Co-Opting Marketing Resources for Hedge Funds - Part Two

Preqin - Building On A Database 

The previous and following articles in this series cover lead generator companies in the hedge fund business who make great efforts to explain that they are not database companies. Preqin is a database company that is trying to add some value beyond that restrictive label, so is coming from a different direction from the other two series subjects, Murano Systems and Brighton House Associates.

Preqin provides data and information on the private equity, real estate, hedge funds and infrastructure sectors. The company started in London in 2002 by making efforts to track private equity information (hence the name) – deal flow, terms, funds, and investor activity. The market intelligence gathered was turned into publications and a database. It was the investor activity that led to Preqin collecting hedge fund related information – there was a lot of overlap among the investors in private equity and hedge funds.

Preqin collated the information the investors (investing institutions, endowments and family offices) gave them into their core hedge fund product, which is a database they call Hedge Fund Investor Profiles. Most alternative investment databases that are sold to marketers are lists of potential targets for the marketer’s product.  And the usual database/list/directory does not make much effort go beyond being a database of contacts.

A contact database typically would have a cursory company profile on a list of targets i.e. North American Family offices.  This data can be found in the public domain from phone directories to websites, and the value of a contact database is that a company or person has taken the time to gather up the data and break it into specific lists or categories.  The value is in the aggregating of the data.  The company profile might have a company name, address, phone number, general area of interest, perhaps some historical information, and the name of the acknowledged head of the organisation.

A Refreshed Contact Database

The Preqin hedge fund database is different from the typical directory-like contact database because it is refreshed on an on-going basis, and carries time-sensitive information. A directory of investor names you can buy relatively cheaply on the internet is an accumulation of all the information gathered to that point – it is a snapshot of standing data and information. Some of the information will be fresh, some will be quite ancient.

Preqin have a dedicated team of analysts proactively contacting industry professionals, monitoring regulatory filings, making FOIA requests and tracking news sources to make the their data and information on all firms, investors and service providers  up to date. The analysts speak to investors at least twice a year, and try to make contact with the larger investors four times a year.

The analysts ask investors in hedge funds what their investment plans are for the next twelve months.  There are two levels of interest captured on the database - actively looking now and tracking a strategy. The information held on the Preqin database is always first-hand, and because of the contact frequency, unlikely to be more than six months old.  This is important in a couple of regards – the investment strategies sought and followed will change over time, and the staff doing the seeking and following will change. Each month around 400 database entries are updated.

Then there is the breadth. Because of the resources applied – 25 to 30 analysts in total – and the period over which data has been gathered, Preqin has a database of investors in hedge funds which is as extensive as any. A directory or list of investor names by category might run to a few hundred fund of hedge funds or pension plans. The Preqin database has 3300 investing institutions, and the firm is currently adding 500 new names a year. For example, at the moment the firm is engaged in a project to identify and contact Foundations, in the process 70-80 names are being added each month.

Of the three providers covered in this series of articles Preqin has the most finely tiered offering by price. At the top of the range is the Premium version of Preqin’s Hedge Fund Investor Profiles.  This gives complete access to all data held for $4,250 p.a. and lists the name, type of investor, background, location, assets under management, current and target allocation to hedge funds, current areas of interest by location and strategy, description of investment plans and key contacts of the investing institutions.

Only the Premium product is downloadable to Excel or the in-house CRM of the client, and can be accessed by 5 users. The Premium product contains consultant information – who works for whom. This is considered essential information in the current hedge fund marketplace as a large part of the industry’s flows are now either mediated by a consultant or advised by consultants.  So hedge fund managers looking for the bigger tickets will buy the Premium version of the Preqin Investor Profiles. As it is, about 70% of Preqin’s clients for hedge fund products take the Premium product.

The Standard Access to Preqin’s Hedge Fund Investor Profiles costs $2,150 p.a. and it enables users to search for investors by location (e.g. list all endowments and foundations in Toronto, Canada), and find investors with specific investment plans (for example, ask who is interested in investing with hedge fund of funds). Another feature is that users can view investors by firm: that is, view which Investors have previously invested with particular hedge fund managers. This can help indicate the biases and investment style of potential clients. So a pitch can be tuned to the sort of thing that the potential investor is known to like, and the fund can be differentiated from unsuccessful investments in the past in the same investment style.

The Standard Access comes with a couple of compromises compared with the Premium Access service of Preqin. The database can be interrogated but not downloaded or linked to a CRM system, and only one user can access the database at a time.  The top-tier of investors on the database can be separately purchased in the form of the Preqin Hedge Fund Investor Review, which is an annual product. The 2012 edition features profiles and analysis for the 1,000 most important investors in hedge funds worldwide, and is keenly-priced at $795. The Review contains listings of investors with a preference for the 10 most important fund strategies.

Entry Level Products

Preqin offer a couple of entry level products: the Emerging Manager Download and the Fund of Funds download, both priced at a great value $1000 one-off cost.

The Emerging Manager Download contains contact details for over 890 institutions that have expressed an interest in investing in emerging managers, making the Emerging Manager Download an excellent way of targeting the high potential investors for a smaller fund. Investors include the full array of hedge fund of funds, public pensions, endowments and family offices and foundations. This Excel download contains details on nearly 3,000 specific contacts at investing institutions including name, position, e-mail and telephone number – sufficient to ensure a new hedge fund manager can contact at least a colleague of the relevant person.

