During the dot.com boom, I observed an interesting anomaly. As an analyst of dot.com start-ups, I was responsible for valuing the new technology disruptors. During the unstoppable colonization of the Internet, the game was about capturing eyeballs — sometimes with complete disregard for a path to profitability.
Once, when interviewing the appropriately jeans-and-T-shirt–clad 20-something founder of a swanky tech start-up in a brightly colored, creativity-stimulating Bay Area office, I bluntly asked the question “How will your business ultimately make money?”
Bemused, he paused for a second. “Frankly, we have not thought about that yet, and no one has asked that question before.”
Such disregard for business sustainability was the norm, not the exception. That particular dot.com company was acquired for $20 million and promptly proceeded to go bust. The experience made me sensitive to the dangers of mass delusion typical of investment bubbles and fundamentally flawed business models —something I fear is creeping into the hedge fund start-up area.
By far the most common question I get asked by emerging managers is “How do I raise money?” To some extent the question is understandable; it’s not as easy to launch as it once was.
During the past four decades, the alternative investment management industry experienced gigantic asset growth. In the early 1970s, the entire pension fund industry, including money market funds, was only $50 billion. The 1974 passing of ERISA and the equity debacle encouraged investors to shift allocations to alternative money managers. Throughout the mid-’80s, thousands of firms became SEC-registered advisors. It took little capital and infrastructure to start a money management business.
Today, however, the barriers to entry are much higher because the industry is saturated and investors are more educated. Additionally, assets are increasingly concentrated with the largest players, making it harder for emerging managers to succeed.
But here’s the trick: To increase the probability of raising money, new managers should stop asking how to raise money.
Instead, emerging managers should focus on how to design a sustainable business. In other industries, whether consulting or consumer products, no founder starts with the question “How do I get paid?” Successful entrepreneurs begin with strategic questions like “How do I build competitive technology or create a client service model that addresses relevant issues?”
Prioritizing the raising of capital before investor needs is a likely contributor to the growing distance between investors and managers. An increasing number of allocators are moving away from hedge funds because their expectations are not being adequately fulfilled. The problem is not just declining returns, but also alignment of interests, incentives, transparency, and business stability.
If hedge fund entrepreneurs took a cue from the best players in other industries and changed their mind-set to first get to know their investors, understand their problems, and design solutions, then they would likely build their business very differently.
Emerging managers wouldn’t think, “I’m going to start trading and build a CTA or a discretionary macro strategy.” Instead, they would identify and understand a specific problem. Some of the problems allocators care about include finding truly differentiated strategies that add value to an already allocated portfolio and looking for research insight that will make their job easier. For example, an anchor investor may allocate to an emerging systematic manager because the new manager has a return profile that is uncorrelated with the volatility of traditional CTAs.
Another critical factor is business stability. Having two guys in an office with a domain name is no longer adequate. An emerging manager needs to be institutional quality before raising external capital. The compliance, operational, and technology infrastructure requires money and time to build pre-launch. This is particularly true in the systematic space: Some institutional allocators now look closely at how much managers invest in their technology infrastructure as an indicator of business stability and competitive advantage.
A third element is partnerships, particularly in the early investment stages. For emerging managers, it is paramount to find investors that view a manager as more than a return stream. Managers are expected to offer research, be transparent, and share economics through equity participation and/or reduced fees with seeders and founder-class investors. Partner investors can also teach a manager by providing perspective on client reporting, transparency, and alignment of interests and, if all goes well, may bring other investors along with them.
A strong return profile, a track record, and a pedigree are just the must-haves to get in the game. They are not differentiators. In a highly competitive asset-raising environment, business sustainability, and all that entails, does differentiate — and is an essential element for a new hedge fund in raising assets.
Katina Stefanova is the founding CEO and CIO of Marto Capital.
