Still Room for Small Hedge Funds
The market is crowded, but volatility offers opportunity
February 11, 2008
Small hedge funds continue to be rolled out, despite the crowded space and challenges of raising capital, attracting assets, and ultimately being able to consistently perform.
"It remains a very exciting space, and professionals that want to be in an autonomous environment are still very attracted to hedge funds," says Marc Bender, chief operating officer of EFX Capital.
According to Hedge Fund Research, at the end of September 2007, 863 funds had been introduced to market, while 408 funds were liquidated. This compares to 1,518 new funds in 2006 with 717 liquidations, and 2,073 launches and 848 liquidations in 2005, a record year. The pool of hedge funds in the almost-$2 trillion industry is around 10,000.
Some observers believe that bigger is better, with large funds having more bargaining power, and the largest 100 funds grab 70% of assets under management. However, investors who may not have access to a large fund can still diversify their portfolio with a hedge fund, Bender says. Small hedge funds are more nimble and run less money so there are fewer liquidity issues. It's easier for them to get in and out of positions, and especially in the current market they have an opportunity to post better returns, says Elizabeth Flisser, president of Capital Z Asset Management.
Investors in emerging hedge funds tend to be family offices or privately held companies. Institutional investor demand is growing for hedge funds, as they offer high returns, but it's hard for small hedge funds to garner assets from them as they adhere to strict requirements for investing and need a minimum three-year track record.
Bender says managers of new hedge funds need to make certain they have a good pedigree and strategy to attract investors. Launching a hedge fund with an esoteric niche is difficult, as it doesn't apply to a wide variety of investors, who are more apt to put money in a hedge fund if they understand the strategy, he adds.
Sound risk management skills remain key to a fund's business. However, at the end of the day, everything boils down to performance, Bender said.
Marketing is especially crucial for small hedge funds. With the overcrowded market no one is reinventing the wheel, but funds have to market their strategy well, says Bender.
Often, hedge funds look to a seeder to provide capital and help them market their fund. They can offer an early stage partnership or infrastructure that helps attract interest in the fund in exchange for a percentage of ownership or work out a revenue plan.
Seeders offer new funds a credible name behind them, although they are very selective in which hedge funds they will sponsor. They can be used in two capacities: An existing hedge fund that is trying to get to a critical mass status will approach a sponsor, or for an emerging hedge fund that needs capital to get off the ground.
Capital Z, a sponsor of alternative asset managers, structures a board for an emerging hedge fund and becomes a minority equity partner. Managers have common characteristics; all are experienced portfolio managers and have managed assets before. The company works with managers to plan different scenarios and helps guide them when growing their hedge fund.
In the last decade Capital Z sponsored 16 hedge funds that currently aggregate $12 billion in assets.
There are managers who see opportunity in the market and are not scared off by the volatility, and view a sponsor as a stable source of capital, says Flisser.
There is a lot of talent in the market now, and it's a unique time on the Street as professionals are moving around, says Jeremy Frommer, head of global prime services for RBC Capital Market, adding managers need capital to get off the ground.
RBC recently launched an emerging manager allocator platform, a pool of capital that is structured to invest in a diversified group of emerging manager hedge funds with proven ability to succeed.
RBC provides capital and resources, such as electronic or algorithmic trading to funds.
When assessing managers for the platform, RBC evaluates a manager's investment process and business process equally. Frommer states they want to make certain managers understand the business, such as how partners divide responsibilities, reporting mechanisms, how they interact with fund administrators, as well as their performance ability.
As long as there is money to invest, small hedge funds will garner assets. It's a great way to be strategic, diversified and deploy investments, Bender said.
(c) 2008 Investment Dealers' Digest Magazine and SourceMedia, Inc. All Rights Reserved.
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