Alternative Entrepreneurs Generating Alpha

By Andrew Cohan, Macoma Capital Group

In today’s challenging hunt for alpha, investors are finding that entrepreneurial channels can provide novel ways to outperform institutional alternatives. The issues impacting return generation are numerous and well-documented, ranging from pervasive and protracted governmental quantitative easing in the wake of 2008, extensive lowering of leverage use across strategies, aggressive governmental probes into trading practices, and systematic reforms in proprietary trading as investment banks jettisoned their top managers following the enactment of the Dodd-Frank “Volcker Rule.” These factors have contributed to investor angst when weighing alternative investments; on one hand, they desperately want to diversify for exposure and risk moderation, but on the other, the large players in the alternatives sector have delivered mediocre results over the past several years that hurt investor belief in the alternative promise of differentiated alpha.

Investors need performance and diversification from their alternative investments.  There’s nothing complicated about these desires, but the ability to source and obtain both goals has become harder to accomplish in the sector. Investors have found their choices for finding alpha and risk reduction squeezed by a lack of knowledge of and access to demonstrated options across alternatives. Casualties include the sub-performing large scale offerings from established industry players which have failed to generate the types of returns and non correlation that encourages participation from investors.

Additionally, structural instability in equities both in the US and abroad has led to market volatility which has eroded returns, compounded by protracted low interest rates across the yield curve.  The Federal Reserve’s recent policy shift in stance from dovish to hawkish, as signaled by Bernanke in June, has highlighted the skittishness of traders throughout the markets as they anticipate the cessation of quantitative easing, which has been funneling $85B a month into the market coffers. All these factors have heightened investors’ illiquidity concerns in alternative investments.

The search for alpha generation has also been hurt by a reduced level of access to top investment talent formerly employed by large scale banks.  Spurred by the Volcker Rule, these proprietary money managers have migrated from their former positions into either retirement from investment management altogether or into the formation of private investment channels. Investor access to this investment talent has been curtailed by this evolution into individual funds where many of these former “stars” have not been able to post the level of performance returns they enjoyed pre-2008. Indeed, a large portion of these managers are closing shop, as they were unable to attract sufficient capital or they were unable to generate incentive fees in the current market environment.

Wealthy families are willing to work at finding alternatives combined with a supportive platform

But investors take note: there are success stories. Entrepreneurs exist who are achieving results, but their visibility is limited due to small size, a lack of analyst coverage, and investor reluctance to commit money to a new enterprise. Those willing to seek alpha where it is found can take advantage of some interesting opportunities through these ‘under the radar’ performers. Given the current state of the markets, wealthy families are increasingly interested in digging deeper to find alpha, and managers who provide a platform that institutionalizes the process are in rising demand. Following are some notable factors helpful in identifying niche talent to uncover these potential investment opportunities.

Uncertainty is the 800-pound gorilla in the room

So what are top concerns for investors about the markets today? Northern Trust’s Wealth in America Survey 2012 of approximately 1,700 family participants indicated that:

• Two-thirds believe the country has yet to get back on course since the financial crisis of 2007-2008
• Fewer than half believe the U.S. economy will be better off in five years
• Only 53% express confidence they will achieve their goals compared to five years ago, and
• Market stability is the top reason they feel the way they do about the future of the U.S. economy.

This general unease contributes strongly to a desire across the wealth management sector for transparency, aligned interests between investors and the managers they choose, diversification, non correlation, tolerable risk levels for reward objectives, and, finally, alpha. They have found it increasingly difficult to obtain these objectives through the established alternative managers. So who can provide these goals in today’s market climate? Entrepreneurs with a focus on meeting investor needs within a structure that provides the noninvestment-related attributes combined with yield have an opportunity to become the industry’s fastest-growing stars.

It has become very clear: investors demand transparency

Transparency in both ongoing reporting and in understanding exactly what comprises the investment structure has become extremely important to high net worth investors. Investors require more details about the way an investment is entered, the ongoing status of its ability to meet their investment objectives, and how it is performing relative to its peers at every stage of the holding period. At the same time, they are not equipped in general to track and monitor this level of disclosure and the impact each investment has on their overall portfolio.  They want investment partners who can deliver both the results they seek and a platform for monitoring and identifying the reporting details their advisors need to track portfolio management issues overall, including tax implications. While established players in the alternative channels have built such processes in-house in response to institutional demands from long-standing clients, smaller and emerging managers have not yet formulated this level of support for their clients in large measure.  Identifying a niche manager who combines the ability to deliver performance returns with institutional reporting details is a differentiating factor that will help launch the entrepreneurial manager ahead of his peer group much more rapidly.

Alignment of interests spells the difference for a ‘go’ or ‘no-go’ action

Aligned interests between the investor and manager are a must-have for entrepreneurial managers to be considered by investors.  As an integral part of the relationship, investors require such managers to have substantial assets invested alongside theirs. They need to see stability in strategy execution and an ability to deliver results as assets under management grow, as well as continued enthusiasm and desire of the alternative managers to commit capital to the investment vehicle in a consistent and sizeable manner.  It has become an unfortunate industry axiom that some of the biggest and best-performing alternative managers who were successful at growing a multi-billion dollar enterprise have waned in their ability to deliver performance for their later investors.  Are they unable to do so at such large scale? Are they as hungry as they were when they first started building their business?  Are they distracted by other factors or lifestyle choices now?

The reasons are likely varied and diverse, but if one believes that the markets are still able to deliver some very attractive investment opportunities for smaller players, perhaps there is some truth to the jaded belief of many industry insiders that enormous management fee income can become a hindrance for established managers to work at uncovering new opportunities in the markets.

