By Nevin Shetty, Managing Director, SierraConstellation Partners
Given the proliferation of new hedge funds over the past decade, and their relative underperformance compared to market indices, many asset managers face redemptions and fee compression which reduce overall firm revenue. As a result, investment managers need to take steps to restructure and optimize their operations or face the grim reality of shutting their doors.
The areas for restructuring include:
- Strategy
- Terms
- Systems & Infrastructure
- Human Capital
Strategy
Many funds run into issues if their portfolio liquidity does not match investor liquidity – market illiquidity and fund redemptions tend to coincide. The issue for managers is when investors want out but doing so would cause a fire sale of a fund’s illiquid investments. Traditionally, managers have gated redemptions to avoid realizing those losses but that leads to investor backlash – never keep someone’s money from them.
Another more feasible route is to side pocket illiquid investments. Side pocketing essentially segregates illiquid investments at an investor’s pro rata share and then pays out investors only after a realized event of the illiquid investments. There is a bit of work involved with administrators, auditors, and tax accountants to operationalize side pockets (and legal work if side pockets are not allowing in your offering documents). But the larger lift is by the investment manager informing and explaining to each investor the use of side pockets.
An alternative approach, which I believe ultimately creates more value for both the investment manager and investors, is to simply raise a new fund for the specific strategy. There is minimal additional operational work required – leverage existing offering docs, service providers, and your back office. Most of the additional work is on you, the investment manager, to talk with each one of your investors on the new thesis. Yes, raising capital is a painful process for most managers. Yes, it will take diligence and time to manage the existing fund and raise a new one. But the ability to bifurcate and execute two narratives will create new opportunities to capitalize on.
Terms
2 & 20 is dead. If you are the rare exceptional fund, you will charge more (e.g. Medallion Fund). For the typical fund, 1.5% / 15% or 1% / 10% with longer lock ups is the new normal.
Fees eat into returns and may ultimately hinder your ability to raise capital because of your net performance numbers. It is important to contemplate your vision of the fund and what the narrative with investors will be. If you are running a concentrated portfolio and need a handful of analysts, you should be willing to accept lower fees for longer lockups to protect yourself against distressed selling to meet redemptions. If you are running a quantitative high frequency trading strategy, you may want higher fees in order to pay for technology costs and acquiesce on lockups.
It’s important to remember that your Fund is a product. Like any product, you have to be able to explain its absolute value (e.g. why you need a wristwatch vs just looking at your phone) and on a relative basis (e.g. why you need a Rolex vs an IWC). The fees and terms should match the value proposition and strategy.
Systems & Infrastructure
With the pressure and burden that comes from managing other people’s money, as a manager, you want to do everything possible to make life easier – thank you technology. By leveraging the right technology, you can make your firm more efficient, effective, and scalable. But it’s not as simple as choosing the hottest new tech service. Think about the purpose that technology is solving and how it integrates with existing workstreams and processes.
If 50% of the firm has Bloomberg Terminals and the others don’t, what is the best way to chat digitally across the firm? Well it depends on a few factors – what operating system do most employees use, do you need the ability to video call both internally and externally, etc.?
Along those lines, there are plethora of new companies, services and programs that cater to various parts of your organization – from investor relations to payroll. This allows your firm to stay lean yet productive.
Given that trading software and portfolio management systems are cloud based, you may want to shift focus away from disaster recovery and more toward data security. With servers in the cloud and no longer needing to “flip the switch” to a remote server site, there is an opportunity to reallocate those resources to ensure that company data is protected from hackers.
Human Capital
The most important differentiator at a firm is the people. Focus on developing a system to attract, train, nurture, and grow talent. Meritocracies are a wonderful thing, but you need to create and maintain an environment to foster that culture.
Is there a formal annual review process? Are the individual, team, and company goals clear? Is everything P&L driven or does process take precedence over outcome? One of the least discussed items at any fund is human resources strategy and it’s arguably one of the most important things for the long-term success of a firm.
