I was fortunate to start my investment career twenty years ago under the tutelage of David Swensen at the Yale University Investments Office. In 2001, I co-founded Protégé Partners, LLC, a specialist asset manager that focuses solely on investments in established small hedge funds and select emerging hedge funds.
I’ve had the great fortune to partner with and learn from some of the most talented and well-known investment managers in the world. In these postings, I hope to share some ruminations about hedge funds and asset management in general.
One of the recent trends in the hedge fund investor community today is a desire to find the next great manager — the so-called emerging manager.
I’ll say this much to start: Finding the right small hedge funds affords investors a wonderful opportunity to earn returns that meet return objectives and that generate risk‐adjusted returns that are among the highest available in the capital markets.
But like everything else, on average, the results will be…average. And the average return in a huge universe of some 6,000 small hedge funds will undoubtedly disappoint.
With that as an introduction, I offer you the following 10 lessons I’ve learned from investing in small and start-up hedge funds.
Lesson One: You Will Make a Mistake on the Journey
A portfolio of start-up managers that successfully meets return objectives will have some great successes and an occasional, but inevitable, failure. Not only will you make a poor decision, but when you look back on the mistake, you will also find that it was forewarned in the Greenwich Roundtable’s “Best Practices in Alternative Investing: Avoiding Mistakes.”
One reason mistakes are common is that start-up managers are resource constrained. When allocating to a start‐up, you often underwrite what may become of the organization, not what it is today. Most start-up managers cannot assemble an all‐star team on Day 1. For example, “Best Practices” suggests that every fund should have an independent risk manager, but I don’t recall ever seeing one at a start‐up hedge fund.
Lesson Two: If You Are Unwilling or Unable to Make a Mistake, Don’t Try This at Home
Investing in small and start-up funds should not be done halfway. Just as you might assess the relative merits of an allocation across every conceivable asset class and thoroughly compare a wide array of managers within an asset class, so too should you make a full assessment of the opportunity set among small and start-up managers. Although no one can be expected to review all 6,000 investment options, choosing among too limited a sample set is suboptimal as well. If an organization does not have sufficient resources to fully commit to navigating the small manager landscape, the odds are stacked against success.
When investing in start-up managers, you need to ensure that your governance structure can withstand mistakes. Most investors are not accustomed to dealing well with negative hedge fund returns. By definition, with 60% of invested capital in hedge funds is in the hands of just 100 firms and 90% in just 340 of them, most boards are shielded from the ups and downs of returns below the smooth surface of a multi‐strategy line item.
Don’t get me wrong — the big firms might make the same mistakes as you when they hire new teams. It’s just harder to tell what goes on inside a large hedge fund. To some governance boards, investment losses are looked upon as a scarlet letter, not as a normal part of the investment process. If a single poor performer in the eyes of a board can jeopardize the entire hedge fund program, small and start-up managers are best left to others.
If you can commit the effort and your governance structure makes allowances for an occasional glitch, you may want to reconsider your hedge fund portfolio construction. An institutional direct portfolio of 15 hedge fund managers might not have a place for a start-up manager in the mix. Furthermore, if you do make a mistake, you need to be prepared to rectify it. The passive buy‐and‐hold strategy typically found in allocations to traditional asset managers or to large hedge funds is a surefire recipe for underperformance with start-up managers.
Lesson Three: Beware of Story Fund Investing
We’re all familiar with the risks of “story stock investing.” Most start-up manager investing carries a comparable degree of “story fund investing.” When you speak to another investor about a hedge fund, he will have an elevator pitch to describe the manager. Many of these stories fit nicely, sound sexy, and offer the dream that the manager will run the next great hedge fund.
It takes a lot of work to get past the story and truly understand the investment philosophy, strategy, process, implementation, and team dynamics that are necessary to render an informed judgment about the merits of an opportunity. Knowing the personalities involved is equally important. Building and possessing a broad and deep network of relationships gives one a leg up on assessing people and helps to expedite a due diligence process that may be time compressed.
Lesson Four: Only Two Types of Hedge Funds Succeed: Those That Are Lucky and Those That Are Lucky and Good
Credit for this lesson goes to my friend Randy Cohen, an investment professor at MIT.
Successful hedge fund start‐ups experience a virtuous cycle that comes in part from good luck. Upon launch, a fund’s performance may be attributable to skill but it also usually depends on the luck of beta tailwinds from underlying markets or strategies.
With strong initial performance, asset growth is more likely to follow. When assets come in, hedge fund managers derive the benefits of a positive feedback loop, gathering necessary financial resources and gaining confidence that their venture is working. A positive psychological state is both conducive to and essential for continued performance, which in turn leads to further AUM growth and resources to build a better business.
Bad luck can make the cycle work in reverse. When even a very good manager launches into headwinds, weak short‐term performance may create severe challenges in accumulating a critical mass of assets. At times, this can shake the confidence of the best of them, and the cycle may turn into a vicious one.
For an allocator, herein lies an opportunity. The ability to segregate luck from skill, particularly in the early going, leaves a bifurcated marketplace that may not be separated for the right reasons.
Lesson Five: Two Heads Are Better Than One, as Long as One Is Slightly Smaller Than the Other
A successful hedge fund requires a team that possesses both business and investment acumen. These are very different skills that are not often found in one person. As a result, partnerships probably have better odds at success than do sole proprietorships. The division of investing and running a business is a delicate one, and it helps to have more than one smart head wrapped around the issues.
