Sometimes, my interviews on this site don’t turn out quite as expected.
I went into this one expecting to title the series of articles “How to Start Your Own Hedge Fund”…
By the time we finished our 2-hour long conversation, though, I realized that an alternate title might be more appropriate:
“Why You Probably Shouldn’t Start Your Own Hedge Fund”
But I’m a “glass half full” kind of guy, so the first title stuck.
This will be another multi-part series, and today we’re speaking with Hetty MacIntyre (see her bio on this page), who contributed those first 2 articles on what it’s like to start and run your own fund.
You can now think of those first 2 articles as the “prequels” (much better than the Star Wars prequels).
She was super-busy with… running her own fund, so we made this an “interview” rather than a traditional story or other article from her.
Part 1 of this series is a deep dive into how you raise capital, the track record you need to show potential investors, and what makes a great pitch vs. a mediocre pitch to Limited Partners.
And it answers the most important question of all: should you even start your own fund?
Off to the starting gates:
Sources & Uses of Funds and the Minimum Cash Balance
Q: So, what’s new?
You’ve been busy for quite a while, so how have things changed since we spoke last year?
A: The usual craziness – see my day in the life account to get a glimpse of what life has been like.
Since then, I’ve rolled my own fund into a larger multi-strategy fund so I could get more time to focus on investing – marketing and administrative tasks ate up a surprising amount of time.
Q: Yeah, I don’t think I could have survived for more than 1 month on the schedule you described. I’m glad that you now have more time to focus on investing.
Anything new in the industry we should know about?
A: The economics of the hedge fund industry have changed dramatically in the past few years – compliance costs have skyrocketed and management fees are down.
“2 and 20” is no longer the standard, and institutional investors are driving that down and getting more funds to accept “1 and 20” and sometimes even less than that.
Expenses have gone up due to Dodd-Frank and the new compliance requirements – institutional investors also want more protection and transparency after the scandals and crises in recent years.
In the US, some states have also implemented stricter regulations and it’s now much tougher to start your own fund and keep it running.
To have a real “institutional-quality fund,” these days, the real minimum is more like $250 million USD.
Q: Wow. That seems really high.
A: It is. The days of starting in your bedroom with $1 million raised from friends and family are over, and even starting in the $20-50 million AUM range would be tough.
I’ve seen some people start with $100 million and eventually grow much bigger, but even at that level a high percentage of your fees will be eaten up by infrastructure and expenses other than employee compensation.
Many new managers do not think about the fund economics at all.
They just think, “Aha! I’m a great investor and I’ve made so much money for my firm or in my own personal account, I can easily start my own fund!”
They forget that by starting your own fund, you’re really starting your own small business – only it’s even higher-stakes and higher-pressure because there’s little-to-no tolerance for failure.
It’s most sustainable to live off management fees, so you need to do the math first and see what amount you need to pay for compliance/infrastructure/administration, your staff, and yourself (most managers, of course, don’t even take a salary initially).
The Real Cost of Capital?
Q: So this is not exactly for the faint of heart.
How do you raise capital if you have a solid investment track record, but you’re brand new and you don’t yet have connections?
A: You don’t (laughs).
It will be almost impossible to start your own fund if you’re in that position. Some people do get funded by seeder funds, but that’s the exception rather than the rule.
They also tend to give you less capital at first – getting over $100 million solely from a seeder fund would be almost impossible, so your only real shot is to start smaller than that and put in place a plan to ramp up to $100 million over 2-3 years.
Your best option, though, is to spin out of an existing bank, hedge fund, or prop desk.
You already have the team in place, you have a proven track record to point to, and you might even be able to re-use (or get discounts on) some of your infrastructure.
Q: OK, so it sounds like if you’re not in an existing team at a large fund or large bank, or you can’t get funded via a seeder, you need to reconsider your next move.
A: Well, you could still start out with far less capital than that and make it more of a “family office” – but I wouldn’t consider it a true hedge fund unless the LP structure with carried interest is in place.
Q: Right, agreed.
So let’s say that you do have a track record, you’ve worked in a solid team, and you know a lot of institutional investors and can get introduced to more through your prime brokerage provider and other connections.
How do you start marketing your new fund?
A: Before I explain that, first note that some firms won’t let you market the track record you established while working for them.
Check your employment agreement carefully to see if you can use your past performance to market your new fund. Your track record can also be problematic because you won’t necessarily have 100% ownership of it.
If you were part of a team or had a superior make final decisions about the portfolio, the results aren’t entirely yours.
So the “new fund marketing process” is more about your process, your story, and who you are as a person than most realize.
Q: So what are they actually looking for in your story and process?
A: Three points come to mind:
- It must be specific – if it’s something vague like “find and invest in undervalued companies,” you won’t have much luck.