Historically funds of funds have been the biggest allocators to hedge funds and are a necessary investor base for hedge fund managers to hit to raise capital. With the Preqin Fund of Funds download of over 600 allocators the marketer or PM of a hedge fund can searched by strategy, location and typical investment size to pinpoint the firms who may be interested in their vehicle.  The Fund of Hedge Funds Excel download contains contact details, including direct phone number and email address, for more than 2,300 individuals at the 600-odd multi-managers from around the world.  As the firms listed range in size from $10 million to $60 billion they will vary from the nimble to the lumbering, but filtering of the list by individual strategy, region and typical investment preferences tags should throw up a very workable long-list of potential investors.

Preqin has also recognised the increasing influence of consultants to flows in the hedge fund industry in its product range. The Premium version of Hedge Fund Investor Profiles contains consultant information, and in addition there is a dedicated product – the Preqin Alternatives Investment Consultant Review ($695). The 2012 edition contains profiles for over 350 different investment consultancy firms.

Consultant profiles within the Review contain information on the types of services offered, asset classes covered, key financial information, direct contact information for relevant contacts and details showing which consultants are being retained by 1,560 institutional investors from around the world. The review identifies key trends in the consultant universe plus information on the market’s make-up.  Of particular relevance for owners or marketers of single manager hedge fund businesses the Review shows which firms operate a buy-list, which firms consider first-time managers, and what they look for when considering new opportunities. The Review is also relevant to investing institutions looking to benchmark their current consultants or to investors considering the services of consultants.

The other directory-like product from Preqin is the Sovereign Wealth Fund Review, which costs $595 and provides a detailed analysis of sovereign wealth funds and their activity in all different asset classes. The Review contains useful analysis plus full profiles for over 60 sovereign wealth funds worldwide. Of all investors in hedge funds SWFs are perhaps seen as the most desirable – they have stable long-term capital, are professionally managed or advised, and can write very large tickets.

The first article in this series covered lead generator Murano Systems and the next article will feature Brighton House Associates. The final part will also draw some distinctions between the three and how they are positioning themselves, and so will come back to how Preqin is trying to compete more directly with the pure lead generators.

Mixed Messages on Health of Hedge Fund Business in Europe

Around three-quarters of the capital in the European hedge fund industry is managed out of London. So looking at the health of the British hedge fund industry effectively reflects the European industry, even taking account of leakage to Switzerland at the margin.

Corporate finance firm Imas Corporate Advisors has done some good work in tracking the investment professionals at hedge fund firms that are registered as Approved Persons with the FSA. Most senior and middle tier staff fall into that category, and it includes everyone that takes investment decisions and those with responsibilities for the direction of the individual firms.

The analysis done by Imas focused on middle-sized and large hedge fund management companies - all those with 10 or more Approved Persons on their staff, amounting to 70 firms. These top firms by size account for the majority of hedge fund assets under advisement in London, as the industry is fairly concentrated.

The result of this collation is given in graphic 1 below:

Graphic 1: Approved Person Employment Change, Q1-Q3 2010, in Larger Hedge Funds

source: IMAS Corporate Advisors/Financial Service Authority

So of the 70 largest firms, nine increased their staff during the first nine months of 2010, six held their investment staff at the same level and 55 firms reduced their staff numbers. Totting all the numbers up gives a decline in aggregate from 1288 to 989 in the year-to-date period covered - not much of surprise given the migration of staff at BlueCrest and Brevan Howard and the like to the Continent.

The second point to arise out of this part of the research carried out by Imas is that nearly half the top tier of hedge fund management companies in the UK are owned by foreign entities. Given the way that some of the very top tier of global managers downsized in 2008-9, it won't be a surprise that the firms owned by foreign entities and nationals cut investment staff numbers slightly more than their UK counterparts. 

The second area examined in the research was regulated company formations. From Graphic 2 it can be seen that the recent low point for hedge fund management company registrations with the FSA was a year ago - the hedge fund industry bottoming just before other financial sectors on this analysis of growth from the bottom up.


Graphic2: Quarterly FSA Firm Authorisations by Sector (2009-2010)

source: IMAS Corporate Advisors/Financial Service Authority

Since then there has been a run rate of around 19 new hedge fund management companies a quarter being approved for registration with the FSA, until the last quarter. The third quarter of 2010 showed a pronounced increase in the number of new hedge fund management companies being approved by the FSA. This looks to be a conseqence of the Volcker Rule, whereby banks must separate own-book risk taking from other activities, whether within the hedge fund format or proprietary capital. The second driver of hedge fund formations in London is the ongoing second-generation effect, as staff spin out of the orbit of brand name hedge fund companies to strike out on their own. Between them these two categories account for 22 of the 28 hedge fund management companies approved by the FSA in the 3Q.  

Net net hedge fund employment at the level of Approved Persons in the UK is down on the year to date, through September. Most of the hedge fund jobs lost to Continental Europe will not return to the UK in short order because the tax disincentives look like they will remain in place for some years. In addition the strategic thrust of the global hedge fund management companies is expansion into Asia ahead of a return to Europe. That written, single manager hedge fund assets across the whole of the hedge fund industry are near record levels, and more funds of funds are expected to receive net positive capital flows after the year-end re-shuffling of portfolios of hedge funds. So shortly the nadir will have been passed for most of the industry by assets, if not by number of funds, as the long tail of the industry lingers on.

