Why Hedge Fund Managers Struggle to Raise Capital

From 2011 to now, there has been an insurgence of new hedge fund managers.  Many of these hedge fund managers are leaving their  institutions to strike out on their own.

Tower Fund Services evaluates the challenges that face them and provides some guidance from those who have made it through.

There are challenges faced by hedge fund managers who are looking to raise capital for newly formed hedge funds.   Statistically, just 5% of funds attract 80% to 90% of all capital inflows.  How do managers get a piece of the pie?

In the alternative investment industry, size is not a determinant of success. With respect to hedge funds, the facetious definition of “two guys and a Bloomberg” has some basis in truth. Some managers have achieved spectacular success with a one or two person operation. However, now more than ever, investors are sensitive to the risk. They see pitfalls and limitations in an unsupported hedge fund business.  Investors clearly see solid infrastructure as the mark of a firm with ability to manage significant assets.

There is no argument when comparing the performance of nimble “emerging managers” to their colossal counterparts that they come out on top time and time again. Data results from PerTrac have shown that since 1996, the cumulative return for funds with less than two years from start-up has averaged 827%, nearly double the 446% average return for funds with two to four years in business.  This is also well beyond the 350% posted by funds in operation for more than four years.

Beachhead Capital Management analyzed nearly 3,000 equity long/short hedge funds.  They study found that small funds in the $50 million-to-$500 million AUM category outperformed larger funds by 254 bps per annum over five years and 220 bps per year over ten years.

Institutional investors look for consistency and an established disciplined process that is documented and sustainable over time.

Investors view operational robustness as a requirement and operational excellence as a point of competitive differentiation. Infrastructure and performance are directly connected. There can be no question that quality of infrastructure is of prime concern. Operational risk issues are more prevalent in smaller funds due to less mature infrastructure and greater vulnerability to redemptions.

To grow AUM, small funds must develop a well-rounded business by partnering with best in class service providers whose strengths offset their weaknesses. Every part of the organization, including external service provider relationships, plays an important role.

It’s also a numbers game as far as how much a large investor can invest in a fund. From an operational point of view, the time and effort to diligence, monitor and account for an investment is tremendous. The investment return required to justify this requires investment in the tens to hundreds of millions of dollars. Institutional investors also have restrictions on maximum percentage they can own of a fund. Generally this may range from 5% to 10%. So practically speaking, an investor who is limited to 5% of a hedge fund and requires a $10 million minimum investment can only look at funds with $200 million AUM.

This is not meant to be a bucket of water on the campfire of new managers reading this. Shouldn’t promising start-ups be attracting more investment from their target audience: endowments, foundations, family offices, and financial advisors? Yes! It is a matter of finding the right audience for managers to be performing in front of. There are many smaller institutional investors, seed capital providers and first loss program investors that are looking to invest with new managers. There are resources are all around to tap into. Keeping communications flowing to current investors, service providers, and industry associations can open up the right doors.

In summary, these interested parties are no less concerned about investing in the right fund as their big brothers. They demand that managers are deploying best practices for all aspects of their business. A hedge fund will need to address ongoing compliance and regulatory requirements, corporate governance, operations, internal control effectiveness, risk management and reporting and investor relations. The only missing characteristic from a large hedge fund is the asset size, which will come over time and a proven track record.

About Tower Fund Services

Tower Fund Services is a third-party administrator offering a full spectrum of tailored outsourced solutions for hedge funds, funds of funds, separate managed accounts, multi-manager platforms, private equity, venture capital, tax lien, and real estate funds. Its suite of services includes fund startup, accounting, valuation, reporting and tax services to alternative investment managers in all strategies and structures.