- It must be repeatable and it must not be dependent on specific economic conditions or a single person.
- It must be understandable – institutional investors always prefer something with lower potential returns that they understand 100% over something very complex, with potentially higher returns, that they don’t fully grasp. In fact, they might be extremely skeptical of high returns (Bernie Madoff, anyone?).
The numbers become more important in proportion to the length of your track record with that specific strategy.
Q: OK, so let’s make this more specific. Can you give us an outline of a “bad” pitch to institutional investors vs. a “good” pitch?
A: Sure… a “bad,” or at least less appealing, pitch might be something like the following:
- Your Story: Upcoming healthcare reform legislation set to be implemented next year has made the market less favorable for medical device companies, but more favorable for certain regional health insurance companies due to the demographic shifts in parts of the country. You believe that the market has not yet fully priced in this reform, and that many companies are undervalued or overvalued as a result. Due to funding shortfalls and the increased cost of regulation, many of the financially weaker companies will also be acquired in the near future as management teams start to recognize their new expense profiles.
- Your Process: To find likely acquisition candidates that are currently undervalued by the market, you focus on 3 key geographies with misunderstood and rapidly changing demographics. Then, you pore through companies’ filings, call suppliers and medical professionals in their networks, and do patient interviews to get firsthand information on how premiums, claims, and fees might be changing over time. You also analyze the Balance Sheets of these companies to identify ones that are most likely to hit a funding shortfall and therefore turn into acquisition candidates.
- Your Returns: You’ve already been doing this for 2 years in your personal account of $100K and you’ve averaged 20% returns each year, verified by a Big 4 audit.
This one might seem like a reasonable strategy, but there are several problems:
- First, your story is too dependent on the current policies of the federal and state governments – what if this changes? What’s your story then? It’s always dangerous to pick something closely linked to specific policy decisions.
- Second, your process is not scalable because it involves a ridiculous amount of reading through SEC filings and doing a lot of field work. It’s very labor-intensive, and you’ll probably need more analysts than you can afford with your management fees to implement this.
- Finally, your returns are for a personal account and it’s unclear whether or not your strategy would work with $100 million in funds rather than $100K in funds. Many strategies work well in one of those ranges, but not both.
Q: Great. And a “good” pitch?
A: A better pitch might be:
- Your Story: In certain “mergers of equals” scenarios, there is a higher likelihood of a deal going through depending on how the exchange ratio fluctuates with the stock price of the buyer or seller. There’s also a strong correlation between those criteria and the most recent earnings announcements of the buyer and seller prior to deal announcement, and how the stock traded in the week immediately after. The market has continuously mispriced the stock prices of companies with exchange ratios and other deal terms in a certain range, and you can exploit these opportunities to earn returns on par with the market, but with significantly less risk.
- Your Process: To find these opportunities, you simply track M&A activity in your sectors of interest and apply a set of 15 “rules of thumb” about the exchange ratio and underlying stock prices to all companies in the set, also looking for specific numbers and points in their SEC filings. If the companies pass your initial test, you conduct additional due diligence on them and take the temperature of others in the market before investing.
- Your Returns: Working in a team of 3 with $20 million in capital at a generalist hedge fund over the past 5 years, you’ve averaged 11% annual returns, always in a relatively narrow band from 8% to 15% in any given year.
This strategy is specific, not tied to a passing fad or trend, and the process is more repeatable / scalable with these criteria.
It’s also less dependent on you, and your returns have been more consistent with a much larger amount of capital over several years.
Q: An interesting “makeover,” to say the least. Did you want to add anything else about structuring your pitch for these meetings?
A: In addition to planning out those points above, you also need to be personable, especially with educational institutions and endowments.
You’ll speak with someone from the institution’s investment office, or an outside consultant if they don’t have a dedicated group of investment managers.
In either case, the final decision usually must be approved by the Board of Trustees, so your pitch to the investment offer needs to be clear enough that they’re able to pitch it to the Board.
Board members are smart, but they’re not Wall Street people. They could easily buy into your strategy, but if they doubt your character they might pass on the opportunity anyway.
Pitch Books… for the Buy-Side
Q: Yeah, you’ve mentioned that point a few times now, so I’m going to return to it in a bit…
Speaking of the process itself, what should you expect from beginning to end?
A: It depends on your audience – the process for a $10 billion endowment that only invests in funds over $500 million in AUM will be very different from pitching to a family office.
If you take the large endowments and pensions as examples, here’s what you might expect:
- Get an introduction via other fund managers, trustees, your prime brokerage provider, or anyone else you know.
- Have a phone conversation where they mostly ask about your strategy and get a handle on what you’re doing qualitatively.
- Then, they will ask around about you in the community and determine your reputation… if they ask around and come up with nothing on you, it might be even worse than coming up with negative findings.
