Treacherous Environment for Smaller Hedge Funds: A Tale of Two Capital-Raising Markets
Barclays Capital has big news for the hedge fund community in its recently released intelligence report, The Money Trail: “Our analysis indicates that investors are likely to allocate approximately $80 billion of new capital to the hedge fund industry this year. 2012 has the potential to be the most significant year for new capital allocations to hedge funds since 2007.” These results are based on a survey of 165 hedge fund investors who represent approximately $4 trillion in assets under management (AUM).
A recent editorial on Bloomberg by Alice Schroeder, author of The Snowball: Warren Buffett and the Business of Life, contradicts Barclay’s seemingly optimistic view: “The sophisticated and flexible hedge-fund business [in 2010] saw no basic change in its overall assets (including all types of funds). Within that industry, though, funds are flowing furiously toward the largest managers because people want the tried-and-true, lest they wind up trusting another Bernard Madoff.”
In fact, many hedge fund managers feel that new hedge fund capital flows are really a tale of two markets: Davids versus Goliaths. This was confirmed in my many discussions with small hedge fund managers (those with less than $1 billion AUM), who felt that established hedge funds capture the overwhelming majority of new fund flows.
Speaking on the condition of anonymity, one hedge fund executive stated that, in his opinion, this is the most important issue confronting the hedge fund industry as a whole. In fact, despite increase in capital flows to smaller hedge funds in 2011, those flows were just 18% of total flows, according to Barclays.
Steve Williams, founder of Brook Green Capital, a third-party marketer serving as matchmaker between interested investors and hedge funds, takes the pulse of the hedge fund community. He summed up the current state of affairs:
“Expected inflows (into midsize and smaller funds) have been delayed further thanks to EU concerns. [The] ongoing confusion, political uncertainty, currency fluctuations, and anxiety is leading investors to stay safe with funds that have larger, proven infrastructure and the ability to react quickly. They are rotating their exposures amongst the current crop of established funds, leaving new ideas for 2012.
“We are seeing more activity on new ideas — discussions, analysis, and interest,” Williams continued. “However, the fact remains that no one or very few of the non-brand-names are getting inflows.”
Kerry Jordan, CFA, of the Chicago-based hedge fund Phalanx Capital Management shares his sentiment, “The current market for raising capital is more unfriendly. The sales cycle has lengthened from 6 to 12 months to 12 to 18 months. AUM growth is a primary concern for funds. Institutional investors are not allocating as quickly.”
One might argue that excellent risk-adjusted returns, or alpha, drive hedge fund flows, and in most markets that would likely drive nearly 100% of capital flows. However, in an investment climate that includes the European sovereign debt crisis, slow U.S. economic recovery, a possible Chinese economic slowdown, and waning enthusiasm for the BRIC countries, investors have less risk tolerance than in years past.
Perhaps that is why investors have shunned smaller hedge funds. For example, smallish Phalanx Capital, a hedge fund focused on the Asia-Pacific region, has a track record that refutes the “returns attract capital” argument. While its returns cannot be made public due to SEC regulations regarding accredited investors and qualified institutional buyers, it has generated positive annual returns each year since its inception in 2005. Having been privy to the fund’s returns, and as a former fund manager myself, I can attest that its outsized results ought to have attracted greater capital flows. Despite this performance, Phalanx remains a David among Goliaths.
So how, in this admittedly difficult environment, can smaller hedge funds hope to raise capital? Phalanx’s Jordan said, “In this environment a fund’s message must be very compelling and tight.”
The ability to provide yield is one way to attract capital. “Credit is hot again because of the backup in spreads and yields, especially in distressed and high yield,” said one New York–based hedge fund chief operating officer, who spoke on the condition of anonymity.
Meanwhile, Brook Green’s Williams offered liquidity, as well as yields, as a remedy: “As liquidity is increasingly disappearing, and as this change is structural and not easily repaired in any reasonable time frame, investors will search for liquid strategies — such as CTAs [commodity trading advisers], equities, liquid bonds, and FX — as well as extra yield in investments such as private equity.”
Could it be that the popularity of private equity is siphoning money off from smaller hedge funds? Doubtful. In a late 2011 private equity research report titled The Pulse of Private Equity states that “private equity firms see a leveling off in terms of transactional activity as YE 2011 approaches, with a stagnant outlook on fund raising.”
One possible systemic explanation for the lack of flow to smaller hedge fund managers is provided by Steve Acker, hedge fund manager at the smallish fund Clinton Street Capital. He says, “Smaller funds often employ high beta or high leverage strategies to generate alpha, and those strategies have not performed well, mostly due to secular market forces. To put it bluntly, they haven’t provided a ‘hedge’ versus the downside, and it’s tough for investors to justify paying a 2%/20% fee when they can get better returns in a retail mutual fund.”
Acker is referring to the typical hedge fund compensation structure, in which investors are annually charged 2% of the value of their investment as well as 20% of any gains in the hedge fund. Indeed, Acker may have a point.
Recent research by professors Adam L. Aiken, Christopher P. Clifford, and Jesse A. Ellis, titled Out of the Dark: Hedge Fund Reporting Biases and Commercial Databases, indicates that the additional return, or alpha, provided by the hedge fund industry as a whole is just 0.04%, or four basis points.
Presumably Goliath hedge funds became giants by eating beta and producing alpha to justify their Goliath-sized fees. But what of the Davids, like Phalanx, whose returns have slain Goliaths but are still capital starved?
Smaller hedge fund managers should take heart as Barclays feels that the “pendulum [is] swinging toward smaller managers.” They note that two-thirds of the investors they surveyed are more likely to allocate capital to funds with less than $1 billion AUM in 2012. So perhaps soon the Davids will bulk up and look more like the Goliaths when it comes to capital raising.