By Susan Barreto
In the coming months, the hedge fund industry’s
grand experiment to support its next generation of managers
will be in full swing.
The search for lower fees and greater alpha has moved on to
greener pastures. Institutional investors are fertilising new
seed deals at a faster pace in search of up to an additional 5%
in annual return, industry studies estimate.
Previously, we have seen a flurry of $100 million-plus
mandates going to the same mega-funds. The unintended
consequence has been the growing divide between the $1
billion-plus single-manager hedge funds and those groups that
manage less than $100 million. It has also made the search for
new talent difficult.
Researchers tell us that funds with $1 billion or more in
assets under management represent only 16% of the total number
of hedge funds, while they account for almost 90% of the
Institutions seeking to take advantage of this trend are now
moving forward with seeding deals after having completing their
basic hedge fund allocations. Examples in this issue alone are
the World Bank, Abu Dhabi Investment Authority, the California
Public Employees’ Retirement System and the
Chicago Police Benefit and Annuity Fund, which is still
considering allocating to emerging managers. Meanwhile, Cairn
Capital is understood to have received seed capital from San
Bernardino County Employees Retirement Association and the
Stanhope Pension Trust in the UK.
To tap into this institutional appetite Hermes BPK, the
alternative multi-manager of the BT Pension Scheme in the UK,
has teamed up with private equity firm Northern Lights Capital
to create a dedicated seeding vehicle.
It is a story of supply and demand – or, in the
words of one pension fund executive, it is a matter of
"cost/benefit analysis". These questions focus on what is the
upside from generating alpha versus the downside from picking a
smaller, unknown fund that may blow up.
During the significant "flight to quality" events such as
2002’s tech burst and the mortgage crisis of 2008,
large funds outperformed small funds, according to industry
research. But young funds generally outperform mid-age and old
funds, and various sources put the outperformance over time
between 2% and 5% on an annualised basis over their older
peers, who are less likely to allocate to riskier investments
in an effort to keep returns stable.
So we have heard this all before. What has really changed?
The pricing mechanism is what is new. Emerging-manager
allocations have become a private equity-like deal with
investor and manager incentives being more fully aligned for a
set period of time. This is popping up in the form of
founder’s share classes. These share classes
encourage investors to allocate assets early by creating more
Barclays Capital found that on average the
founder’s share class management fee discount is
approximately 50 basis points and the average incentive fee
discount is 5%. There is often a set hurdle rate as well, which
is something similar to what was offered in the early days of
the hedge fund industry.
Also discounted may be other add-ons. Rather than allocating
to an emerging manager fund of funds or a platform,
institutions are able to lean on a specialist consultant or
fund of fund manager acting as an advisor. For funds of funds
and consultants, this means they are charging less than if they
were offering a set product or overseeing an entire investment
Why would consultants and funds of funds want to offer a
discount? Simply because they, too, are able to source new
forms of alpha for their own benefit in the future.
A new alignment of incentives is just now underway and
institutions willing to research their options more fully will
find less pricey performance in early-stage hedge funds.
Whether this discount comes with any hidden costs such as
illiquidity or volatile performance has yet to be tested.
Institutional mandates: August 2010