How Hedge Funds are Raising Capital in 2009: Strategies, Opportunities & Challenges in the Marketplace
The Curran Group
Several of our clients implemented dramatic changes to their business and strategy over the last 12 months. They are beginning to think about the short and longer term needs with regard to human capital. Many of the organisations that we work with are continuing to focus on the tightened credit market and the difficulty in raising capital. We have seen the demand for effective marketers and fundraisers dramatically increase over the past six months. Many firms are looking at new avenues to increase capital and attract new investors. Fundraising is unquestionably a top priority for all of our clients.
We have worked with various managers and funds that have successfully raised capital in the past 18 months. There is a clear pattern with successful fundraisers in 2009 – they are completely transparent, operate with the highest ethical standards and adhere to strict governance policies. Their actions are guided by the interests of the manager and investor. Furthermore, they approach their 2008 results with full transparency – even if they have suffered losses. These firms have openly discussed with us their challenging year, key learning and changes to the fund. While the previous year’s redemptions were driven primarily by high net worth individuals and smaller family offices, the hedge fund capital base is becoming more institutionalised. The majority of the institutional managers told us they still fundamentally believe in the hedge fund model as an investment class. We learned that current investors are the foundation and growth model for the future of the business.
The fundraising process begins well before the marketing team contacts potential investors. The leading firms have a clear, well-defined strategy in place for the entire process. The optimistic news is that sales, marketing and business development roles have increased their importance and value within the hedge fund and asset management space. In the past, many of the leading funds placed less of a premium on capital raising roles.
The fundraising environment is increasingly challenging for funds of all sizes. The majority of our data is derived from funds between US$100–3,000 million AuM.
The Curran Group explored five themes in capital raising for 2009:
Internal marketers and many of the smaller placement agents are customising their approach and targeting a specific investor segment. In the past, fundraisers have relied on large databases, rolodexes and friends of the firm. Today, the process generally requires significant upfront research before the fund contacts the marketplace. Several endowments in the US$200–600 million range have become a sweet spot for asset managers in the US$500-1,000 million range. Endowments of this size generally rely on consultants (ie Cambridge & Associates) to recommend managers. However, the mid-cap funds usually fall below the radar of large consultants. The smaller endowments are eager to allocate to funds with a solid track record and strong manager. These endowments simply do not have the manpower to uncover leading managers in this asset class. We have seen multiple family offices begin to redeploy capital in congruence with their current allocations. This group remains cautiously optimistic, looking for market stabilisation before fully jumping back into the game. However, the market challenges have not prevented family offices from investing in hedge funds. Some of the CIOs plan to increase their allocations later this year and early-2010. We have heard numerous family offices telling us that they are not looking at new managers until the end of the year. The pensions, endowments and foundations appear to view the market through similar lenses. The pensions are closely evaluating the managers and the terms of their investments. We have seen a few large pensions forcing stringent new terms on managers and funds (specifically in the private equity space). The new rules focus on transparency and better alignment with the managers. The pension funds are applying pressure over fees and liquidity terms. We believe public pension plans will continue to build their allocations in hedge funds in 2010. Several endowments and foundations are reevaluating their liquidity risk and rebalancing portfolios. We have seen two endowments judiciously enter funds that were previously closed; the newly open capacity is allowing them to enter the fund. Yet, one of the messages from the endowment space is that they will continue to allocate their capital with great confidence. They fundamentally believe in the long-term value for alternative assets.
The funds of funds (FoF) appear to be under extreme pressure in the marketplace, yet they are still one of the leading distribution channels for hedge fund investing. They are continuously fighting to justify their value. We believe if the FoF are able to tweak their model into more of a consultancy and advisory role, they have an opportunity to succeed and grow. FoF provide high net worth individuals an avenue into hedge fund investing. The FoF are focusing on their overall operational model, beginning with transparency and governance. Investors would like to see FoF invest and upgrade their technology and reporting processes, increase manager due diligence, consistently monitor the environment and resolve liquidity terms. The liquidity terms were one of the stronger points of contention in our conversations with investors. The investors believe in the FoF as a business but not as they operate today. They are concerned with the alignment between investors and managers, as well as the ability to alter the current liquidity strategies. FoF managers and investors believe that all of these recommendations are fixable although at a high cost associated with each recommendation.
Additionally, we have seen multiple FoF (US$500–$1,000 million AuM) looking for partnerships to help stabilise their business in the short term. FoF are looking for complimentary partners with a strong cultural fit. The fee pressure continues to push the FoF. Our checks lead us to believe this space will continue to consolidate in the short term as high net worth individuals shy away from the model. However, we expect to see the FoF grow in the longer term.
Transparency and Governance
The majority of our conversations focused on transparency and governance in the marketplace. We have heard a very similar message from the bulk of investors and managers – the objective of transparency is to monitor performance and fund allocation. To quote a portfolio manager from a US$2 billion fund, “Our performance is still the main driver but if we cannot measure up with our transparency and operating procedures, we will lose this game.” We heard this same message from multiple sources in the industry. Investors and portfolio managers told us that this is a focal point on all meetings with perspective investors.
We were moderately surprised in our discussions surrounding managed accounts and funds. Many investors believe this model works as long as they fully understand the environment. Other investors are not willing to participate in a fund if the firm also manages separate accounts. The governance, transparency and systems with separate accounts require additional operating costs and liabilities. Our take on this issue – separate accounts will continue to grow in the hedge fund world but investors will navigate with prudence.
Systematic Process and Disciplined Strategy
A systematic process and strategy will fall in line with strong governance and operating procedures. We have seen FoF upgrade their operations personnel and technology, systems and resources to demonstrate a clear process for the investment team and reporting structures. Two investors told us that they would like to see the operational due diligence and risk management groups function autonomously from the portfolio managers. This team would be able to reject investments based on their research.
Portfolio managers will need to continually focus on their process, disciplined investing approach and strategy. Investors value a candid manager discussing his strategy and performance – both positive and negative.
The percentage of allocation by hedge fund investors has slightly decreased in 20092, where endowments and foundations remain the largest investors in the hedge fund space3. Many of the investors and managers that we spoke to for this report indicated that they are holding large cash positions and expect reallocation in the next 12 months. Also, many of the investors that we met were open to lock-ups if the investing strategy validates the requirement. However, the lock-ups must align with the manager’s interests and other liquidity terms.
It was quite clear to us that investors and managers are dealing with significant fee pressures in 2009 and we expect this to continue as the market stabilises. We heard several ideas from investors and managers regarding new structures and framework. A few investors would like to see a sliding scale versus a flat fee. Furthermore, they believe the measurement period should not be based solely on the calendar year. The fees are also better aligned as a progressing event and not necessarily paid each quarter or year. The performance fee is based on liquidity and investment plans. Two investors told us that the high water mark should be a thing of the past as it does not always work as planned (ie paying for performance twice).
Several investors are willing to pay "2 & 20" with new and more favourable terms and conditions, depending on the fund and strategy. The new conditions will lead to decreased fees if certain benchmarks are not reached, while the new fee structures will lead to a maturing and stabilising industry.
We believe that the recovery and maturation of the hedge fund industry directly correlates to the alignment between the investor and manager. Managers and funds will tweak their business models, building firms with long term objectives. The new era in fundraising will influence new models for the hedge fund industry.
The information contained in this document is proprietary and confidential and may not be duplicated, disclosed to third parties or used for any purpose not expressively authorised by The Curran Group.
1 General information based on The Curran Group’s conversations, meetings and industry themes in the marketplace.