Much has been written (by the consulting industry and of course by the larger managers themselves who work most closely with the consultants) about the largest hedge fund managers getting bigger and the smaller hedge fund managers getting squeezed out. I wrote previously, “I think we will start to see the emergence of a new paradigm over the next 5 years.” “The larger managers will come under increasing pressure as their size impacts performance, attracts the attention of regulators and these firms force changes to business models and structures that once ensured an alignment of interest with investors.”
In the first quarter of 2010, $16.3 billion in new assets flowed to HF managers with less than $5bn, after they received $10.3 billion in all of 2010 (HFR). Since publishing the post above, a couple of industry reports have been released that provide some additional data points:
- assets are flowing to firms in the $1bn to $5bn range while funds under or around $1 billion are also attracting flows (Citi Prime Finance)
- 54% of investors will now consider investing in start-ups according to Prequin (JPMorgan Cap Intro has the number at 69%)
- 15% of institutional investors are considering adding emerging manager funds to their holdings in the near future while 21% of investors would consider providing seed capital to a fund compared to 11% in 2009 (Prequin)
- 66% of endowments would invest in an emerging manager, 54% of family offices and 32% of public pension plans (Prequin)
Investors should consider allocating to smaller managers or start-ups because they tend to generate better performance than larger funds. According to data compiled by PerTrac Financial Solutions, firms managing less than $100 million outperformed those managing between $100 million and $500 million by 280 basis points, and those managing more than $500 million by 380 basis points, on an annualized basis between 1996 and 2009.
Investing in smaller managers comes with a different risk profile to larger funds. Historically risk management and infrastructure/ systems have been less robust, business models and governance structures less well developed, and key man risk more pronounced. However, the first generation of post Lehman HF managers has now emerged with stronger, more institutionalized structures, processes and operating models that should allay some investor concerns. In addition, smaller managers can have fewer stakeholders to satisfy and a business model more aligned with investors’ interests.
The reason most commonly given for the out performance of smaller funds is that they are able to navigate challenging trading conditions more nimbly and put on trades that larger firms cannot contemplate. Investors can also often extract fee concessions from smaller managers which compound over time and make a significant impact to investors’ bottom lines.
Multi-managers/ fund of hedge funds (FoHFs) and seeding or acceleration capital businesses provide the smart way for institutional investors to access the emerging manager space – particularly those managing less than $500 million. The top players provide superior coverage and due diligence, and sufficient scale to make a meaningful allocation across a diversified portfolio of managers.
The best firms in this space are genuinely committed to helping emerging businesses grow and succeed. Investors looking to allocate to emerging managers should look for FoHFs/ seeding businesses with both hedge fund and private equity skills/ experience and insist on an equitable deal structure/ economics.
Bloomberg has recently reported on some of the major players/ business models. I’ll publish a profile of a firm you may not have heard about when I return from vacation.
You can access the reports here.