Current trends in the alternative investment industry (plus 5 top tips for emerging managers)

Types of fund/investment strategy

• Meklinsky estimated that his group’s global pipeline is 65-70% private equity, real estate, and venture capital, likely driven by investor demand and the return profile. The rest are what he called “larger hedge fund startups,” noting that the barrier to entry has shifted from what used to work at $50 or $100 million in AUM to slightly over $300 or $400 million.
• Berger estimated that almost half of what his team is seeing are long-short equity managers, although with different strategies, like healthcare and emerging markets. Private credit, multi-strategy, and real estate funds also predominant.
• Both mentioned that they are seeing more strategies around cryptocurrency or digital assets, but expressed that they are cautious in working with those due to regulatory concerns, audit issues, and other uncertainties.

Average launch size

• Meklinsky reported seeing an average launch size among new managers of probably $75 to $100 million. But he noted that the greatest predictor of actual launch size is generally the investor base, so his group looks for not only pedigree, but also what the investor base looks like: pension, endowment, family office, etc. It’s not as frothy as he would have expected, he said; “There’s the errant $300-400 million launch, but generally that’s someone who is coming out of a much larger shop with either a seed from the GP or a significant equity contribution of their own,” he said.
• Capital raising is still a major challenge, with a lot of headwinds especially for emerging managers, Berger said. Comparing 2021 versus 2020, there were a lot of launches, and the size of the manager has increased. But he noted still seeing a lot of “friends and family”-type money coming in, and portfolio managers (PMs) putting a lot of their own liquid capital into the fund, because they want to have skin in the game. (More on that later.)
• But, Berger said, it’s not necessarily what they start with, because it’s more of a marathon than a sprint. Obviously, it’s better to start with more capital, but his team also looks at the manager’s pedigree, whether they have a business plan, and their longer-term strategy to grow the fund, and potentially add infrastructure, analysts, and multiple funds.

Fees

• With various factors putting pressure on fees, the old “2 and 20” regime – a 2% management fee, plus an incentive fee of 20% of profits – is gone, Meklinsky and Berger agreed. Meklinsky put it now closer to 1.5% and 10% or 1.5% and 15%; Berger put the management fee down to 1.5%, or even on a sliding scale from 1.5% down to 1% for some larger funds. Berger noted some additional trends:
  • In many cases, for certain strategies like long only, the manager won’t even charge an incentive; they might just have a management fee, or if they do charge an incentive there would be a hurdle over a certain benchmark.
  • A founders class may have a lower incentive fee or allocation and management fee over a longer lockup period in terms of capital, and then the standard class would be something more, like 1.25% and 15%, or 1.5% and 15.5-17.5%.
  • There are still some managers who ask for and get 2 and 20, but those are experienced managers who have a proven track record over multiple funds.

Seed deals

• While every new manager wants to talk to every large seeder and has great aspirations, “the delta between what you really wish for and what you end up with is a country mile wide,” Meklinsky said: often more than 25% to 30% among the managers they’ve talked to in the last 12-18 months. The seeds they’re seeing are in the $15 to $20 million range. “I think it’ll be years before we see the $200-$300 million seed unless the pedigree [of the manager] is so significant – someone who’s got a 10- or 15-year track record with beating the index return by significant proportion,” he said.
• A manager has to cast a wide net and talk to a lot of people, and if they have a good story, the odds of a significant launch are greater. But still, seeders look at hundreds and hundreds of emerging managers every year and only seed a handful. So an emerging manager must have their own capital and or a friends and family class – which is itself a vicious cycle because they’re making concessions along the way on those investors’ fees.
• It will be much easier for an emerging manager to raise additional capital once they are fully operational, with real trades, real performance, real service providers, real NAV calculations, and real investor statements, Berger said.

• 2021 has been fairly frothy, with the markets still trending fairly well on a year-over-year basis, Meklinsky said. Sometime in Q3, people are going to get back into their offices and take a good look at where performance has been, he said, and determine their risk tolerance for Q4: Is it time to take money off the table and let it coast for a while?
• There’s a lot of uncertainty, Berger said, with a lot unfolding from a tax perspective, politically, inflation, etc. There are questions around tax proposals, particularly around capital gains rates and carried interest. This uncertainty may cause fund managers to adjust their trading strategy, but he said he thinks they’ll adjust to meet the fluctuations in the marketplace. Overall, he expressed optimism: “I’m pretty bullish on the alternatives industry, I think it’s going to continue to grow. … Hedge funds have performed well so far this year, and I think that performance is going to propel them to increase the overall AUM of the industry, and I think more and more new funds will be out there.”