The Hedge Fund Registration Act Ensnares Non-US Funds

Up to now overseas-based investment advisors to offshore hedge funds did not have to register with the SEC. It used to be that the American system of fund regulation was based on regulating the products that were sold, rather than the firms carrying out the business. The old form of regulation was about mitigating mis-selling of products to individual investors. So a form of investment that did not allow unqualified investors in a fund regulated in another country (offshore hedge funds) was not covered by domestic US regulation. John Doe of Main Street was not allowed into hedge funds, and the funds were not allowed to be marketed to retail investors in the United States. So there was no need for protection of the little man.

Today, offshore hedge funds are still not allowed to be marketed to retail investors in the United States, and unqualified investors still may not buy hedge funds. However, first there was the enforced registration of all (domestic) hedge fund advisory firms, and now the the US legislators have gone a step further by seeking to regulate non-US entities with hedge fund clients in the United States.

In the first week of this month the US Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Bill"), which contains The Private Fund Investment Advisers Registration Act of 2010 (the "Act"). The Act requires all private fund investment advisors to register with the SEC, whether they are US-based or overseas-based.

It is a curiosity, at the least, that the SEC has this role. Speaking to a House Financial Services subcommittee this week, SEC Chairman Mary Schapiro said “it’s really not clear” what (systemic) risk, if any, the hedge fund industry presents. Even if she is not clear, I am: it is quite feasible, given the scale and activity scope of hedge funds that in combination hedge funds can have systemic impacts. In the UK this addressed through the FSA monitoring exposures of the largest hedge fund groups operating in its jurisdiction. The hedge fund industry assets are not managed by many groups, so this focus on the bigger groups is very sensible and practically readily achievable. The SEC should follow suit and limit the number of hedge fund groups it (or another regulator if it doesn't want or see the need for such a responsibility) tracks. However that is not enacted by the new US hedge fund legislation, and the scope is broad, too broad.

That written, there is, I should point out, a Foreign Private Adviser Exemption, but the criteria are set at a level that all non-US hedge fund groups would have a business aspiration to exceed. The Act provides a limited exemption from registration for a "foreign private adviser", which is defined as an investment adviser that: (i) has no place of business in the U.S.; (ii) has in total fewer than 15 clients in the U.S. and investors in the U.S. in private funds that it advises; (iii) has less than $25 million (or such higher amount to be determined by the SEC) in assets under management attributable to clients in the U.S. and investors in the U.S. in private funds that it advises; and (iv) does not hold itself out to the public in the U.S. as an investment adviser, or advise an investment company registered under the Investment Company Act of 1940, as amended (the "Investment Company Act") or a business development company. 

It might take a few marketing trips to bring in 15 US clients to a European or Asian hedge fund, but it is certainly do-able for a Billion Dollar Club member (or a fund with a track record of more than two years) to have that number already. And $25m of US-sourced capital as a threshold will exclude few commercially-sized hedge funds

And what is a "business development company"? Does this include an offshore marketing company that an overseas hedge fund group might have in place to mitigate tax payments within the hedge fund management company?

Also, who is this regulation for, who is it protecting? The likes of CalPERS and other giant state pension plans, sophisticated family offices like the Rockerfeller Foundation, the Endowments of Harvard and Yale, all invest in hedge funds, but given they are qualified investors and large in their own right shouldn't they operate under a "buyer beware" philosophy?  To repeat, the man in the street in the United States cannot buy a domestic hedge fund, still less an offshore hedge fund. 

A few consequences of the implementation of this Advisers Registration Act are: that the costs of being in the hedge fund business have gone up again, reinforcing the tendency for the industry to concentrate; non-US funds will find it more difficult to obtain seed capital from US-based incubators and early stage backers; the Gucci tasseled loafers/Bass Weejun penny loafers division within the hedge fund industry will be reinforced. Across the Atlantic we are being forced apart from our American cousins in hedge funds, by the EU Commission and the US Congress.



Addition of 22nd July: a comment from Andrew Shrimpton, Member at Kinetic Partners: “The expanded authority of the SEC will have a far reaching effect on the alternative investment industry, both in the US and in Europe. Not only will asset managers who handle significant assets in the US now be required to register, they will also be faced with more onerous compliance and monitoring obligations. Therefore, managers in the UK and Europe need to consider whether they are obliged to register with the SEC and respond appropriately to the heightened scrutiny and new demands.”

According to Kinetic Partners SEC registration will have the following bring with it the following requirements of managers: 

•  comply with applicable SEC filings such as the Form ADV I, Part II and accompanying Schedule F;

• develop a compliance manual, code of ethics, employee investment policy (personal account dealing policy) and a compliance monitoring programme that meet with SEC requirements and industry best practices;

• undertake an annual review and testing of the compliance programme; and

• undertake annual compliance training.

Where applicable, firms should also consider their global group structure and how the Bill may affect non US managers within their group. For example, many managers operating in the UK also have an offshore, non US, manager which delegates to the UK. 

This posting used information made publicly available by law firm Seward & Kissel LLP and a press release from Kinetic Partners.

Fund of Hedge Fund Dis-intermediation - Evidence from Japan

Following up on the  prospects for funds of hedge funds, which I have covered earlier in the month, I neglected to mention dis-intermediation by investing institutions. This is a natural phase of development for institutional investors of scale.

