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Advice For Emerging Hedge Fund Managers

It’s never been more difficult to launch a new hedge fund. On one hand, regulatory and compliance requirements translate to increased costs for entrepreneurs bidding to be the next Ray Dalio or Alan Howard. On the other hand, hedge funds have, in aggregate, underperformed the S&P500 since central banks decided to start printing money in the aftermath of the global financial crisis, leading to criticism over fees and, from some circles, whether hedge funds are worth it at all.

So, for those who still want to take the plunge, what do they need to be cognizant of?

Panayiotis Lambropoulos, Portfolio Manager at Employees Retirement System of Texas, says that would-be hedge fund managers need to be aware that they are undertaking an endeavour much greater than trading.

“I think the first thing anyone launching their own hedge fund needs to understand is that they are launching, looking to manage, grow and build a business, not a trading desk. Therefore, they need to make an honest self-assessment and understand who they are and who they are not - good analysts don’t [necessarily] make good PMs and good PMs don’t [necessarily] make good business owners. Investors can tell the difference”, he said.

Jeff Willardson, Manging Director at PAAMCO Prisma, adds that it’s imperative to understand just how much money you will need.

“You’re going to need between a million and 2 million of your own money to fund your business whilst you’re raising capital and getting things up and running”, he said. “If you don’t have that amount of money you might not have enough time to accumulate the resources that you need.”

Lambropoulos agrees.

“Build an adequate financial runway; plan on the right amount of capital to run the business on your own under the presumption outside capital may take a while to arrive. As a point of guidance build a flowchart/module approach to you building your business with key dates and marks. Understand what the fixed and variable costs of the business are”, he said.

Those managers seeking to get in front of larger investors like ERS Texas face additional expectations – and therefore cost pressures – in the form of service provider selection.

“A fund must possess the highest of calibre third-party service providers equivalent to the calibre you would expect from much larger and established peers. To a degree, that is somewhat unfair or unrealistic, but given the large amount of capital institutions like ERS Texas are looking to invest, that capital comes attached with higher expectations”, he said. Furthermore, “your third-party service providers are your allies - select service providers based on their expertise in hedge funds, their reputation in the industry and their ability to grow with the business and adapt to change.”

Those that are still undeterred by these hurdles need to understand the mistakes that can befall emerging managers launching their business. Lambropoulos argues that managers need to understand that success is about much more than track record.

“[Some] Founders believe that as long as there is strong pedigree and experience on the resume and some (perhaps) available past returns then investors will automatically invest, or at the very least, the decision to invest should be much easier. That’s not the case. Pedigree and past performance are just two pieces of a larger puzzle. There are a number of quantitative and qualitative factors that are considered for a possible investment”, he said.

Secondly, Lambropoulos says it’s important to ensure the messaging around the investment process is tight and that self-awareness is key.

“It is often the case marketing pitches cater to the audience at hand as opposed to staying true to the philosophy and process that belong to the Founder and served as reason to launch a fund to begin with”, he said. “[Some] Founders don’t have the self-awareness they are not good business owners and managers of people.”

Willardson says that managers need to understand how they are differentiated.

“One of the biggest mistakes people make is that they don’t know how different they are from others in the space, or, they think they’re very different from others in the space and they haven’t done a good job of understanding the landscape”, he said.

Willardson adds that managers need to be very aware of why they are launching their fund and whether the environment is conducive to producing returns.

“Usually, managers are running from something instead of running towards something. They’re running away from a compensation situation where they weren’t being taken care of or they’re leaving a situation which they felt was sub-optimal. What you really want to do as a manager is come out and start generating performance at the time that’s most optimal for you to do so. You want strategy tailwinds so the market is receptive to the kind of strategy that you have because if you come out at the wrong time and put up a bad first 12 months, it’s going to be significantly more challenging for you to build a business on top of that.”

Lambropoulos agrees, adding: “Timing is everything. As you think of launching, think of the investment environment and account for beta tailwinds. You don’t want to come out of the gate with a big performance drawdown or launch a fund whose strategy may not be in need. For example, at the moment there are not many emerging distressed managers because we’re not really in a distressed cycle” he said.

ERS Texas, in partnership with PAAMCO Prisma and its PAAMCO LaunchPad initiative, is willing to commit longer-term to managers in return for some of the economics of the business. Is this arrangement going to be a new reality for many new hedge funds, and if so, what is the extent of that reality? Will those who don’t accept these terms survive?

“I think it’s the reality of today but it’s hard to say how long that reality lasts. It doesn’t necessarily mean you won’t survive; it depends on what your goal is for the firm you’re looking to build. Some managers are comfortable taking the slow and methodical way of building a business, others are not. Some managers can manage a Fund cost effectively, others cannot” said Lambropoulos. “I believe the industry goes through cycles reflecting the underlying investment, economic and regulatory environments. Performance is also another headwind that is putting a lot of investment capital on the side-line for the time being. In addition, funds today need more capital just to meet higher expenses and regulatory-driven costs. So, there are a number of reasons why funds are having a hard time raising meaningful capital in a short period of time. Investors like ourselves are somewhat price makers because of where we are in the cycle of capital raising and due to some of the headwinds mentioned above.”

Regardless of whether new managers are willing to offer economics of the business or not, Lambropoulos admires those that do launch their own fund.

“I view the launch of a fund as a launch of a business. Founders that undertake that task should be commended because it speaks to an entrepreneurial and risk-taking spirit that I admire. You want to see that hunger, drive and desire to build something of your own.”

© The Sortino Group Ltd

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