Operational Incubation The New Standard for Investors and Managers

By Sara Malak, The Alpha Cooperative

A frustrating dichotomy exists in the investment world in the form of a question which plagues emerging money managers. “I need assets to grow my business, but I need a business to grow my assets.”  Hedge fund industry assets increased 222% to a record $2.01 trillion in the 10 years ended Dec. 31, according to data from Deutsche Bank’s 10th Annual Alternative Investment Survey. And 2012 looks likely to continue the growth trend, with survey respondents predicting total hedge fund assets to rise by 12.4%.

Investors with 10% to 30% cash holdings in portfolios are likely to put half of that capital to work, potentially adding $39 billion to the industry, the survey found.  “…the investor searches for smaller and midsized managers will continue in 2012, particularly as larger managers reach capacity and end-allocators look to smaller and more nimble funds for new sources of alpha,” concludes Deutsche Bank in their survey.

The constraint is not the supply of capital. “There is plenty of capital; the constraint is finding the great managers with whom to place the capital,” stated Barry Bausano,  head of Deutsche Bank’s global market equities in the Americas and its joint head of global prime finance, when asked about the findings by Dow Jones Newswires.  While no one would dispute the validity of investor concerns surrounding the viability of managers who seek to acquire their money, it sets up a seemingly insurmountable problem for these same managers.

Many professionals have tried to address parts of the issue, but none has succeeded in solving the whole for the emerging manager to pass muster with the investor community.  Most managers try independently to blend some combination of inside/outside skills and resources to surmount the due diligence hurdles thrown in their path during the investor examination review of financial responsibility, risk assessment, compliance and investor reporting, and operational functions.

Managers typically rely on an in-house CFO/COO/CCO guru to troubleshoot the most obvious of concerns surrounding the non-investment related functions of the business. They then backfill with a cadre of outside solution providers to cover the shortfall of skills and specialties that investors demand in addition to the primary task of investment management.  Typically, they cannot afford to hire the level of non-investment expertise essential to winning over the investor in a manager selection process, despite having the financial acumen to manage the money with the investment talent staff.

In the fund’s early stages, fee income and start-up capital is tight.  Employee salary allowances are often sacrificed for individuals not essential to the research and running of the money management core business.  From a manager’s point of view, that is the answer that makes sense in their prioritizing of the business. “What point is there to build staff if I don’t have the talent base I need to run money?”  From an investor’s point of view, however, there remains the troubling concern of “Who’s minding the business of running the business while the investment staff is immersed in research and trading?”

The unvarnished truth is that both factors are essential to the business, and that there is not enough working capital to address both sides in-house for emerging managers. So what’s an emerging manager to do?  Seek only those investors who won’t ask the hard questions?  Not likely.  Find one ‘magic bullet’ employee who can do it all?  They don’t exist in the eyes of the investor, although many managers have tried to pass one off in the due diligence process.

There is a new solution, the model of which was formed in response to these challenging issues which have been growing along with the increased scrutiny and operational pressures placed on managers from the investment community in the post-financial crisis era.  A new solution, The Alpha Cooperative, an operational incubator, was created largely in reaction to this bifurcated need of both manager and investor. This cooperative approach provides both managers and investors a platform for business growth, diminishes conflicts of interest, and allows managers to maintain their unique focus.

How is this achieved?  The Alpha Cooperative (“TAC”) combines a high standard of best practices with a seamless business structure to meet the challenging operational and regulatory climate wrapped in a new model that balances administrative and operational hurdles, including a scalable pricing structure for services.  Top-tier vendor fees are reduced through a cooperative economy of scale to allow emerging managers on the platform to focus on managing consistency of investment style and risk.  They also reap the benefit of reduced business risk through continuity of an exceptional operating resource.

TAC has secured the essential funding, formed a Board of Directors, established key resource relationships and engaged personnel for the business; we also assembled an advisory committee of seasoned professionals.  This committee allows TAC to gather informally critical feedback and assessments that help in planning, developing, and implementing best practices and innovative solutions relating to TAC and its services. We believe that collaboration with top thinkers in the hedge fund community will allow the business to refine and improve its suite of services and future offerings that optimally serve both managers and investors.

