There is never a shortage of news or opinion articles in the media about the growing interest of institutional investors in the hedge fund business. After all, some hedge funds have certainly offered investors with potentially very attractive risk-adjusted returns, which many pensions and endowments can use in today's environment. However, as of now, it still does not quite feel like most institutional investors have a tested game plan or direct investment mandate to allocate capital to this investment opportunity set they seem not to understand--especially up and coming, emerging hedge funds which tend to have the greatest return potential.
In that case, how does one approach institutions for hedge fund business development during the early days of a firm's life?
In the process of building hedge fund businesses in Asia and the U.S. over the last decade, I have had numerous conversations with major asset allocators ranging from U.S. or Australian government pension plans to family or corporate endowments--each managing well over billion dollars. There are always one or two opportunistic, experienced and flexible firms in that community, but the majority of investors are still looking to their consultants to educate themselves on how to evaluate and invest in hedge funds.
Unfortunately, many of these intermediaries themselves are in a "learn-on-job" mode. Often, hedge fund business development is limited to a handful of "funds of funds" (FoF) that leverage existing relationships to win institutional mandates. Furthermore, and not so great for emerging managers, this institutionally-oriented intermediary group has extremely strict asset level criteria for fund selection: They often ignore many great, truly emerging funds (less than half a billion dollars under management).
As many studies indicate, the best time to get to know a manager is in the fund's early days, when the manager is truly focused on building the business and performance for the long run, and has the greatest drive to succeed. If the manager doesn't make it during that first two year window, s/he will likely struggle to grow the firm for years to come. Accordingly, hedge funds generally are on the fastest growth path right after launch. In fact, as assets flow into funds and managers become comfortable receiving sizable investments from large allocators, performance often drops down on the manager's priority list, as per several published studies on this topic.
The good news for emerging managers is that this trend of "a select group of emerging manager intermediaries" is likely going to reverse within the next year. For example, up until 2010, there was little--if any--interest among emerging manager consultants when one looked at the hedge fund space. There are, on the other hand, several well-established emerging manager specialists overseeing multi-billion dollars in traditional long only, real estate or private equity mandates. Within the last year, I have come across at least four interesting firms that have identified this emerging manager recommendation angle as an attractive way to grow their businesses and are having traction with institutional allocators. With the arrival of these types of specialists in the hedge fund world, we may see an interesting shift in the way pensions and endowments around the world are educated on how hedge funds grow and perform.
All of these developments make it that much more crucial for hedge fund business development heads to consider as many alternatives as possible--and as early as possible--to get to know these newcomers to the institutional intermediary space and identify those pension / endowment investors that are looking to educate themselves over the next couple of years. The key words here are "education" and "over the next couple of years."
For those emerging asset management firms that are most proactive in building key relationships with a variety of institutions and their existing and new consultants, there certainly are many interesting growth opportunities in the institutional fundraising area.
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