First the institutions use small allocations as a percentage of assets and tap into third party expertise to implement the strategic allocation. This first toe-dipping willl typically utilise a fund of hedge funds, or for the  larger institutions, several funds of funds to keep them all honest. A minority of new investors in hedge funds will use a third party advisor, like Albourne Partners, and allocate directly to single managers, or these days look to use replication, like USS of the UK.

The investing institution then gets used to working with hedge funds, gains experience and understanding, and they often move onto increased strategic allocations and change to a new mode of implementation. This may involve making strategic bets on particular hedge fund investment strategies, say emerging managers, credit hedge funds, or directional managers. Moving from diversified mandates to using more specialised mandates (in addition) might also be implemented via specialist funds of hedge funds, but is as likley to involve active selection of single managers. 

So it is natural for investing institutions of scale, with sufficient in-house expertise, to progress to selecting hedge funds individually. There is an extra incentive to do this, a negative motivation, when the foundation exposure to hedge funds (via funds of funds) is seen as disappointing. To a significant degree this has been the case for the last two years, to the downside and then the upside, by turns. There are good reasons for the significant under-performance of funds of hedge funds, particularly in 2009, but it can have commmercial impacts through changes in underlying investor attitudes. A recent example was the change in approach of the South Carolina Retirement System. Formerly the allocation to hedge fund strategies was 70% in funds of funds and 30% directly in single manager funds: that split is to be reversed in future.  This trend to dis-intermediation is also being reflected in Japan.

Japanese life comapnies have amongst the longest experience of exposure to hedge funds amongst investing institutions. In the middle of the last decade Japanese pension funds allocated to hedge funds too. The core of the exposure has always been by fund of hedge funds. The status of funds of hedge funds as the core means of obtaining exposure is under threat. For the last five years Daiwa Institute of Research has surveyed Japanese pension funds regularly on their hedge fund investment intentions. Historically the most common intended allocations to hedge funds were to funds of hedge funds in the surveys. In the lastest survey, and for the first time, the most common intended allocations were to a hedge fund strategy other than fund of funds, in fact more pension funds of Japan intend to allocate to managed futures funds than funds of funds.

There is some anecdotal evidence that Japanese investing institutions intend to allocate more directly to single manager hedge funds, but the key point is that the share of capital in the hedge fund industry that has been routed via fund of funds will only continue to decline. Funds of funds willl increasingly be dis-intermediated at the industry level, though individual firms may grow through taking market share.  

The Shrinkage of Hedge Fund Seeding Capital

I have written in the past (http://simonkerrhfblog.blogspot.com/2009/11/gathering-assets-still-difficult-for.html , http://simonkerrhfblog.blogspot.com/2010/01/excess-supply-of-emerging-managers-to.html ) that my expectation is that emerging manager hedge funds will find raising capital difficult. Part of the reason for this view is the shrinkage of seeding capital providers. Infovest21 is the source for this overviewing of the status quo in hedge fund seeding:



The size of assets committed in the overall seeding industry dropped in 2008/2009 as has the number of seeders actively providing seeding capital.


Seeding is very resource-intensive. It requires sourcing a wide range of proposals, having the skills and resources to analyze diverse strategies, having negotiating skills and helping put businesses together. This cuts down on the number of firms that can do it, says Patric de Gentile- Williams of FRM’s Capital Advisors. “People are getting out of seeding business because it is a very hard business - you need to find the talent, be a risk manager of the talent and have a disciplined marketing plan for the business,” adds Anthony Scaramucci of Skybridge Capital.

In 2007, there were 50-90 seeders. Today, there are just a handful of active seeders. Many of the active seeders don’t expect the seeding activity to get back to 2007 levels. Many key personnel at some of the larger seeders have left. Many are virtually out of the business but not publicly admitting to that, says one seeder.

The vast majority of seeders were a part of larger businesses. Those businesses became stressed by events in 2008 and had to refocus on their core business at the expense of their peripheral business. “Where seeding was a peripheral activity, it had to be sacrificed even though this is the one of the best times for seeding. In addition, some seeders were within investment banks and were using capital from the bank’s balance sheet. When 2008 arose, much of that capital was withdrawn,” adds Gentile-Williams.

It may be tough for some of the fund of funds’ seeders to come back. Scaramucci says, “If they don’t have the right resources in their organization, then they think they’re in the funds of funds business as a seeder. They’re not in the funds of funds business: they’re in the private equity/intellectual capital management business…When a fund of funds goes into the seeder business, they approach it the way funds of funds would. They don’t get deal terms right. They’re not partnering as tightly with the manager.”


In terms of seeing new candidates to be seeded, seeders say they haven’t seen a better environment. There are large numbers of talented people who want to be entrepreneurs who have been displaced by either the collapse of the firms they were with, whether hedge funds or investment banks, or are in an existing platform where they can’t supply enough capital.


Outlook



Gentile-Williams observes that the first quarter of 2010 has been more active than last year. “The pipeline is very strong; eight or nine managers are in [our] pipeline which could lead to a transaction in the next few months.”

Asset raising at the seed level i.e. raising a new fund is still challenging, say a number of seeders.As general interest for hedge funds picks up, emerging managers will benefit. The challenging piece is that some of the established largest managers, who had been closed, opened up to new investment following the financial crisis. Some of the largest allocators are currently going directly to the larger funds.

If the hedge fund situation improves and liquidity returns to the market, former seeders could return but they will probably do one-off deals rather than a dedicated fund. It could be done as a side letter not as a cookie cutter fund, says a former seeder.