At the same time, a co‐portfolio manager structure created by a marriage of convenience is a recipe for failure. In my experience, very few equal co‐portfolio manager structures survive. We rarely know what goes on behind closed doors in hedge fund relationships (and marriages, for that matter), but shotgun weddings have failed in this business almost every time.
The reasons for this run the gamut from differing views about portfolio construction to an unstated belief that returns would be better without the other involved. Better investment structures have slightly unequal investment leaders, where one portfolio manager drives the car and the other second-guesses his directions.
Lesson Six: Personnel Turnover by a Start‐Up Is Usually a Good Thing
As mentioned before, in a resource-constrained environment, a small hedge fund may be unable to attract the talent it wants. If the business has legs, its leader will have a chance to upgrade the quality of the team. I’ve seen this time and again, and it almost always affects returns positively.
The act of improving the organization also reveals a lot about the head of the firm. For a person who may have demonstrated success in managing money but who may never have managed people, taking steps to evolve the organization in a positive direction manifests business acumen that is necessary for success.
Ironically, investors almost always draw the opposite conclusion; most allocators believe that any staff turnover is bad. Indeed, turnover generally is a negative signal for a mature fund. Mature funds are prosperous businesses that can attract and retain talent. If someone leaves, there’s usually an inside story as to why. But the pattern recognition of turnover in the small manager space is very different from what most allocators have developed. As a result, investors usually miss this inflection point and the good returns that may follow.
Lesson Seven: Individuals and Partnerships Are More Complicated Than You Will Ever Know
As the son of a psychiatrist, I may have a genetic fascination with self‐awareness, self‐discovery, and self‐motivation. In an industry full of hard-charging type‐A personalities, managers often do not take the time to fully comprehend who they are, why they act the way they do, and what consequences their actions have for the organization around them. Yet self‐awareness matters a lot in investment success over time.
While it is difficult to understand what drives an individual, it is exponentially more challenging to understand the internal dynamics of a group. Cultural, psychological, and behavioral characteristics of organizations are built in the early days, and getting it right can make the difference between success and failure.
If the inner workings of the collective mind aren’t hard enough to figure out, incentives to share the truth are weak for people in the know. Each employee of a hedge fund has a vested interest in exuding only the positives to an allocator or prospect. Frequently, the only truth tellers are a fund’s junior analysts, who may be naive about the business consequences or have an ulterior motive to tell all. Even then, truth is in the eye of the beholder, and an allocator needs to put an analyst’s perspective into context when trying to draw conclusions.
Lesson Eight: Managers Are Always Too Optimistic
Every start-up manager thinks his circumstances are unique and special. A start‐up manager may tell a compelling story about his strategy, past track record, and team cohesiveness, alongside other reasons why his start‐up really isn’t comparable to other ones. It may all be true, but I hear the same thing about 80% of the time.
Managers are also too optimistic about their prospects for attracting capital. The industry is full of highly intelligent, highly talented, and highly motivated people — only a few of whom launch successful businesses. It is the very reality of how many amazingly talented people have found their way to the hedge fund industry that makes it so competitive. Few hedge funds can create true product differentiation, so the world really doesn’t need another hedge fund.
Lastly, market conditions are never as easy in real time as a start‐up manager perceives they will be in advance. In twenty years, the only time I found it easy was when I looked in a rearview mirror. Nevertheless, start-up managers consistently seem surprised at how much harder the investing conditions are when they launch than when they were at their last career stop.
Lesson Nine: Hedge Funds Are Sold, Not Bought
Unlike twenty years ago, when it was reasonable to expect that a manager could put up numbers and eventually attract capital, today there are so many funds that someone is always doing fantastically well. Performing well is not enough; managers must also sell their story effectively. The necessary allocation of time to building a business has ramifications for investment performance too. Most managers underappreciate the laborious process of marketing and underestimate how much time it takes. Similarly, most investors don’t appreciate that marketing and client services require an integral, ongoing, and continuous allocation of time for 99% of hedge funds, 99% of the time. The big funds have figured out how to manage their time efficiently and effectively; smaller ones may struggle with this balance.
Lesson Ten: No One, Including Me, Has the Answers
As much as I’ve learned a thing or two from having the good fortune to play this game for a long time, there’s no magic wand or silver bullet to ensure success when investing in small and start-up managers.
Small and start-up manager investing is active management for allocators to the fullest extent. Those who make only a halfhearted attempt to seek its rewards are far more likely than not to stumble upon many of the pitfalls that lurk. Part of full engagement includes seizing opportunities to negotiate a fair deal. When you are inside the sausage factory, you’re often amazed that anyone else would want to join you. Investing in start-up managers doesn’t make a lot of sense unless you are compensated for the additional risk of the unknowable. This may take the form of seeding, fee discounts, additional transparency, or capacity. Without the added compensation, accepting the additional risk rarely rewards allocators over time.
Despite all the challenges, I still believe the opportunity in this space is phenomenal. With the proper resources and energy, sorting through lumps of coal, pressurizing them, and finding diamonds in the rough universe of small and start-up managers give allocators a much better chance than anything else I know to broaden their opportunity set, generate alpha, and provide high risk‐adjusted returns.