Nonprofits Spy Emerging Hedge Funds
October 28, 2010 Institutional Investor’s Foundation & Endowment Money Management

Emerging hedge funds--new entrants with fewer assets under management--can provide nonprofits willing to take a risk both excellent returns and diversification. But such investments take courage and often involve risk and a need for increased due diligence. FEMM Contributing Reporter Joseph D'Allegro recently spoke with a panel of experts about the trials and tribulations of emerging managers: Morgan Creek Capital Management Managing Director Michael Hennessy; Michael Welz, a v.p. and senior investment strategist at USI Advisors; Gravitas CEO Jayesh Punater; and Centaur Performance Group CIO Henry Pizzutello.

FEMM: How do you define what constitutes an emerging manager hedge fund? Welz: Emerging managers are managers with less than $2 billion in assets under management. This is a big change from 20 years ago, when emerging managers were defined by a ceiling of $500 million. With the evolution of the financial market, I think it is likely that this ceiling is not going to remain static.
Pizzutello: In the past, "emerging manager" was meant to include funds run by people that had not done it before. Now, however, I think that definition is evolving to include those with solid work experience in the financial services industry, who may have run similar strategies either for a fund or a proprietary trading group, but without a definitive track record to speak of. In addition, I think there are a number of managers who have lost assets during the financial crisis, but have been able to manage the risks and survive, and are now about same size as the typical emerging manager. I would look at these "re-emerging managers" as an asset, because one of the major risks, business survivability, has been defined, but the smaller size still retains the possibility of alpha generation.
Punater: Three categories of emerging managers exist: a prop trader from a sell side firm with a track record, a portfolio manager from a larger fund that is branching out on their own and a portfolio manager from an asset manager or from the asset management group of a large investment bank.
Hennessy: Definitions of emerging managers differ by investor, and they also differ by the managers' ages, experience levels, pedigrees, resources, strategies, and specific approaches to their strategies.  

FEMM: Should endowments and foundations invest in emerging managers? Pizzutello: One of the primary reasons for investment in emerging managers is diversification and alpha generation. Just as small-cap stocks and emerging market debt offer greater potential investment returns, so does the investment profile of emerging managers.  
Hennessy: Emerging managers represent an often overlooked and important source of diversification in a portfolio, the diversification of manager life cycle. A well-structured portfolio is like a well-planted garden, where you have some seedlings you nurture, some more established small- and mid-sized managers, and some older, larger managers.  Jayesh Punater
Punater: To get optimal performance and access to very good talent, endowments and foundations should invest in emerging managers. Sometimes, the very large brand name firms do not have great performance, mainly due to their size. Emerging managers usually have good track records from their previous jobs, but also have a significant amount of their own capital tied up in the fund--so it offers good opportunity to achieve alpha to endowments.
FEMM: What are their advantages and disadvantages compared to established hedge funds? Hennessy: Emerging managers tend to be hungrier, nimbler, more flexible, and have more capacity to provide LPs. Notably, it has been fairly well established that emerging managers tend to perform better than older managers. Every great manager was once an emerging manager--well, perhaps with the exception of a few studs who spun out of Goldman Sachs during the heydays who started up with billions day one. However, the universe of emerging mangers also sees a higher rate of failures. Due to FinReg, you are already seeing a migration of impressive talent from banks and prop desks to the entrepreneurial fund management business. Also due to FinReg, however, the costs and resources needed to hang out a shingle have risen significantly, during a post crash environment that has made it very difficult to fund raise. This has tended to provide barriers to entry, so that there are not as many mediocre "two guys and a Bloomberg" hanging out shingles.
One disadvantage of investing in emerging managers is that it is more difficult to ascertain the likelihood of results. The players and entities by definition are on a new team in a new league, without a live track record that many use to gain a sense (often false) of comfort. Another disadvantage is that an investor takes a certain amount of career risk by investing in anything other than the household name brands.  
Punater: The main advantage is the ability to get good performance. The main disadvantage is sometimes lack of good infrastructure around risk management and mitigation of operational risk. Also, size you can only invest a certain amount without becoming the majority investor. Investors can work around this by doing a managed account.
Pizzutello: Most emerging managers do not have issues managing the investment side of the business, but often suffer when trying to manage the other phases of running a business. Areas such as personnel, compliance, payroll, real estate, IT, etc., are usually foreign to the emerging manager, and capital deployed toward these areas is sometimes a second thought. However, it is likely that inattention to these primary areas of business will become an issue in the long term survivability of the enterprise.
Welz: The outperformance of emerging managers has been very well documented in academic research and industry publications. This research suggests that managers with smaller portfolio sizes can be more flexible, giving them an advantage to produce alpha as compared to their larger peers. But, that advantage comes at the price of an unclear picture about the financial viability that is inherent in every new or small business with the lack of a real track record. Further disadvantages may include the depth of the infrastructure, lack of stability, and possibly increased costs of monitoring operational risks.
  FEMM: How does due diligence differ from vetting established managers? Pizzutello: I think that more weight may be given to investment results of the established manager, while business risk and risk management may be the focus for newer managers. Emerging managers also have to understand the perspective of those on the investment committee. It is easier for a member of the committee to justify to their peers allocating to an established manager, as it means less career risk for them. Even if an established manager underperforms following an allocation, it is easier to justify that decision based on solid past performance.
Punater: The main focus should be on operational infrastructure including technology, risk management capabilities and of course the management team.
Welz: The due-diligence process takes additional concerns into consideration. These could be: how the firm infrastructure is going to be built out over time; how transparent the record keeping is at the current time; how this will all be impacted by potential growth. The role of the manager must also be examined. There might be a big difference in performance if the manager is able to focus on utilizing his/her skill to manage assets, versus a manager who must wear more hats due to a relatively undeveloped infrastructure. Due diligence also takes the importance of ownership structure into account, as there is a possibility of flight risk. Evaluation of additional costs for staffing and regulatory compliance can also possibly show a restricted growth potential of the manager.
Hennessy: You do need to dig deeper in order to establish for what and how much the manager was responsible at his or her prior shop with regard to decision making, influence, and performance. Determine why the manager has left to start a new firm, how much the manager is putting at stake in terms of absolute dollars and as a percent of net worth, as well as fund AUM. What did the manager leave in the way of resources, talent, information and intelligence at the prior firm, and what has the manager done to compensate if not replicate those at the new firm? What is the ownership of the new firm, how are the incentives aligned, and how are the economics distributed throughout the team? A great approach to take, to spread the risk, is to establish an emerging manager program or farm team, by which you assemble a diversified portfolio of promising new talent.