There will be more capital committed and new players. There will be a small number of large players. Some family offices and some institutions are seeding. On the family office side, seeding is often viewed opportunistically. For example, The Koffler Group seeds only one manager or so a year. It seeded EchoBridge with $20 million in 2008. Another example is Parly Company which has seeded about 25 funds in the past.

Some larger pensions are also entering the seeding arena. CalPERS is considering providing start-up money to hedge funds similar to what it has done with private equity. The UK pension fund Railpen is expected to start a hedge fund seeding operations in order to gain greater control of alternative assets. Details haven’t been publicly disclosed yet but sources expect the model will follow the CalPERS and Hermes’ models.

In 2010, New York State Common Retirement Fund seeded London-based Finisterre’s emerging market hedge fund with $250 million.

Problems and Solutions in Investing with China-based Hedge Funds

This blog has been running for four months and this is the first posting to mention China. At the start of the year as strategists and economists gave outlooks for 2010 it was all about China. Anthony Bolton, after a career as a London-based fund manager at Fidelity dedicated to UK equities, has come out of retirement to run a Chinese equity fund and is to be based in Hong Kong. As a destination for investment, the popularity of China-focused funds is certainly on the rise. Sales of China-focused funds via Fidelity’s fund platform, FundsNetwork, increased by 59% in 2009, while sales into Fidelity’s China Focus Fund alone increased by 239%. That is how enticing China is as an investment destination. However, whilst  there has been a China theme to many investment portfolios, and the largest hedge fund companies have opened Hong Kong or mainland China offices, Chinese dedicated hedge funds have been something of a side show in the hedge fund industry. This reflects that China is much more developed as a manufacturing centre than a service and financial centre.

So China is recognised as  representing the largest global growth opportunity on a multi-year basis, but immature as far as the financial sector and capital markets are concerned. The Chinese equity markets represent a rich opportunity set, as do all frontier markets, but in this particular case, partly through cultural considerations, they can be difficult to access successfully and sustainably and with as much confidence in the execution as in the high concept. The practical difficulties were recently addressed by dedicated hedge fund site http://www.chinahedge.com.cn/, using comments by GFIA as a springboard.

The rest of this post is in two parts: the article from Chinahedge, which has been re-written but not changed in shape or substance, and in part two a full, considered response from London-based Fund of Funds manager Caliburn Capital Partners, which targeted exposure to the China theme some years ago, and which has supported exposure in the region through a Singapore office.

Part One - The Problems

The investability of mainland China based managers has become an issue, as reflected in the decision by Singapore-based research firm GFIA to stop covering and investing in hedge funds based in mainland China. It has largely shifted its coverage to western-trained managers based in Hong Kong. As an example of the issues investors face it cites that on a number of occasions China-based hedge funds would not reveal the identity of fund backers or the background of portfolio managers.

Compliance issues

The majority of offshore Chinese hedge funds are run from Hong Kong and the mainland China cities of Shanghai and Shenzhen, with very few in Beijing. For those with a Hong Kong office, almost all of them are Hong Kong Securities and Futures Commission-registered.


"At the very beginning of the due diligence process for investors allocating to China hedge funds investors should check to see if the investment manager is regulated, if the fund they manage have independent directors, if the fund is administered independently by a well known firm, and if the firm is audited independently by a top grade auditor." Andy Mantel, founder and CIO of Pacific Sun Investment Management (HK) Ltd, told China Hedge by phone. Andy is one of few offshore Greater China hedge fund managers who is non-Chinese but is fluent in Mandarin having been in the Greater China Region for about 20 years. “Basically all mainland headquartered hedge fund managers fail this initial due diligence test.”


Based on the statistics of China Hedge Fund Managers (Onshore) Database complied by China Hedge, most of the mainland managers (about 200 managers) are only managing local Chinese hedge funds denominated in RMB which are not accessible by global investors. Around 10% of them are running offshore Greater China hedge funds as well. Some have HKSFC-registered operation. Only a few of them have no HKSFC-registered operations which may cause some compliance issues.

Transparency and disclosure issue

GFIA mentioned in its report that those mainland-based managers show "a lack fundamental transparency and openness." It is an issue with some mainland-based fund managers that they are not willing to disclose their real holdings, and they do not have a disciplined risk management either, according to Kaikai Hua, director of a Shanghai-based wealth management company. He said, “normally they have a bet on one or two stocks or PE investments, and cover up the big loss or a liquidity problem until the stocks stop trading, or the IPO fails.”

Before selecting China managers for their US-based institutional clients, Bill Hunnicutt strictly required the Chinese managers must be willing to accept complete portfolio transparency which is now mandatory post-Madoff. Bill is the President of Hunnicutt & Co., LLC which is a placement agency based in the US. Bill said this means showing a current portfolio upon request. “Some larger US institutions require daily transparency via a dedicated website, while others will accept transparency via 3rd party vendors who then provide a general summary of the portfolio to the client.”

Business and cultural differences

There are clear cultural differences between local managers and global investors. Most local managers come from mainland mutual funds and securities firms. They are accustomed to running funds to a local standard, not those expected by global investors. “If the local managers do not tell you the companies they hold because they do not want others copy the idea. Knowing something early than the market is an important way for them to make money", Kaikai said.


The cultural differences may be exacerbated by communication problems. Most local managers are not comfortable to talk and write in English, so, the email reporting and newsletter that foreign investors in hedge funds expect may not be produced on a timely basis, if at all. “They would rather not say anything than express something badly. It takes a while for investors to fully communicate with these managers.” Kaikai said.


