Book Excerpt: So You Want To Start a Hedge Fund

Of all the challenges start-up hedge fund firms face — hiring the right people, attracting capital, setting up adequate infrastructure — generating noteworthy performance is among the toughest, and it’s only gotten harder over the years. Just ask Ted Seides. A veteran hedge fund investor, Seides co-founded Protégé Partners, a fund-of-funds firm that invests in start-up hedge fund managers, serving as president and co–chief investment officer until his departure in September 2015.

Seides and Protégé’s co-founder, Jeffrey Tarrant, famously made a $1 million bet with Warren Buffett back in 2007 that a portfolio of funds of hedge funds would outperform an index fund tied to the S&P 500 stock index over a ten-year period. (The winner of the bet will donate the proceeds to charity.) Eight years into the wager, Protégé’s fund-of-funds portfolio is lagging Buffett’s index fund by nearly 44 percentage points. Still, Seides thinks backing hedge funds, in particular promising start-up managers, is a risk worth taking. He has recently written a book, So You Want to Start a Hedge Fund, which aims to impart the lessons he learned over the years as an allocator to early-stage managers.

Seides, 45, honed his craft at the hand of legendary hedge fund investor David Swensen, who taught a course at Yale University (where Seides was an undergraduate) and also ran the school’s endowment fund — a job he still holds today. When Swensen mentioned in class that each year he hired one student to work in the endowment office, Seides jumped at the chance. “There was something that resonated in me with Swensen,” he says. “He’s a natural teacher, and he cares a lot about sharing what he knows.” Swensen, of course, created the so-called endowment model of investing, which emphasizes alternative investments in portfolios as a means of hedging out risk and boosting returns.

Seides is frank about the difficulties start-up hedge fund managers face both in operating a new business and managing a portfolio that outperforms — a feat he says is even harder to achieve than it was when he started his firm. His book is filled with case studies of firms that looked amazing on paper but for various reasons never gained traction. One such firm is “Dubuque Capital,” a pseudonym that along with the names of its principals is based on “Field of Dreams,” the book-turned-blockbuster-film about an Iowa farmer who is compelled to build a baseball diamond on his farm. After hearing the film’s famous catchphrase, “If you build it, they will come,” in a dream, the farmer, played by Kevin Costner, follows through despite accusations of insanity, and to his amazement the ghosts of baseball legends, including Shoeless Joe Jackson, show up to play on his field.

In 2005, Ray Kinsella, Terence Mann and Archie Graham launched Dubuque Capital, a long-short, distressed and special situations fund, after working together in research at a large hedge fund. With Ray managing the portfolio and Terence and Archie scouring for ideas, the team made a series of shrewd investments that led to strong results, including shorting mortgage companies in 2007 and 2008. In the summer of 2009, with assets approaching $100 million for the first time, they hired a first-rate marketer and prepared to tell their story to the investment world.

In 2007, Terence sourced a seemingly compelling one-off private deal. For the price of $1 million, the fund could take over a partially built apartment complex with an abutting park. Its previous owner had run out of cash after plowing over $20 million of equity into the project. Dubuque expected that it would need to fund $2 million to $4 million of additional capital expenditures over two years, after which the facility could begin enlisting tenants. Dubuque looked at the investment through its distressed lens and believed it had a unique opportunity to make an outstanding return for the fund with low risk.

Through the first half of 2009, Dubuque had outperformed the overall stock market by almost 140 percent from inception, but the remainder of the year and the beginning of 2010 were a challenging period for the portfolio. Running close to neutral exposure, Dubuque did not participate in the soaring bull markets and flat-lined in the back half of 2009. A few mistakes on the short side hurt returns in the first half of 2010.

Meanwhile, the apartment complex never turned cash flow positive, and Dubuque continued to fund its operating losses in order to keep it alive. Each time the project was slated to turn the corner, another obstacle came in its path. The time to profitability got pushed back by low rent rolls, delayed permitting and a new set of tax ordinances in the town. Dubuque invested several million dollars in the business beyond its initial expectations, bringing it to a 7 percent position after a 2009 write-down, and both Terence and Archie began spending two days each week at the facility, dealing with a host of unexpected issues.

By early 2010, Dubuque had maxed out its private equity allocation at 10 percent of the fund. At that size, the single investment overshadowed Dubuque’s otherwise good returns. Potential investors in the fund saw an eyesore in the private and balked at entering. In light of the disappointing performance in the first half of 2010, the three partners saw no way out of the predicament and decided to shut down the fund in the summer of 2010.

