When asked to evaluate the factors critical to launching a hedge fund, managers are certain to focus on two key areas: investment performance and raising capital.
This is confirmed by a survey of 188 general partners at start-up hedge funds, conducted in the first quarter. Participating hedge funds had average assets under management of more than $63.2 million, with the AUM totals ranging from $42 million to $131 million, and were five years old or younger.
The general partners were nearly unanimous in agreeing that performance and raising capital are of paramount importance at inception. Unfortunately, the research also suggests that the early-stage focus on investment management and capital raising may lead some managers to overlook other important start-up components (Figure 1).
For example, about a third of respondents consider it extremely important to attract and retain talent. However, at this point in the life cycle of a hedge fund, much of the talent is motivated because of their current or potential position at the growing fund. About three in 10 consider managing investor relationships as critical. One in five point to cybersecurity, while about one in 10 highlight accounting and administration. These findings likely reflect a near-term need to prioritize functions and selectively deploy available resources as the fund raises capital and establishes a track record.
The First Two Years
Hedge funds launch with capital from a variety of investors, such as the personal funds of the general partners, friends and family, and key investors.
However, survey responses regarding anticipated sources of capital over the next two years suggest general partners will rely heavily on investments from personal and professional networks during the formative stages of the fund (Figure 2). About seven of 10 general partners surveyed plan to seek funds from business associates, and a similar number expect to turn to friends and family.
Nearly two in five general partners are seeking more money from family offices. Previous research has shown that many family offices are strongly interested in new hedge funds. However, accessing these boutique money management organizations can be a steep hurdle, as the family office universe, while growing by leaps and bounds, is often intentionally opaque.
A substantial minority of hedge fund general partners expects to source capital from family offices. However, most new funds are not immediately planning to seek funds from investment professionals or institutional sources such as pension funds, endowments and foundations. This is a realistic and necessary approach for most new funds. Despite increased anecdotal and documented interest in “smaller” funds among these investors, they tend to shy away from funds without an established performance history.
The situation changes dramatically as hedge funds approach maturity. After the first two years, the chart is essentially inverted, with institutional investors replacing personal and professional networks as the most likely sources of capital (Figure 2).
What is clear is that the general partners of these hedge funds are looking to leverage their existing networks to raise capital. Few expect to initially be in a position to effectively approach many institutional investors. However, that scenario changes after two years.
Leveraging Networks
How effective general partners are in leveraging professional and personal networks to raise capital can depend on the strategies and tactics they use. Only 18.1% of respondents are employing a systematic process to identify and leverage these relationships. The more common approach is being opportunistic rather than relying on a regimented, goal-driven methodology.
Meanwhile, 43.6% of the general partners report that they customize their presentations to each individual prospect. The majority relies on the same presentations to explain their hedge funds’ investment philosophy, styles and so forth.
What can prove beneficial in raising capital when leveraging professional and personal networks is to take a highly systematic approach to maximizing the value of the networks and communicating the benefits of investing in the hedge fund.
A case study of one fund-raising effort sheds some light on the process. The scion of an exceptionally affluent family worked in the family office and planned to launch a new hedge fund. He planned to assemble the investment team and manage assets, with seed capital of about $40 million from family members. This individual was responsible for raising an additional $160 million from external sources.
After about six months of knocking on the doors of institutional investors, third-party marketers and people he knew, he hadn’t brought any money to his hedge fund. This lack of success led to the adoption of a capital-raising approach based on a bespoke street-smart networking methodology. The following is an outline of the networking approach employed:
Preparations. Before approaching anyone, three actions were taken:
1. His very extensive list of contacts was evaluated and high-potential individuals were identified.
2. A customized assessment instrument was developed.
3. A “template narrative” was constructed.
Evaluations. Using the customized assessment instrument, likely investors were assessed from his high-potential list.
Solicitations. The evaluations, coupled with the template narrative, resulted in individualized narratives for each “probable” investor.
This approach raised capital for the hedge fund and led to introductions to other potential qualified investors. The hedge fund closed having raised about $500 million (including seed capital), an amount way beyond what was originally thought possible.
What is critical to understand is that the success of this capital raising was mostly a function of the inheritor’s extensive, powerful and unrecognized personal/professional network. Admittedly, this is an extreme case that was chosen to emphasize the power of having a systematic process to leverage relationships for raising capital.
Many hedge fund general partners likely have extensive networks that can also be similarly monetized. However, as noted, few are approaching the matter in a systematic way. For example, while usually overlooked, it is often vital for the general partners to identify and consider second-order and third-order relationships (i.e., the contacts of one’s contacts), and not just the people they directly know. Long-term success is often dependent on their ability to customize the positioning of the hedge fund depending on the needs, wants and preferences of each prospective investor.
Beyond The First Two Years
Going out beyond the first two years, the expected sources of new capital shift dramatically. It tends to move away from professional/personal relationships to institutional investors (Figure 3). This is a function of:
• The expectations of having “tapped out” professional/personal relationships.
• Having the size (i.e., assets under management) and investment performance track record that makes the hedge fund attractive to institutional investors.
• The level of interest in obtaining more sizable “chunks” of money to invest.
More than three-quarters of the general partners expect to be able to source funds from pension funds. Two-thirds see endowments and foundations as viable sources of capital. Also, slightly more than half are expecting to work with third-party placement agents, fund-of-funds or capital introductions professionals.
Family offices, meanwhile, are seen by a larger percentage of general partners (about seven out of 10) as high potential source of funds. With the number of family offices rapidly multiplying and their increasing institutionalization, more hedge fund general partners are seeing them as very good sources of new capital. As previously noted, a major complication for hedge funds is accessing family offices.
The most commonly identified sources of new money—business associates, friends and family—become significantly less important to most of the hedge funds. The same can be said of the clients of investment professionals.
This shift to the expectation of institutional capital raising is dependent on the anticipated success of the hedge fund over the previous two years. However, if the agendas of the general partners are achieved in those two years, the groundwork is set to gather significant money from pension funds and institutions.
