By Najy Nasser
According to the English proverb: ‘Hunger is the best sauce.’ In investment terms, those with the most to gain from strong performance, work hardest to achieve it. Hunger can, therefore, be a strong source of return. When it comes to harvesting the ‘hunger premium’, getting a headstart enhances the opportunity further.
Research shows managers tend to perform best during their early years. Very hungry is very focused, not just on posting strong returns to attract investors, but also on managing risk. A drop in performance will be felt more profoundly by an emerging manager trying to attract capital than an established firm. Smaller funds are also more nimble, allowing them to more quickly and dynamically move assets, and can more easily exploit opportunities before crowding diminishes the return potential.
The hunger premium is particularly strong where an emerging hedge fund is led by a highly experienced and seasoned portfolio manager who previously worked at a larger hedge fund or banking firm. These managers, which may previously have managed billions of dollars, combine the experience of tenure with the nimbleness of managing considerably fewer assets under management.
Getting a headstart
Smaller, more nimble funds of hedge funds are better placed to exploit the hunger premium by getting a headstart in building relationships, securing capacity, accessing founder share classes and negotiating better fees.
Many large $5bn funds of funds looking to allocate a 5% position (i.e. $250m) are effectively ruled out of investing with emerging managers where their holding would represent more than 10% of a hedge fund’s total AUM. This ‘critical mass’ continues to increase, driven by increasing industry assets, the growing regulatory burden and demand for institutional-level infrastructure. Larger funds of funds tend to wait until a fund can demonstrate at least six months’ track record and has assets in excess of $100m. Because emerging managers are less able to absorb capacity, smaller allocations (often around $10m) are rarely worth the time and effort involved for larger funds of hedge funds to conduct the necessary due diligence and manager research.
Smaller funds of hedge funds have an edge in harvesting managers’ strong early years because they do not suffer the same structural constraints.
The more capacity constrained a strategy is, the bigger the advantage of a headstart, as the performance potential of a manager may be significantly depleted by the time they hit the radar of large funds of hedge funds.
Long term benefits
The advantages of a headstart are not short-lived.
Hungry funds are more willing to negotiate on fees. Investing from day one often opens the door to founders’ share classes, where managers offer a certain amount of capacity at lower fee levels, which are maintained for the life of the initial investment. This can have a substantial impact on performance over a prolonged period. For example, where a hedge fund returned 15% net of a 2% management fee and 20% performance fee, early-bird investors who secured fees of 1% and 10% would receive a net return of 17.78%. Compounded over five years, lower fees enhance returns by 25.47%.
Furthermore, future capacity can often be secured during initial negotiations. Even where it cannot be contractually secured, managers tend to prefer investors with whom they have a strong relationship, especially those who showed support early on. This often allows early-bird investors to opportunistically add to allocations even in closed funds as there is virtually always a limited amount of rebalancing by other investors, or funds may need to take in a limited amount of capital to cover costs.
Harvesting the hunger premium
While the ability to harvest the hunger premium requires a nimble, entrepreneurial decision-making process at the fund of funds level, identifying genuine and sustainable talent in a world of increasing dispersion requires experience and strong industry relationships. These attributes can only be gathered through tenure and the knowledge born of investing in emerging hedge funds through several market cycles.
Combining a nimble, yet experienced manager selection process with risk-conscious, performance-hungry emerging managers can yield significant results in terms of performance and downside protection.
Najy Nasser is chief investment officer of HeadStart Advisers
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