Diversification must carry the ability to deliver on non correlation as well

Today, being different is not enough to be considered diversified in the market place.  As the past several years have illustrated, sometimes painfully, global markets tend to react serially to the news which impacts them in a meaningful way.  This risk on/risk off mentality creates large-scale movements that can contribute to a cascading effect across market classes, leading to excessive correlation among varying assets. The alternatives category of investments has risen in prominence in direct relation to this correlation effect, as investors seek better protection against wholesale volatility in their overall portfolio, which adds to their risk exposure. Entrepreneurial alternative managers can benefit from this increased interest by investors in seeking true diversification.  These managers identify and exploit select and discrete investment opportunities to produce results with demonstrated return characteristics that do not track the broader market movements, and thus, deliver this non correlated effect on portfolio allocation.

Risk matters: the risk/reward relationship will ultimately carry the day for investor decision-making

The twin investor mandate to diversification with non correlation is the equally pressing need to find investments that can also balance returns with acceptable risk behaviors.  The desire for risk/reward balance is by no means new; the ability to deliver on it has become more difficult to achieve given the confluence of market volatilities when digesting news, good or bad. When compounded with investors’ desire for diversification, the narrowed range of opportunity to achieve both goals places the alternatives sector at the forefront of strategic market approaches with an ability to deliver on both objectives.

The largest alternatives players are often constrained by investment mandates and sheer size from exploring niche opportunities which will not yield sufficient scale to impact their large positions.  Many of the more interesting investment opportunities in these niche areas are under researched or essentially hidden to these large alternative managers, yet can provide interesting vehicles of diverse and unique returns. Smaller managers are free to explore and construct individualized investment strategies that suit their tailored objectives with far less curtailment on their investment decisions. In contrast, when one or more of the larger managers takes a position in the market, it generally becomes leading news the same day.  Entrepreneurs do not have to compete with the bigger players and are able to establish positions early on and let their investment thesis develop with less coverage, or even awareness, by industry analysts and players, of the deals themselves.  This ‘under the radar’ covertness can work to the benefit of both the managers and their investors. The entrepreneurial alternatives manager who has created a business of identifying opportunities that deliver results with attractive risk tolerances can jump themselves ahead of the competitive pack by highlighting this ability.

And last, alpha is an objective investors are not prepared to ignore when selecting an alternative partner

Last, but certainly not least, is performance. It will never be out of fashion or undesirable for professional money managers to demonstrate performance value to their investors. What has evolved is how this alpha is measured and in what context it is evaluated in overall portfolio management. All the bells and whistles a manager can point to in their market approach cease to be compelling if they cannot combine those attributes with a repeatable practice of delivering value to an investor over a mutually acceptable time frame. The experienced managers who come out of prior institutional investing positions and have made the transition successfully to a smaller, more nimble but less efficient investment environment are one such category of entrepreneurial manager with a solid opportunity to obtain alpha for investors.

The new rule in alternatives: adapt or become obsolete

Alternatives managers need to be able to source opportunities, structure deals, attract and retain investors with aligned interests, and deliver alpha and results consistent with the objectives set forth. If they can also deliver this value within a solid institutional framework that enhances their investors’ ability to understand the objectives, partner with established and high-quality service providers and industry professionals, track and monitor performance along the way, and deliver attribution and reporting requirements that keep pace with the increased regulatory requirements, these entrepreneurs have the opportunity to become an established fixture in the alternative space delivering value to investors for years to come.

Opportunity knocks (if you are willing to seek it where it exists)

Today’s alternative mandates should include opportunistic strategies.  More important than ever is the quality and strength of a manager’s network to uncover access to exclusive and differentiated deal flow. Entrepreneurs with an ability to go where an opportunity presents and focus on the merits of a deal rather than finding investments for specific sectors or categories have an increased ability to be able to capitalize on the market overall.

Some of the more compelling areas of the market today for these types of opportunistic strategies include energy, real estate, and other hard assets given the dislocations in those markets.  For example, old conventional producing oil and natural gas fields are for sale in certain areas of the Gulf Coast as low gas prices have created motivated sellers and an increased focus on shale development has directed focus away from these “non-core” assets.  Many of these fields have been under-maintained, and as a result the right operators can add substantial value with relatively basic improvements.  This not only allows investors to diversify away from traditional investments via hard assets in energy, but also allows for substantial alpha generation if they can partner with the right operator on the right assets.

An additional opportunistic investment exists in the form of subdivisions sold by banks that have marked down real estate owned properties to an attractive level for investors.  The banks wish to sell all plots at once, and homebuilders often want to buy lots over time.  There is a lack of traditional capital in the middle of this transaction, and thus room for opportunistic investors to step in and earn high returns as the provider of necessary but non-traditional financing.  Recent examples have included subdivisions in attractive and growing suburbs of Atlanta where the assets sold for approximately 50% of replacement cost of the horizontal infrastructure (roads, sewers, etc.), and builders signed contracts to start buying lots immediately.

Another interesting opportunity exists today in aircraft engine leasing, through acquiring aircraft engines and leasing them to airlines while engines on existing planes are being repaired. Today there is a decline in values for older aircraft due to lack of financing options.  This dislocation yields an opportunity to “create” engines below market cost by purchasing the aircraft, selling the air frames, and keeping the engines. There is an availability of these assets as European banks exit transportation and infrastructure finance businesses and sell off portfolios and collateral. This creates a private opportunity for establishing a portfolio of performing assets that will ultimately be an attractive IPO opportunity as an exit strategy.

Andrew Cohan is a founding member and the portfolio manager of Macoma Capital Group, an opportunistic direct investing/special opportunities partnership specifically tailored for large family offices. The company's primary goal is to generate attractive risk-adjusted returns over medium-term timeframes while assuming reasonable, calculated risks. For more information about the company, contact andrew.cohan@macomacapital.com, or visit www.macomacapital.com.