Reaction from the investment community has been positive:

“An emerging manager who ensures his fund can deliver the highest caliber of operational services is of far greater interest to an allocator, fund of fund, or private investor who is reviewing plural options in alternative investments,” stated a leading prime broker in alternatives.

“Staying abreast of the complexities of our industry’s regulatory requirements and the reporting and transparency needs that such issues bring up is a key advantage TAC brings to managers who are trying to navigate a very complicated space,” added a fund allocator to emerging managers.

“It’s a sad but true fact that the main hurdle small funds face is surmounting the myriad of business issues required in establishing an operational infrastructure demanded by investors.  TAC can assist managers in overcoming that hurdle,” offered a third-party marketer focused on the small- to medium-sized manager.

While there exist many players in the industry who can and do provide some of these services, both separately and bundled, TAC is the first to offer a comprehensive menu of institutional infrastructure that can be tailored both in depth of detail and, most importantly, pricing structure, to accommodate the individual cost pressures each emerging manager faces within their strategy and operational infrastructure needs.

Although no one disputes that every manager soliciting investor capital needs to be structurally sound from a business perspective, niche managers have a widely disparate set of needs for both key reporting requirements and personnel build out, in-house and outsourced.  They require a solutions provider that can flex with their changing and growing needs as they ramp up their business’s growth.

Building a best practices business not only requires experience in the industry but also the ability to work effectively together toward a common purpose. TAC helps managers consistently meet new and evolving industry standards.  Through that effort, TAC contributes to a new supply of emerging managers who can meet investor demands for innovative and quality alpha strategies, thereby increasing diversification and breaking down the barriers to entry for emerging managers.

Some of these higher level services include ongoing due diligence, regulatory filing, compliance testing, internal auditing, public relations, and sales support, including introductions and prospect tracking.  This level of support is typically unavailable within the hedge fund industry to the emerging manager, as support is generally based on asset size and there exists a general lack of interest from the other industry providers, most of who tend to focus efforts on larger managers.

TAC’s deeper level of commitment to the emerging manager relationship can provide the combination of investment and business strength that allows these smaller managers to achieve the next level of growth and moves them up the investor food chain in terms of allocation interest.

“The essential advantage of TAC’s partnership role with growing managers is two-fold: one, the addition of institutional infrastructure and two, the ability to both assess and continually monitor a manager’s fund performance and progress with capital-raising.  This combination can significantly increase the emerging manager’s chances of success in building out a viable and robust business structure that leverages available outsourced industry talent with a minimum of business risk to both himself and his investors,” explains Charles Zaffuto.

In short, the advantages of this new business model are clear for both managers and investors alike.  While the platforms offered by TAC are designed to help managers achieve their maximum level of operational efficiency, investors also reap the benefits of associating with the centralized services provided through TAC.  Investors have confidence in knowing that they are investing in an institutional quality firm dedicated to the growth of the business.  They also have the knowledge that the managers on the TAC platform operate in an environment of continuous regulatory and operational infrastructure analysis.  Additionally, they are able to focus on due diligence of investment styles and strategies. And finally, they have access to a number of different strategies, with one point of contact for operational and infrastructure issues.

Building a business is a considerable effort in any industry, but particularly so in the hedge fund space.  In addition to distinguishing a strategy and product offering within an already-crowded and competitive space, managers must simultaneously convince their prospects that they operate successfully within a complex regulatory environment as well as deliver transparency and robust investor communications programs.

Fund managers who choose to partner with TAC enhance their business chances for long-term success by leveraging a relationship that adds skill, scale, and superior deliverables to the inherent investment talent of the fund. Investors who are seeking to partner with institutional-quality talent at all levels of hedge fund management offerings quickly recognize the value of such a partnership in mitigating the operational and business risks associated with smaller fund managers.

Sara Malak is with TAC, which  focuses on emerging managers with a wide range of strategies and assets under management ranging from $25m to $200m. An additional focus is on established hedge funds that have faced significant redemptions or attrition and have been forced to reduce operational staff due to reduced fee income. www.thealphacoop.com

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