By Keith Black, PhD, CFA, CAIA, FDP, Managing Director, Content Strategy, CAIA Association, and Mark S. Rzepczynski, PhD, CEO, AMPHI Research and Trading
Managing alternative assets is especially competitive for small and emerging managers. At the end of 2020, HFR data shows that the private hedge fund industry had $3.6 trillion in assets spread across over 8,000 funds. These assets are highly concentrated. Nearly 60% of hedge fund firms have less than $250 million in AUM and control less than 3% of industry assets. In other words, there are over 4,000 small hedge fund managers fighting over less than $100 billion in assets.
There is no strict definition of an emerging manager. Some define an emerging manager as one with less than a three-year track record, while others might consider small managers to be emerging managers when they are below some threshold AUM. Nevertheless, while emerging firms often have a short track record, the investment manager may often have years or decades of investment experience at other firms.
Investors have a variety of reasons for investing in funds with the longest track record or largest AUM. Often those reasons have to do with the operational and investment due diligence processes, where many of the smaller and newer management firms may not have made the investments in the appropriate people, processes, structures, and systems that are required to pass muster with investors. The largest investors may, by necessity, need to invest with the largest funds given their operational and legal requirements. If an investor has a rule that their assets can’t comprise more than one-quarter of assets in a fund, the investor who invests a minimum of $125 million in each fund can’t consider investing in funds with under $500 million in AUM.
To understand current due diligence practices, CAIA Association recently surveyed its global member base, receiving responses from 111 asset managers and 233 institutional investors. CAIA members were instructed to only complete the survey if they were regularly involved in the manager research process, whether as an investor searching to place new allocations, an asset manager searching for new investors, or a consultant interviewing asset managers on behalf of investors.
Our previous blog, “The Art of Due Diligence, Part I: The Story Beyond the Numbers" noted that both qualitative and quantitative factors, as well as investment and operational factors, are all integral to the due diligence process. Operational and qualitative factors become even more important in the due diligence process for emerging managers, as they may not have the length of track record required for robust quantitative analysis.
We note the presence of an operational veto, as 39% of investors are likely or very likely to not invest in a fund that passed investment due diligence if there are concerns about weaknesses in the operational processes of a fund. Firm infrastructure is a critical matter.
While emerging managers may score well on the qualitative and investment-related due diligence processes, it is often the quantitative and operational processes that make it harder to be approved for investment by consultants and institutional investors. For example, 93% of CAIA members surveyed noted that the length of the track record is somewhat, very, or extremely important in the quantitative analysis of a manager. With a manager reporting zero or perhaps just a few months of return history, investors don’t have any ability to draw significant quantitative conclusions regarding the historical return or risk of the fund. That is, it is difficult to compute accurate or relevant information regarding key quantitative factors such as volatility, drawdown, returns, or Sharpe ratios.
CAIA members also weighed in on the most important factors to consider with operational due diligence. In many cases, emerging managers can successfully outsource many of the operational tasks, such as compliance, accounting, valuation, prime brokerage, and external legal counsel. Areas under direct control of the emerging manager include liquidity, capacity, performance reporting, and valuation policies. Still, emerging managers often have relatively small staffs, so it can be difficult to build an organizational chart with a separation of duties and control. 95% of CAIA members surveyed believe organizational controls are somewhat to extremely important part of the operational due diligence process. Key concerns addressed by separation of duties include valuation policies and cash management, which are at least somewhat important to 97% and 91% of investors, respectively.
Unfortunately, fees are an important part of the equation and closely tied to meeting operational due diligence requirements. While investors may push for lower fees, emerging managers need those fees to build the employee base, along with the compliance, accounting, and trading systems demanded by investors. Pushing for a good fee deal may actually increase the operational risks faced by investors because managers may be forced to compromise on infrastructure investments.
The survey did provide some good news for emerging managers: size doesn’t matter! That is, having a small level of AUM does not automatically disqualify an emerging manager from investment. Only 28% of investors surveyed note that AUM is very or extremely influential in the manager selection process. When due diligence experts were polled on factors that disqualify funds from investment, the top factors were ranked as returns, risk, compliance, experience, and operational risk. Issues of middle concern include philosophy, style drift, and staffing. The factors least likely to disqualify managers include fund terms, fees, and AUM of the manager.
While size does not matter, operational competency still matters a lot. If the emerging manager can pass the operational due diligence screens, they may be considered for investment consideration regardless of AUM. But, there are rising fixed costs which make passing these screens more difficult. It can be challenging for emerging managers to have the resources required to invest in the team, systems, and structures to meet the strict standards of large investors. While outsourcing is often acceptable for many of the operational functions, managers may need to make a substantial investment of personal capital to build the internal team and systems required to impress the due diligence team.
In some cases, the emerging manager may only need to get the initial attention of one or two key investors or consultants. If a manager is able to impress one or two early investors, the referral network of those investors may lead to conversations with other investors. Nearly 75% of investors surveyed noted that a key source of leads for investment in new managers comes via referrals from other investors. Passing the due diligence process for the initial investor or consultant may seem to be expensive or time-consuming, but it is a barrier to success that must be overcome. Efforts and costs to build infrastructure for initial investors may be recouped from a low chance of rejection and a quicker due diligence review. It can be well worth making an investment into the firm’s operational structure, in addition to research and portfolio investment infrastructure, to obtain the approval of that initial seed investor. Subsequent investors will likely have similar requirements before making an allocation to the emerging manager.
50% of surveyed investors consider organizational structure as very or extremely important in the due diligence process, so time spent on building the business structure is not wasted effort. Some investors prefer large multinational asset management firms, yet other investors may prefer the boutique partnership where the decision-maker has a sizable stake in the business and aligned incentives. This is where emerging managers can differ substantially from large firms. A small team with members that already own or can be promoted to a point where they own a portion of the asset management firm can maintain a focus not seen with larger organizations. With a small team and just one fund strategy, the manager can demonstrate a level of commitment and teamwork that may be harder to find in large global asset management firms. Emerging managers with small, cohesive teams may be able to distinguish themselves given their often strong focus on culture and firm dynamics. The percentage of investors considering cultural and team factors as very important or extremely important, include alignment of interests (91%), employee compensation and ownership (62%), employee retention (75%), and team dynamics (74%).
Nearly 90% of investors surveyed believe that emerging managers require a more intense due diligence process than managers with longer track records, larger teams, and perhaps most important, a number of large and influential investors already invested in the fund. The most important factors in the selection of emerging managers, ranked as very important or extremely important, are quality of operations (84%), research (82%), and investment infrastructure (78%). If emerging managers can score well in these categories, investors will more likely make an allocation even if the manager scores lower on size constraints (50%), staffing (61%), and scalability (51%).
Emerging managers who make the investment in infrastructure, operations, and research may be able to attract investment from large allocators even with a small team, a short track record, or a small AUM. Having the infrastructure to run larger money will create the opportunity to run larger sums. It is worth impressing initial investors, as key referrals from a top allocator may help to open the door and move the manager to a point where they are no longer considered emerging.
For additional insights from our Member survey, check out Part I of this blog series, “The Art of Due Diligence, Part I: The Story Beyond the Numbers," or hear the authors discuss the survey results during our recent webinar.