Tower Fund Services Provides Insights on Why Many Investment Managers Struggle to Grab a Slice of the Pie

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From 2011 to now, there has been an insurgence of new investment managers leaving their prop desks and large 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.

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To grow AUM small funds must develop a well-rounded business. . .

Here is the challenge faced by managers who are looking to raise capital for newly formed funds: historically just 5% of funds attract 80% to 90% of all capital flows to hedge funds and this will continue in 2013. How do managers get a piece of the pie?

In the alternative investment industry, size has never been 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 two or three person operation. However, now more than ever, investors are sensitive to the risk. They see pitfalls and limitations in an unsupported fund business and 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 and 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 and 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. As alternative investments become a more significant part of portfolios, investors have started to target firms they perceive to be institutional quality organizations.

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 and each contribution must be well coordinated.

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 pure dollar amounts in 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 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. For one, keeping communications flowing to current investors, service providers, and industry associations can open up the right doors.

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 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 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.

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Vincent Sarullo
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