A new white paper from Citi Prime Finance’s U.S. Business Advisory team, one based on interviews with and surveys of more than 90 investors, discusses the decision-making of those institutions that invest in newly launched hedge funds. It finds that funds of funds continue to dominate the “day one and early stage investor” space.
What do funds of hedge funds want from the managers of the newly-launched funds? Chiefly: they want to deal with a management team they already know.
The significance of D1/ES funds is that by definition the funds themselves don’t have a significant track record, so any investor in this space faces “an incremental risk beyond [those of] their normal allocations to more established hedge funds.”
Citi’s paper sharply distinguishes D1/ES investors from seeders. Seeders, e.g. investors who obtain economic participation in the future revenue of a fund as the price of their early support, were not part of the target group. D1/ES investors do make demands, but of a different sort.
Funds of Funds
As noted, funds of funds dominate this space, and do so for a simple reason. That is their business model. They exist to invest in hedge funds, and their goal is to be fully invested at all times, not to have a lot of money sitting around as cash. Thus, funds of funds have expansive and experienced due diligence teams in place, so the marginal cost of evaluating a start-up fund is small.
This is especially so in the United States and EMEA, less so in the Asia and Pacific region.
Funds of funds are different in these respects from pension funds, or sovereign wealth funds.
Citi quotes an unnamed large institutional fund of funds that told them: “We believe the early years are the best performing years for a hedge fund because they have no conflicts of trying to run a business and are fully focused on maximizing performance.”
Of course, the newness of the fund doesn’t imply inexperience on the part of the manager. D1/ES funds are often added to a FoF portfolio, Citi says, precisely because of the management’s previous experience: “Oftentimes, these are senior, but not lead portfolio managers emerging from organizations that had been closed to new investments or otherwise limited to capacity,” the white paper notes.
Suppose, though, that you are a hedge fund manager seeking money during the first year of your own fund. How might you go about it? The white paper indicates that this can be a challenge. A pension fund told Citi, “We probably review about 150 managers per year. Our ratio of awarding money though is very small. Out of 150 managers last year (2010), we awarded to two.”
What is perhaps more daunting; the number of new launches is increasing, so there are more early-stage funds after those same two awards. Though the specifics of the Volcker Rule are still under discussion, the very fact that the Securities and Exchange Commission is moving toward its implementation is having an impact. The banks are winding down their prop desks, and the former occupants of those desks are opening new hedge funds, looking for investment from those same fund of funds.
Preferential Treatment: A Caution
Early investors expect some preferential treatment, perhaps a lesser fee than the late comers will have to pay, perhaps special redemption rights, etc., such as may be embodied in a side letter. Such letters may also include “most favored nation” clauses, specifying that the early investor will receive terms as good as any that may be offered to later investors.
Side letters can have “significant ramifications on a manager’s business mode,” though, so Citi strikes a note of caution. “If a manager has given MFN rights to a DI/ES investor and subsequent investors require preferential terms,” the consequences can snowball.
Also, managers should consider whether their early-stage investors are going to stick with them for the long haul. As your fund matures and develops a track record, will it become a core position within their portfolios? Only 10 percent of the investor-respondents in Citi’s survey said that “nearly all” of their D1/ES positions will make that transition. A heftier chunk, 25 percent, said that only “few” will do so.
On average, investors responding to the Citi survey indicated that 39 percent of their ES allocations will make that transition