So local Chinese managers have something to learn in terms of the normal global practices and standards of running a hedge fund, as recognised by international investors. It has been suggested that mainland Chinese managers of hedge funds would benefit from getting together on a regular basis to share some thoughts of running a hedge fund business – a draft practice for participants would follow. Some managers recognize that there is a trend of increasing allocation to China-based managers, and in response they have recruited Chinese partners who are Western-educated and/or have worked for Western companies so that they can acquire that necessary knowledge about the standards expected by global investors.

Changing regulated status

The current Chinese law has regulated Chinese mutual funds, but these regulations do not apply to onshore Chinese hedge funds. According to MarketWatch published by Citi Securities and Investment Services dated 17 December 2009, the mutual fund law review workgroup, set up by the China Securities Regulatory Commission, has reached an agreement to include privately-raised funds as regulated mutual funds in the revised Mutual Fund Law.


Li, Zhenning, Chairman of Shanghai Rising Fund Management and the member of the mutual fund law review workgroup suggested that the regulator release licenses on privately-raised funds (commonly called local hedge funds) in the future. Investors, thus, can expect better regulation of local hedge funds in areas such as transparency issue and information disclosure.

Comparative advantage of Chinese-speaking CIOs

”Some local CIOs are sound managers. They know what they are doing, and what risk they face. Despite the lack of transparency and absence of rigid risk control systems, mainland-based managers have a big advantage in that they know the market well. They are more alert to the growth engines in the market, as well as problems in the companies. They spend more time talking to people in the street, and ask what they think of a product. It’s much easier for them to get access to companies too,” Kaikai said.

To combine both HK and mainland managers

“Hong Kong is by far the best place to manage a China fund. Aside from the unparalleled infrastructure and regulatory environment, the free flow of instant, uncensored information is vital when making investment decisions.” Andy Mantel said. “Research activities on the mainland can only add value if it is a supplementary research and information gathering office in support of the manager's headquarters,” Mantel emphasized.”


Kaikai Hua states that Western-trained managers based in Hong Kong have a different strategy. Most of their holdings are big names and liquid stocks. They perform better in a bear market or when market is in a correction. And they have a better understanding of tools for hedging. “We see that one side are stock pickers, and the others are portfolio manager.” Hua suggests that clients combine both, so that they can enjoy the advantages each offer in accessing the growth of Chinese market.

Chinese hedge funds are growing

There is a strong case to be made that the Chinese hedge fund sector is becoming more significant within the global hedge fund industry. Many institutional investors have started to monitor and even allocate to Chinese hedge funds in their global portfolios. “We should not neglect the China market” is the common belief of most global investors.


The booming equity market has helped the growth of industry assets. The industry recorded encouraging growth figures last year. Chinese onshore hedge fund managers launched 242 products in 2009, according to a report by Chengdu, Sichuan-based Sinolink Securities Co Ltd. The average size for every fund was about 90 million yuan ($13.2m), the report said. The 151 non-structured hedge funds returned 54% on average in 2009. As the end of 2009, the local China hedge fund industry reached around RMB 50 billion ($7.4bn). Zhang Jianhui, Director of Fund Research with Sinolink Securities, said at the Sinolink Hedge Fund Forum last Saturday in Beijing that the hedge fund industry of China would manage about RMB 100 billion as at the end of 2010.

Part Two - The Solutions

Thank you for giving us the opportunity to respond to Peter Douglas’s comments. Whilst we acknowledge that Peter is well respected in the industry and has a long track record as a specialist on the Asian hedge fund industry as a whole, we would take issue with his view that mainland based managers are not transparent enough for investors to assess them properly from a qualitative perspective.



For the sake of clarity, what we mean by “mainland based managers” are those where the Portfolio Manager is generally based in China, may or may not have a Western background or speak very good English, but will have a Hong Kong office (or other location outside the mainland) and will be registered with the SFC in Hong Kong (or equivalent in other jurisdictions). This group includes some of the most well known and longest established Greater China hedge funds and all of our comments below are based on this group of managers. (There is a second group of mainland based managers who don’t have an investment management company outside of the mainland but who offer offshore products. Caliburn does not invest in this second group of managers because the law is not clear if mainland based funds offering offshore funds should be classified as Permanent Establishments, which would mean the fund and firm would be subject to tax. Currently we are seeing the market leaders in China’s mainland fund management industry, who are in the process of launching offshore products, all setting up offices outside of the mainland in Hong Kong.)


Bearing in mind the definition above, we have built an extensive peer group of mainland based managers who we monitor and from whom we receive regular updates. In our view, some of the strongest Chinese research teams from both a bottom up and top down perspective are mainland based. Their research edge comes from their ability to pay significantly more than the established, large local mutual funds so they can hire the best research analysts. We also find that in these teams there are more analysts with direct industry as well as buy or sell side research experience which provides an additional research edge.


These managers generally provide monthly reporting which is of a high standard with good portfolio level data, and they are happy to speak about the portfolio composition and their market views in some detail. If there is a problem it may be that some of the larger managers ($300m AUM or above) may be reluctant to offer transparency to other than significant investors. Equally, bottom up stock pickers may be reticent to elaborate on their rationale for individual and current stock picks. However both of these observations can be made of hedge funds in general and are not particular to China. In general we do not encounter these difficulties with the majority of funds. Clearly, full transparency is always available through a managed account with most mainland based managers. Of course, just as in the Western hedge fund industry investors will again need to meet a certain minimum investment size to take advantage of this option.


