Supporting the Next Generation of Emerging Hedge Fund Managers

Because the investment management industry combines low barriers to entry with the potential for incredible rewards it attracts the best and brightest. So, the best way for aspiring hedge fund managers to maximise this potential is to own a fund management business, right? No. The odds are firmly stacked against most emerging managers because the industry is now exceptionally competitive. Between the growth in passive and the institutionalisation of the allocator community, any remaining net flows have gone to gigantic multi-strategy hedge funds. These behemoths have sucked the life from single strategy hedge funds.

There have been major consequences for the investment management industry food-chain. Based on asset growth data over the past decade, the most capital-starved niche in the investment manager life cycle, especially in Europe, is at the seed stage. As an emerging manager, I have experienced first-hand the tough conditions in this part of the investing food-chain. The few backers of early-stage managers tend to focus on $50m+ checks and require a revenue share or equity in the manager. They also tend to focus on shorter-term, specialist traders, at the expense of longer duration or unconstrained investing styles.

So, the largest bottleneck is at the earliest stage where emerging managers with strong pedigree but lacking institutional seed capital seek $10-$30m to get in business. They lack the scale and operations that 99% of institutions have come to insist upon, which is creating the gap. What does characterise them is that they are obsessed with investing and tend to believe in the concept of “margin of safety”, a common-sense mental model that has stood the test of time and produced excess returns. They tend to be fiercely independent and take a medium- to longer-term approach. While their assets under management are too small for conventional allocators, they generally have a commingled vehicle or a managed account, audited or verified returns and may or may not have a regulatory solution. But while their returns might be well above the industry average, they do not qualify for typical seeders.

Few, if any institutions want to be the first institutional investor to commit capital. Reasons for this behaviour include too much regulation, too little risk appetite and, ironically, too much money. It is also a specialist area requiring resource as the universe is large but opaque (and not in databases) so a network needs to be built. The result is that few institutions engage in this niche in a systematic way. Some family offices are involved but demand is high, and supply is low so we would posit that attractive fees in exchange for locked up capital can be negotiated.

Certain emerging managers might be able to join a large multi-manager. After all, the largest pod shops are the most successful money-making machines in history and employ the best and brightest traders in the world supported by world-class infrastructure and large capital pools. But they are only a fit for a specific, elite profile of trader. Medium- to longer-term directional and/or unconstrained investing approaches simply do not fit. 

Indeed, most start up PMs want to forge their own path and see investing as their long-term vocation as opposed to maximising short-term earnings by finding the right “seat.” They intentionally do not want to be part of a larger organisation and do not want tight risk limits imposed upon them. Their strategies are also generally unlevered by design and holding periods longer. Peace of mind instead of high stakes bets and high stress.

Even if they have significant specialist experience, they also frankly do not have the required risk management experience to run large, levered books. They also seek direct, enduring relationships with their LPs. So, the pod shop option is not the best fit.

To summarise, herding and career risk in the investment management business have conspired against asset growth at the bottom of the food chain, creating an opportunity for a new entrant to provide capital in a systematic way to niche managers with proven higher returns.

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Theron de Ris is founder of Sorengo Partners

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The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher, The Sortino Group