Challenges hedge funds face

Challenges Hedge Funds Face When Raising Capital

Challenges hedge funds face

Hedge fund managers face a challenging market when it comes to raising capital. Several factors contribute to this environment, such as: a fragmented marketplace, an ever expanding qualified global investor base, a lack of a clear sales and marketing strategy, and regulatory constraints. There are also several options hedge funds can consider when raising capital. These include the use of a third-party marketer, attending conferences and cap-intro events, and hiring investor-service consultants to pinpoint qualified investors. Taking hedge fund seeder capital and using digital investment platforms can amplify offerings to a broader network of investors. Below we dig deeper into some of these challenges and share potential solutions.

A Fragmented Marketplace

The marketplace is becoming increasingly fragmented with large funds receiving the bulk of investor capital, while new and emerging funds are simultaneously growing in number. Oftentimes, institutional investors make allocations to more established hedge funds. Track records, a solid infrastructure, and established partners in compliance and risk control are increasingly important to these investors. For new funds, the biggest challenge is getting off the ground and raising capital. Since the financial crisis, investors are more skittish about fund allocation. Calpers recently pulled out of hedge funds altogether citing high fees and lack of performance as some of the reasons. However, the established trend is for institutional capital to continue flowing into hedge funds.

Due diligence is also becoming more involved and time-consuming for managers. Investors increasingly scrutinize every aspect of the business. Additionally, a more cumbersome due diligence process requires a fund to have a well-conceived market plan. How do funds differentiate themselves? The competition is fierce. According to a BarclayHedge study, small funds under $100M represent 60% of the hedge fund universe in terms of the number of funds. In the most recent Citibank hedge fund industry snapshot, large funds over $500M represent over 76% of total assets. Smaller funds face a selection bias, as large funds flood the market with powerful distribution networks and well- financed institutional clients.

An Expanding Qualified Investor Base

With the growing wealth of emerging markets and increased interest from U.S. investors, there is an expanding investor base. The biggest challenge is targeting those appropriate qualified investors. With institutions increasingly allocating to large funds, smaller funds compete by targeting specific markets interested in their unique strategies. Fund managers have to understand what makes their fund compelling, and ultimately differentiate themselves from the competition. This can be a challenge for managers fundraising for niche funds. Inherently, niche funds have a smaller potential investor base. With growing market wealth, a fund must have an understanding of how to structure and accept foreign investment capital, which can be expensive for new funds as it requires complex legal expertise. A growing foreign investor base creates a complex environment for managers when competing for overseas investors.

A Lack of Market Understanding

Raising capital is challenging due to the ever increasing complexity of the hedge fund marketplace. In order to compete, a fund needs a valid value proposition targeted to potential investors. Many managers make the mistake of forming a concept first without a clear sales strategy. There must be an understanding of the demand for the product in order to know how and where to sell it. This affects pricing and structure. Costs must be calculated, plans vetted, and an infrastructure and sales team should be put in place to execute the strategy. This is an expensive undertaking.

Institutional investors are also demanding institutional infrastructure, ensuring that the fund is a safe place to park their money. Additionally, in order to raise capital from a sophisticated investor base, managers need to convey in a transparent manner how their performance and alpha generation are repeatable in all market conditions. With fierce competition and an increase in options, there’s been a general downward pressure on industry management and incentive fees. According to the latest HFR Market Microstructure Industry Report, average management fees for funds declined 3 basis points from the prior year to 1.51%. Average incentive fees declined 40 basis points to 17.8% in 2014. This creates another challenge for fundraising as investors are increasingly scrutinizing fee structures.

Changing Regulations

Changing regulations, particularly the ability to advertise funds (the lifting of the ban on general solicitation) publicly under regulation D rule 506(c), has created increased transparency but also increased competition. This not only opens up a different potential audience for funds, but also presents a unique set of challenges. The marketing aspect of advertising a fund through digital channels and print can be costly. This aspect of fundraising requires a different skill-set typically associated with an investor relations or hedge fund marketing professional. In addition, a fund that is using general solicitation needs to adhere to stricter requirements pertaining to investor verification, which can be costly. The Dodd-Frank Act, passed in 2010 in response to the financial crises, has significantly increased the cost of compliance. When funds become a certain size, over $150M, they are required to register with the SEC. This sometimes puts an onerous compliance burden on some fund managers. Being a registered investment advisor, however, increases the chances of attracting institutional capital, since many institutions have a mandate to invest with funds over a certain AUM. This is a classic chicken or egg issue for emerging funds that can’t get recognized without reaching a certain AUM, but can’t get to a certain AUM without being recognized.


Potential Solutions

The ability to raise capital through digital channels has proliferated since the passage of the JOBS Act. Now funds can advertise online to potential qualified investors. Challenges remain in this opaque hedge fund marketplace, but increased access will result in more transparency. Hedge funds can utilize alternative investment platforms to create visibility through a targeted network of investors. Additionally, funds can utilize a third-party service with access to a wide range of investor contacts with information about their investment preferences. This is valuable information to target specific investor groups interested in certain strategies. For example, it would be valuable for emerging managers utilizing distressed asset strategies, or established macro funds run by women or minority managers to know specific investor groups interested in their investment thesis. Networking and conferences are still building blocks to create investor networks, and with successful returns a fund can build additional investor networks through positive referrals. Hedge fund seeding is becoming a great way for a fund to take a longer-term business and investment approach. With an increase in operational expenses it’s difficult for funds to get off the ground. With seed capital, investors participate in injecting startup capital into a hedge fund operation. The fund will use the capital to build out infrastructure and lay the groundwork to be able to attract investors more effectively. The investors in the hedge fund seeder will typically get economic participation in the fund’s future earnings. In a crowded marketplace dominated by larger players, each of these tools should be considered as a potential fundraising strategy.

 

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