- If they like your story and your reputation, they’ll invite you in for a day-long presentation where you present slides, go through your story, your process, how you manage risk, your team, your performance statistics, and more.
I already went through how to present your story and investment process, but I’ll stress two important points once again here:
- They spend a lot of time getting to know you as a person. They want to see that you’re ethical and act with integrity.
- They focus on how you deal with stress and what you do when your investments don’t go well. So do not make the mistake of focusing too much on the “upside.”
The questioning will also differ depending on your track record; someone with 15 years of experience has been through many more business cycles than someone with only 5 years of experience.
Q: Right, and so then they make a decision after this day-long presentation?
A: No, of course not – that would be too easy.
They might take up to a year to make a decision after that, and they’ll have you come in to pitch once again to a different group, ask you more questions, and then do a “site visit” where they come to your office and talk to more of your staff.
They really, really want to get to know you on a professional and personal level.
If all goes well, they might then submit a proposal on your fund to the Board of Trustees, which usually meets 4 times per year.
You pitch yourself to them, answer any questions, and then they make the “final decision”… which could sometimes be another few weeks / months away.
Q: I get headaches thinking about this entire process.
What if you approach family offices and high net worth individuals to raise funds?
A: It’s much quicker with them because there are fewer layers of bureaucracy.
I was introduced to a HNW family by a friend, talked on the phone about my strategy, and drove to the family’s vacation house that weekend to go over the paperwork.
It helped that the patriarch of the family was a former fund manager himself and understood what I was doing from the get-go.
Q: Yeah, that makes sense. What’s the “hit rate” like with these investor meetings?
A: It’s very low, especially if you don’t have much experience or you’re not already at a well-known fund.
Most fund managers approach hundreds of potential LPs, each of which have different criteria.
Endowments and pensions prefer not to invest directly with a new manager unless it’s a top person spinning out of a fund they already invest in.
They’d rather get exposure to new managers through dedicated fund-of-funds.
Consultants also play a big role in this process for both small funds and large funds – endowments and pension funds pay these consultants to find potential new hedge fund investments, and it’s their job to know everyone in the community.
There is a “size bias,” though, so if you’re under $100 million in AUM, you won’t get much attention from them.
The bottom-line: this is going to be a time-consuming, ego-bruising, and drawn-out process.
It is arguably even more difficult than raising venture capital to start a “normal company” because the tolerance for failure is much lower.
A VC expects that most of his investments will fail, but a pension fund investor would be livid if your new hedge fund goes belly-up and they lose all their money.
Q: That’s putting it mildly…
Besides coming across as untrustworthy, what’s the top mistake that fund managers make in this pitching and capital raising process?
A: That’s an easy one: they never address their own failures or their unsuccessful investments.
I’ve been on both sides of the table before: I worked at an endowment that invested in hedge funds, and then I pitched my own fund to these potential investors.
At the endowment, new managers would often come in and give us 10 case studies of them earning 50%, 70%, or even 100% returns with their strategies.
But no investor is perfect. Everyone loses money sometimes.
Very, very few people ever brought up these “failure” stories, explained what went wrong, what they learned from it, and how they applied those lessons to future investments.
Q: It almost sounds like they think they’re in IB interviews, where the failure / weakness question is just a silly throwaway one asked by unimaginative interviewers.
Let’s say you successfully raise capital – what’s your relationship with these LPs like over time?
A: It depends on the investor – at the minimum, you’ll send out quarterly or monthly performance updates and an annual letter (similar to Warren Buffett’s annual investor letter), but some managers will also send out case studies on specific investments they made.
You decide on the terms upfront in the investor agreement, but they also expect you to be responsive to any questions that come up. Investors will call you randomly to ask how things are going or to get you to explain the strategies you’re currently using.
In general, endowments and large funds will be much more hands-on and will scrutinize you very closely. They’ll check in with managers in between quarters, and some large funds have entire departments just for monitoring the funds they’ve invested in.
Of course, it’s in your interest to minimize the amount of information you’re required to send out – reporting just adds to the already high administrative burden, on top of all the compliance and tax paperwork.
Q: Great. Well, not great about all that administrative stuff.
So onto the strategies you use, the technical work, the hiring process, exit opportunities, and more…
Q: Fair enough. Stay tuned for Parts 2 – 4, where we delve into all those topics and more.
The rest of this series:
Complete Series - How to Start Your Own Hedge Fund:
- How to Start Your Own Hedge Fund – Introduction and Overview
- A Day in the Life At Your Own Hedge Fund
- Part 1: Raising Capital and Launching Your Fund
- Part 2: Hedge Fund Investment Strategies and the Technical Side
- Part 3: How to Hire Your Team and Build an Organization
- Part 4: What If Your Fund Doesn’t Work Out, and Exit Opportunities