last year HFR reported that funds in their early years tend to outperform funds in their later years, with the most significant outperformance occurring in the first 12-months of operation.  

The report added that analysis of new funds by new managers versus new funds by existing managers found that while both outperform in the early years, new managers significantly outperform the established managers in the first year. This first year of performance is one of the key factors for emerging managers to showcase their abilities and further attract new flows.

The success of the first year is important for managers and is an early determination to investors on whether or not to keep that fund on their radar.

An investor highlighted “we always hope managers are being very thoughtful when they are viewing the true objectivity of the market environment and their strategy. If it’s going to work and if they have a bunch of compelling opportunities then that’s a great time to launch, but if not then they should think twice.”

Despite the current hostile environment for emerging managers, there is hope. They are able to adapt and survive more easily in the market than the larger, less mobile funds. Institutional investors are actively seeking out great early-stage managers with whom to partner for the long-term – at least this is what our team has been told by the institutions in our network. However for many managers, it may not feel like that way, but if you find yourself and/or your team going to pitch meetings and spending years on a review list then take a look, maybe something is broken within your business. It isn’t always your AUM that is a deal killer – but we will talk about what those are in another post.

So what are those 3 characteristics managers need? In securing the investment it seems that experience, performance and business sustainability are the most favorable characteristics in attracting institutional funds.

Disclaimer: When we discuss investors in this post we are looking at those institutional investors who specialize and/or have a dedicated interest in the emerging manager space.