In the run-up to the financial crisis, a number of well-regarded distressed-debt funds looked for creative ways to augment returns from the low yields available on junk bonds. One innovative tactic was a new business called rescue funding (later renamed the more euphemistic “direct lending”). Rather than compete in the primary market, hedge funds started sourcing corporate borrowers on their own to lend directly. The investment strategy ranged from creating loans that would later refinance or securitize to a “loan-to-own” strategy should the business default.

Direct lending in 2006 had a flawed premise that led to disastrous consequences when 2008 rolled around. In 2006 credit markets were wide open for borrowers. With poor underwriting standards, almost any company could find financing. As a result, hedge funds that lent money to companies in dire straits needed to ask the question of how they would exit a loan to a company that no one else would touch during one of the great bull markets for credit. With the possible exception of loan-to-own strategies, these direct loans most likely would never get repaid at par.

Managers that stretched for yield through direct lending were compelled to freeze redemptions at the end of 2008. The direct loans had no bid in the fall of 2008, and managers had no clearing price to mark their portfolio.

Managers should steer clear of private investments in the early stages of their fund’s life. The math simply doesn’t add up, and the positions inevitably result in a poor time allocation for the manager.

Small managers who come across attractive private opportunities should “just say no.” Without establishing credibility among allocators and building a sustainable franchise, the unfavorable risk-reward of a private is too much risk for a small fund to bear.

Focusing on what matters most can help allocators create sensible rules to follow. All too often, allocators impose artificial constraints on their investment universe to the detriment of their investment results.

For example, the liquidity of a manager’s underlying holdings will ultimately determine the ease with which an allocator can exit. So long as the manager’s positions are liquid, an allocator can easily exit a fund without incurring additional losses.

One of the great challenges of starting a new investment fund is the self-fulfilling nature of investment returns. Successful hedge fund start-ups experience a virtuous cycle that comes in part from good luck. A fund’s short-term performance is often attributable in large part to the beta tailwinds of underlying markets or strategies. With strong initial performance, asset growth is more likely to follow. This asset growth, in turn, can create a positive feedback loop, allowing the manager to hire more and better people to improve his organization. A positive psychological state is both conducive to and essential for continued performance, which in turn leads to further AUM growth and resources to build a better business.

Bad luck can make the cycle work in reverse. When even a very good manager launches into headwinds, weak short-term performance may create challenges in accumulating a critical mass of assets. At times, a difficult stretch of performance can shake the confidence of the best of them, and the cycle may turn to a vicious one. For an allocator, herein lies the opportunity. The ability to segregate luck from skill, particularly in the early going, leaves a bifurcated marketplace that may not be separated for the right reasons.

Residential mortgage-backed securities (RMBS) funds have had a rocky history over the past two decades, with fortunes correlating with the U.S. interest rate cycle. In the late 1980s and early 1990s, a handful of funds experienced great success monetizing mispricings in the embedded prepayment option of RMBS products. When the Fed hiked rates six times in 1994, these mortgage funds fell on hard times. After that dislocation new funds like Ellington Capital arose and had a few years of monstrous returns until Long-Term Capital Management imploded in 1998, bringing RMBS and most other spread-based strategies down with it.

Following the most recent financial crisis, in 2008, a number of new hedge funds arose with teams composed of former proprietary traders at Wall Street banks. LibreMax Capital and Seer Capital, led by alumni from Deutsche Bank; Axonic Capital and Tilden Park Capital out of Goldman Sachs; and One William Street from Lehman Brothers all launched around 2009. At the time, the entire RMBS sector was out of favor and trading at deeply distressed prices. These firms opened their doors, put one foot in front of the other and posted outstanding returns. By the end of 2014, each of these new firms managed in the vicinity of $2 billion.

The serendipitous timing of these fund launches allowed every one of them to post among the best returns in the hedge fund industry. It remains to be seen how well these firms will weather a reversal in the interest rate cycle, as history would suggest they will not all survive. In the meantime, the sector as a whole provides an example of the importance of early returns in the successful launch of a hedge fund business.