There’s no one trick when it comes to raising capital: Even when a manager has a great pedigree, says the right things, wants to do the right things, has a business plan, presents well, and hires the right team and service providers, it’s still hard to tell who’s going to be the one who’s going to be successful and who isn’t, Berger said.

But you can tell who won’t be successful, he said.

Here are five top tips for emerging alternative investment managers, based on what Berger and Meklinsky identified as either steps toward success or “red flags” they’ve seen in conversations with such managers. Many come down to one key theme: Understanding that you’re no longer just managing investments to produce profits, you’re running a real business with real business responsibilities.

1. Don’t start a meeting with a potential service provider by asking about their fees.

Both professionals agreed: When a manager comes to them and asks for price first – before any discussion of their strategy, structure, investor base, what they’re trading, etc. – it’s a big red flag.

“The conversation generally ends quickly, because it shows they’re not thinking about what value we’re giving you, and how we’re saving you from yourself, potentially,” Meklinsky said.

Hiring an auditor, an attorney, or a fund administrator just based on a lower fee can be an indication that a manager doesn’t understand the business and what’s required to be successful in it, Berger said: Managers need trusted advisors they can turn to for business, tax, compliance, and accounting advice.

Managers who don’t have much capital to invest into the business on their own may be tempted to cut wherever they can. But at the end of the day, you can’t provide good service to your clients without covering your expenses. Plus, hiring low-cost providers can leave investors with low confidence in the output they’re getting, especially from a fiduciary perspective.

2. Be able to answer questions about your strategy, team, processes, etc.

Meklinsky’s team seeks to avoid managers who don’t have the answers to questions that should be obvious.

Who’s your CFO, COO, auditor, your service provider ecosystem? Asking for referrals for those positions, or not knowing which positions to put in place, can be a sign of poor preparation.

“As administrator, we’re standing over your NAV. We naturally want to understand your valuation process, what your risk process is,” Meklinsky said. “Folks that don’t have that nailed down clearly have not operated in a seat whereby that was paramount to them A) keeping the seat, B) driving return.”

3. Have your budget established, and understand your cash flow.

Your anticipated AUM on Day 1 will provide some level of cash flow to pay certain expenses. But at some point – be it on Day 1 or in your first six months or two years – it may be a deficit. What commitment have you made to fund that deficit?

Coming to a meeting without a budget can tell providers you’re not serious about your business. Good managers understand that they’re running a real business and take that seriously, Berger said: Come with a full budget, estimate AUMs by quarter, cash flows and outflows, and figure out who they can hire, what they can outsource, and who they can eventually bring in.

“You’re running [a business] day to day, and you can’t hit the wall where there’s no cash flow,” Meklinsky said. “You have payroll, you have vendors that need to be paid. And the minute that breaks down, everything else in your investment-related process breaks down as well. And that’s usually the death of the hedge fund. It ends pretty quick from there.”

4. Have “skin in the game.”

“When we talk to managers, one of the first questions I ask is, how much of your own capital is here? Because it’s the greatest indicator of the confidence in their own success,” Meklinsky said.

“Skin in the game” also provides staying power: Managers with that funding can better weather a cycle where the fund isn’t doing well. You need to have enough money to still pay your people and keep your alpha-driving team in place until the fund improves performance.

The cost of running a business is high, and if the AUM isn’t there, PMs will have to put up a significant amount of their own capital to keep the business running, Berger said – typically $1-2 million. Many just throw in the towel after two or three years if their business is flat and performance isn’t great.

So family offices, seeders, and other investors and allocators will expect to see that at-risk personal capital. If they don’t, the allocators and seeders will not invest.

5. Stick to your game plan.

In a crowded space, what makes a manager stand out is not just performance, but consistent, risk-adjusted performance, Berger said. Investors will dig into where performance is coming from, and even if the manager hit it out of the park by shifting their strategy, the investors (especially institutional ones) may like the results, but not invest if there is a strategy shift. “You have to stick to the game plan in your strategy,” he said.