A recent article in The Economist provided an excellent overview of the challenges of establishing a hedge fund in the current environment, even if the article's title, "Launch Bad" left a little to desired, assuming it wasn't a simple typo. Actually the first sentence was somewhat off the mark also, claiming that "bar inheritance or winning the lottery, there are few swifter paths to immense riches".
It is estimated that there are over 20,000 absolute such funds globally, variously described as absolute return, alternative or hedge funds. There are no doubt some which have made their founders immensely wealthy, but in spite of their profile they are a significant minority, and almost none have done it swiftly. The Economist should know better.
However, back to the excellent article (excluding the title and the first sentence) which does paint an accurate picture of the challenges facing not only any aspiring fund manager, but the vast majority of the existing funds as well.
The article focuses on the increased level of due diligence and compliance which institutional investors in particular focus on, an area that is frequently difficult for new and emerging managers to tick the appropriate boxes. Bernie Madoff of course made things more difficult in this regard, but with the increased institutional investment, plus the risk averse post GFC world, this was always going to be the trend.
Along with due diligence from prospective investors the current crop of new managers also face increasing regulatory hurdles, particularly in the USA and UK/Europe. Australia's regulations have remained reasonably constant and consistent, (short selling bans aside) but that may be because they were better to start with.
Fees remain under pressure, but that is probably consistent with margins in most other industries, and particularly in financial services. In addition, any industry that emerges into the mainstream is always going to face competitive pricing pressure.
The initial capital raising process is certainly more difficult than it was seven or eight years ago. Back then the big investment banks would toss anywhere from $50 to $500 million to a star trading team wanting to leave the desk and set up on their own, just to ensure they could feed on the fees from prime brokerage operations including leverage, brokerage and stock lending.
Now many start ups have little other than choice of the three F's (friends, family and fools) or a couple of seed investors with which to build the three year track record that most institutions, asset allocators and research houses demand. Umbrella groups or incubators in Australia such as Bennelong, Ascalon and Pengana generally prefer a decent track record prior to risking their capital and reputation by investing in an early stage or start up manager.
There are exceptions, mainly those former star portfolio manager with a prior high profile who gain the backing of an institution or distribution house, but they are certainly in the minority. All this leads to the question, why bother?
For some it's the opportunity, some a necessity as the big banks close their proprietary trading desks as a result of the Volker Rule in the US. For others, the challenge, or wish to prove their own worth after ten or twenty years under the perceived security of a broad corporate roof.
But what of the investors who back them and take the risk of allocating to early stage manager? Reduced fees certainly don't make the difference, but all the research shows that early stage, smaller or boutique fund managers provide significantly better returns, better transparency and more personal investor relations.
It is open to debate if this improved performance is due to the alignment of interests, managing smaller pools of capital, or lower levels of bureaucracy, but it hasn't changed much over the past decade.
So much so that the big end of town is trending back to funding start ups, but with the added incentive of sharing the revenue when they're successful. As in the past however, and in spite of the impression given by The Economist, only a handful make it to the front pages, and almost all will take a decade at least to confirm their position.
Hardly swift or overnight success, and only if they provide their investors their promised, or hoped for, returns.
Chris Gosselin
CEO, Australian Fund Monitors