In a short period of time, Alex Klabin and Doug Silverman demonstrated what can happen when a manager is both lucky and good. Alex and Doug both graduated from Princeton University and started their careers as investment bankers. In 2003 they met at York Capital Management, a multibillion-dollar, global, event-driven investment firm. The pair worked together for five years at York, learning the discipline of value and event-driven investing across global equity and credit markets. They left York in February 2008 with entrepreneurial aspirations to build their own firm. Despite their impressive résumés, neither was known to the allocator community, so they entered into a strategic relationship with a seeder. Alex and Doug launched Senator [Investment Group] in July 2008 with $200 million, mostly from the strategic investor.

Some of the exceptional volatility that would later go down in the annals of financial history started wreaking havoc on the markets around the time of their launch. Senator’s defensive positioning — long the equity of pasta, soup and cereal manufacturers and short the credit of highly levered financial institutions — helped them preserve capital when Lehman Brothers failed that September. Despite finishing the year with a slight profit, Senator had not raised much capital beyond its initial investors.

Alex and Doug made another fortuitous timing decision in early 2009 to expand Senator’s portfolio to a normalized risk level and capitalize on the once-in-a-lifetime dislocations that existed in both the credit and equity markets. Senator posted positive results in every month of 2009. Investors rushed in the door after seeing Senator protect capital in 2008 and pivot to produce a 60 percent net return in 2009. Senator grew to $1.5 billion by January 2010.

Some combination of skill and luck set Senator off on the right foot, and prowess kept them going. Over the five years that followed, Senator generated consistent performance above industry averages, making money for the wave of clients that followed the exceptional 2009. Senator has continued to build on its initial momentum for seven years running. Through a combination of strong performance and measured inflows, the firm has grown every year since its launch and managed nearly $9 billion in assets at the end of 2014.

Luck plays an important role in successful outcomes in both investment management and in life. Had the Fed not staved off the financial crisis and taken down Wall Street proprietary trading, mortgage traders would not have had the opportunity to launch new funds in an environment with an abundant supply of distressed paper. Had Senator started a year or two earlier, it may have been fully invested into the financial crisis or, alternatively, may have been underinvested in periods when other managers performed well.

Luck is what happens when preparation meets opportunity. Each of the RMBS managers and Senator spent their careers prior to launch focusing on the elements of success within their control. They were fully prepared to capture the luck that markets afforded them.

Allocators should be keenly aware of the return drivers behind a fund or strategy’s performance. Postcrisis mortgage funds all worked because a market dislocation presented a broad opportunity to buy cheap mortgage securities. Similarly, activist strategies, a hotbed of activity in 2013 and 2014, benefited from a pronounced U.S. equity long bias. Allocators should consider the ramifications of changing market conditions on the underlying strategies they pursue.

For every example of tailwinds like those benefiting RMBS fund launches in 2009, many more times a surge in interest for a fund or strategy follows a period of terrific performance and leads a softer patch. Market conditions are never as easy in real time as a start-up manager perceives they will be in advance.

The best performance month in a manager’s career inevitably comes the month before his launch. There’s no reason why this happens, but it seems to occur with alarming frequency.

The months preceding the launch of Signpost Capital in early 2012 were exciting ones for portfolio manager Siddharth Thacker. Following his graduation from Harvard Business School, Siddharth worked at Ziff Brothers Investments for five years, where he met each of his three founding partners of Signpost. Though each partner left ZBI at a different time, the quartet re-formed under the umbrella of Citadel’s Pioneer Path and worked together for a few years. After significant planning, the group decided to set out on their own and left Citadel in 2011.

Signpost’s story resonated with many. Its global long-short focus, long-term time horizon, differentiated sourcing of ideas and diligent research process (which harnessed the lessons of history) led to a portfolio of ideas that didn’t look like other funds’. Through prelaunch marketing efforts Siddharth got comfortable that the firm would achieve a critical mass of assets in its initial months, and he turned the team’s efforts toward building the portfolio in the fourth quarter of 2011 to prepare to invest fully upon launch.

Signpost was ready to roll with its paper portfolio as the holiday season came around. However, Siddharth began to sense that investors interested in its Founder’s Share Class were not planning to sit around during the holidays signing subscription documents, so he made the decision to push off the launch by a month.

As Murphy’s Law would dictate, Signpost’s paper portfolio posted a return of approximately 6 percent in the month of January 2012. Rather than launch with a splash, which no doubt would have garnered even more investor excitement, Signpost was left scurrying to refresh the portfolio after a number of its core names reached price targets in just one month.

Signpost performed well enough during the rest of the year to attract a few hundred million dollars, but it never had the chance to post what may have been its best month in January 2012.