Of the three mainland based managers with whom we are currently invested, one provides us with probably the greatest transparency of any manager that we follow, including providing the full portfolio twice a month and an enormous depth of insight directly from the CEO and senior investment team. From the remaining two we receive monthly portfolio information with very good transparency such that we are able to establish and monitor all of the key risks and sources of return of the funds.


There is no question that communication is not always easy with mainland based managers. There are often cultural and language difficulties to overcome and few are polished presenters. It is therefore important to have Mandarin speaking analysts but it is not just about language. For Caliburn as a thematic investor, research does not start with the manager; we do a lot of work to understand the underlying market and investment opportunity. This includes attendance at industry and corporate conferences as well as independent meetings with regional thought leaders. The natural result of these activities is that our research team is armed with a good understanding of the Chinese macroeconomic situation, policy news and sector news together with a general knowledge of stocks in key sectors. With this as background it is possible to establish a better relationship with managers. Our thematic work supports very specific and focused questioning and with this approach we have been very pleased with the level of disclosure we have received to date.


In relation to getting comfort with the risk management processes at these firms, as with all peer groups there are funds where we trust the risk management and there are funds where we remain cautious or sceptical. Without question a significant commitment of resources and time is required to regularly communicate with the funds and ask the right risk related questions to form a view. From an operational point of view, the mainland based funds that we have approved for investment have top tier independent 3rd party service providers (administrator, custodian, prime broker, and auditor) and in this respect reflect the best practices of their non-Asian counterparts.


In terms of performance in stress periods, broadly speaking most of the China based managers are bottom up investors and they did not protect the downside in 2008 as much as we would have hoped, though poor performance over this period is a common failing from across the hedge fund industry regardless of geography. We were pleased to see a number of managers sticking to a disciplined valuation approach which meant they were already running low exposure levels before the crisis unfolded. In general terms our invested China managers fared better in the second half of 2008 than in the first half of 2008 and China managers as a group performed much better than their BRIC peers over 2008 as a whole. Importantly, a number of China managers who lost 20% or more in 2008 subsequently made significant improvements to their risk management and their adherence to risk disciplines and this has served them well in months such as January 2010, during which they cut exposure and balanced their portfolio much more effectively than during the difficult Chinese markets of early 2008.


In conclusion, overall the standard clichés apply: you get out what you put in. We commit significant time and resource to achieving a detailed understanding of each manager’s approach. We routinely make multiple trips to interview a manager in his / her office and follow up these on-site visits with a number of conference calls before deciding to bring a manager forward for discussion at our internal approval committee. There are barriers to entry and the investment opportunities may be less accessible as a consequence. However this can make the opportunities more interesting and the barriers can be overcome with a commitment of analytical time and a consistency of approach that reassures the manager that you are serious and there for the long term.

Richard Howard
Caliburn Capital Partners

Podcast 3 - A Q&A with Two Third Party Marketers of Hedge Funds

Click on the emboldened header (e.g Part One) to link to the sound file. Clicking on the link will open a page containing the sound file - download or play in your browser

Part One
(8 minutes)

Clicking on the link above will open a new window with two choices available: download the podcast or play the podcast.

1.50 What are Third Party Marketers?

2.23 How was 2009 for Third Party Marketers?

4.05 Databases over Third Party Marketers?

6.00 Transactions versus Relationships

7.01 Repeat Visits to Targets

7.58 Decisions by Committees

Part Two

(13 minutes)

0.00 Branding in the Hedge Fund Business

2.48 Marketing Materials

4.16 Clarity of Materials over Logo Design

5.10 Boiled-Down Presentations

6.37 The Last Two Minutes of the Presentation

7.13 Matching Material to Territory and Investor type

8.22 Establishing Trust

8.55 Initial Assessment of Manager

9.40 Friends & Family Money First

10.47 More Established Manager for Institutional Investors

11.19 The Sourcing of Managers

Part Three

(6 minutes)

0.00 Next Stage after Identifying the Managers to Work With

1.50 Marketing Due Diligence

3.04 The Sweet Spot Now

5.18 Strategies to Appeal in 2010



My Thanks go to James Palmer of Red Sky Capital Solutions (redskycapsol.com)

And Barry Rogers of Alternative Investment Management (AIM) Partners (research@aimpartners.co.uk)

for their contributions to the discussion podcast above.

Excess Supply of Emerging Managers to Come?

One of the consequences of the growth of institutionalisation of the hedge fund business is that it has become a lot harder for small and start-up hedge fund managers to get commercial traction. In the late Nineties it seemed that a manager only had to turn up with a credible background and they could launch with $30 to 50m. In the early Noughties it was still fairly easy to set up and it was quite common for a large wealth management company or fund of hedge funds to put a manager they believed in into business. From 2003 onwards the bar was raised for start-ups – managers had to come to potential backers with much more of a complete package, including a preference for two portfolio managers and an analyst or two. "We expect start-ups to have a headcount of five or six," was a typical quotation at the time. It was not impossible to get going on either a bigger or smaller scale, but if it was smaller it was odds-against.

