Institutional Investor's Alpha Magazine - July/August 2008 - (Page 38)

Small Hedge Funds the dinosaurs. As we reported in our annual Hedge Fund 100 ranking (May 2008), the biggest funds are only getting bigger. At the start of this year, the world’s 100 largest hedge fund ﬁrms controlled $1.35 trillion, fully three quarters of all hedge fund assets, up from 54 percent as recently as 2003. The market pressures since last fall have been tough on almost all hedge funds, but especially on smaller ones that lack the deep pockets of a JPMorgan Asset Management ($44.7 billion), Bridgewater Associates ($36 billion) or Farallon Capital Management ($36 billion), the three largest ﬁrms in the Hedge Fund 100. “It’s a much more diff icult environment,” says Sam K i r s c h ner, c o -fou nder of MayerCap, a New York–based fund-of-funds firm that has $300 million in assets and specializes in small, emerging managers. In the ongoing market turmoil, small firms that market to the growing mass of funds of hedge funds — JACK MCDONALD, CEO, — which pool money across CONIFER SECURITIES separate single-manager funds — have felt some of the greatest heat, including demands for concessions on fees and “side letters” seeking minimum-return guarantees. Some investors in recent months have even drawn down their accounts in these funds — creating a ripple effect that single-manager funds feel too. Small hedge funds that survive and sometimes even ﬂourish seem to do it by ﬁnding a niche that lets them exploit a competitive edge. It helps to keep operations simple by outsourcing some functions. Staying true to strategy is vital, as is judicious hedging and avoiding excess leverage. “The funds that have survived are hedge funds with real hedging strategies, not long-only funds masquerading as hedges,” says Robert Knox, co-founder and senior managing director of Cornerstone Equity Investors, a New York private equity ﬁrm that invests in hedge funds. Baijal and Vandenhoeck credit Aravali’s survival to its having a specialized investment strategy that uses moderate leverage — borrowing six times capital versus the more typical eight times for other municipal bond arbitrageurs — and sticks with the best credit quality available because lower-rated munis would have triggered margin calls. As a result, says Baijal, the ﬁrm’s investors — most of which are conservative institutions — have remained loyal. “They recognized that similar dislocations in the market, especially the muni market, never lasted long,” he notes, adding that some of them have even committed new capital. “At recent prices the municipal market looked cheap.” Baijal remains bullish on the Aravali strategy: “As the pressures of the banking crisis and subsequent erosion of balance sheets subside, we should experience normalization toward historical relationships, but not without volatility in the interim. Successful funds will be able to take advantage of this volatility to generate excess returns.” Most managers say one of the keys for small funds in hard times is having a solid operational footing. “Investors have been kinder to managers who are focusing on what they do best — investing — and not putting out ﬁres in other parts of the business,” says Jack McDonald, CEO of Conifer Securities, a San Francisco–based provider of middle- and back-ofﬁce hedge fund services. “If you set out to build a business — not simply run some money — and built the business around a good strategy and a good team and did so gradually, your chances of survival are much higher.” Outsourcing some functions may be costly: Fund administrative costs are typically 10 to 20 basis points of total assets (for a $100 million fund, the bill for rent, technical support, bookkeeping and so on can run to $200,000 annually). But doing the same thing in-house at a small fund requires hiring perhaps three full-time professionals. Costs aside, McDonald says, outsourcing “plays to the strengths of a start-up, which are usually stock picking and investment management.” Robert Blum, co–managing partner of Full Circle Capital, agrees: “The survivors are those who set out to build businesses, not simply manage money.” Still, managers like Blum say that in recent months they’ve spent a lot of time with investors doing things like putting “strategies and performances in context.” He adds that the ability to generate alpha is not necessarily held above all else, as it was a few years ago. MayerCap’s Kirschner takes the argument one step further, asserting that size, not performance, is the top contributor to overall hedge fund attrition. The data seems to support his claim: Hedge fund data provider Hedgefund.net reports that funds with less than $15 million in assets — 21.6 percent of its database — have accounted for nearly half of all closings in 2008. Alex Boguslavsky, a MayerCap portfolio manager, says he sees this played out all the time in the small funds in which his ﬁrm invests. They often outperform bigger ones but lack the capital and the infrastructure to withstand market shocks. Sometimes even ﬁrms that manage to survive the ﬁrst few years end up having little choice but to look for a bigger ﬁrm with which to merge. Take the not-all-that-odd case of a fund started by Ralph Rosenberg, a Goldman, Sachs & Co. alumnus who in 2006 set out to build a ﬁ rm to focus on investing in distressed-loan portfolios. Rosenberg put up $20 million of his own money to launch R6 Capital Management and by October 2007 was managing about $300 million but had seen little in the way of success, being up only about 5 percent during his ﬁ rst 12 months in business. The next month he announced plans to merge R6 Capital with the much bigger Eton Park “Investors have been kinder to managers who are focusing on what they do best — investing — and not putting out ﬁres in other parts of the business.” 38 • INSTITUTIONAL INVESTOR’S ALPHA • JULY/AUGUST 2008 http://Hedgefund.net

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - July/August 2008

Institutional Investor's Alpha Magazine - July/August 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Mr. Big Goes Small The Good Guys: Adopt This School! Interview: Man's Great Hope Cover Story: The Gentleman Activist Strategies: The New Bankers Profile: Staying Alive Research Center: The Best of the East The Asian Sensations Alpha Bytes: Into the Light Unhedged: Commentary: Speculating on Washington

Institutional Investor's Alpha Magazine - July/August 2008

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