In the period 2005-2007 asset flows into the hedge fund industry became the dominant driver. The consequences included a break-away pack of winners amongst allocators of capital to hedge funds. The flows of new capital were dominated by institutional assets such that institutional imperatives dominated the processes and mind-sets of funds of funds businesses. Ticket sizes became bigger generally. And this was a problem to new and smaller funds – as investors in hedge funds commonly have prudence rules that limit the percentage of assets of a fund they can represent. In this era the second generation manager was the most successful route to hedge fund launches. This was a very safe route for the middle men of the business – as many more of the boxes could be ticked at launch, particularly if the second generation manager stayed under the same roof. The same can be said where additional strategies were launched by the management company for a successful large hedge fund.

Times since the middle of 2008 have been tougher for newly launched funds. There were far fewer of them, but redemptions across the industry made things very difficult. The outflows of capital across all funds left capacity at great and very good managers. Logically the first flows into the industry went to the best managers with available capacity, which was all of them.

New Supply

Late into 2009 the word was that the reining back of capital at investment banks, but across the sell-side generally, was going to compel an outflow of talent into the hedge fund world. Investment management consultancy Laven Partners have said that they are seeing a trend for traders from banks to launch new businesses, partly reflecting concerns about remuneration levels within banks. They say that many traders working as the number 2 or 3 portfolio manager in a fund feel that now is the time to strike out on their own. In particular this is true in funds that are well below their high water mark. Other service providers confirm the trend - prime brokerage departments were said to be running longer lists of newly formed funds coming to market. For example Morgan Stanley reported a 10% increase in prime brokerage clients in the 4th quarter. So 2010 is expected to build on the recovery in launches of the second half of 2009.

Anecdotal evidence suggests that for Europe at least, the first half of 2010 will be a busier again for new launches. Three quarters of Europe's hedge funds are in the U.K., and in the U.K. the management companies of the investment advisor have to be approved by the F.S.A. Start-up consultancies say that they have a good pipeline of new and completely independent managers, and the workload at the FSA confirms this. In early 2008 I was involved in a fund launch, and the authorisation part of the process took around 4 weeks with the F.S.A. Whilst it is true that the FSA is subjecting applications to greater scrutiny, that firms are being told by the FSA that applications are piling up, and that the average processing time is approaching 12 weeks, reflecting an increasing number of fund management company and fund launches. Rob Mirsky of Laven Partners told me that the FSA is certainly still backed up - even getting a case officer at the FSA at the moment is a struggle, he says.

Demand

So what kind of demand environment are these management companies and new hedge funds going to launch into? Alternative investment data specialist Preqin surveyed investors in hedge funds in the last couple of months to find out about their attitudes to emerging managers. The Preqin survey suggests that only 29% of investors would consider investing in a hedge fund with less than $100m in AUM. Further, they suggest that, in the main, funds of funds are the only investor type to get involved. So a principal difficulty faced by emerging managers is that they are mostly trying to attract capital from a type of investor that remains under commercial pressure itself because of its own investment returns and capital flows. 

Flows at the industry level, having turned positive in April/May of last year, have reversed in the short term. After seven straight eight up months up to November last year, flows turned negative in December 2009, according to HFN. In October investors committed $16bn of new capital to hedge funds, and in November investors subscribed a further $26bn. However, in December investors redeemed $4bn from hedge funds, according to analysis of the HFN database. Given the emerging bear phase in equity markets, it is not expected that capital flows into hedge funds will resume with force until later in 2010.

Industry level flows can be very important to new funds. Funds of funds went through a lot of fire-fighting in the second half of 2008 and the first half of 2009. The senior staff that have the ability to make seeding decisions or can decide to back an early-stage manager were completely occupied with existing investments (and keeping their firms afloat) during that twelve month period, and only emerged with some degrees of freedom in their management choices very recently. When industry flows are consistently positive again funds of funds will be able to get on the front foot in decision-making. In the aggregate, funds of funds have barely had any positive flows yet, even when single managers were gathering assets again in the second half of 2009. So the major source of capital for small and new hedge funds has been, and will continue to be, constrained for capital and senior management time in the first half of 2010, with a few small exceptions.

The small exceptions are funds and funds of funds that seed and invest in new managers on a dedicated basis. Seeders have been making capital commitments, and are well invested - many are looking to raise additional capital before they can back any more new funds. There are some new entrants: United Investment Managers and Aptima Capital Management have both recently announced plans to launch fund of hedge fund vehicles focused on emerging manager hedge funds. They should both have plenty of choice, at least in Europe.


Addendum I: according to magazine AR, the assets garnered by new funds declined 36% to $14.89 billion in 2009 —the worst showing in years. In total, new funds in 2009 that were managing a minimum of $50 million in assets by year-end amassed a mere $14.89 billion, the lowest on record, according to the biannual survey by AR, which has been tracking the biggest new fund launches since 2004. That is 36% less than $23.17 billion in 2008—a figure that was helped by two mega launches from Goldman Sachs that raised a combined $7 billion—and 63% less than in 2004, when assets garnered by the biggest new funds peaked at $40 billion.

While the number of new fund launches in 2009—53 funds met AR's criteria for inclusion—came close to those in 2008, the average assets are lower, and the number of funds managing more than $1 billion has collapsed. Only two funds were able to end 2009 with $1 billion in assets or more, as compared with 2008, which boasted five funds managing that amount. 


Addendum II: Edgar Senior, head of capital services at Credit Suisse in London, commented in February 2010: "It is harder to launch new funds than in the past, so existing hedge funds that have capital to deploy and have built out the institutional infrastructure have the luxury of choice." (source: Financial News)