Getting Past the Gate: Capital Introduction at Prime Brokerage Firms

Actually, I think I will go ahead and at least do a "Section A" for Part II this afternoon, because a big part of my whole premise for starting this thread is that learning how to get to the capital introduction stage will also help one get off the ground in the first place past the seed stage.

Maybe I'm putting the cart before the horse here--I don't know--but in any case, this would be the life cycle stages of development for an aspiring hedge fund.


II. STAGES OF HEDGE FUND DEVELOPMENT

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A. Four Stages of Hedge Fund Development

Stage 1. Launch and Initial Fundraising, represents the very early days of a fund's development, including the prelaunch activities of securing initial investment capital. The types of investors are typically individuals known personally to the manager or seeders which require only a baseline of institutional preparedness.

Stage 2. Getting Beyond Retail, should also take place relatively early in a fund's lifecycle, ideally within the first 180 days. At this stage, managers have established a groove, the fund is functioning well on a day-to-day basis, core personnel and systems are in place and the fund has established clear marketing materials for targeting entry level institutional investors.

Stage 3. The Institutional Threshold, represents a significant hurdle for most funds. At this stage, managers have received several small institutional commitments, perhaps from family offices, consultants and third-party marketers. Now they are ready to break into institutional investors who will require significantly more during the due diligence process.

Stage 4. Major Institutional Fundraising, is only attainable once the manager is able to articulate their "edge," adhere to best practices and demonstrate a significant track record of repeatable performance with minimal volatility. Even when all these conditions are met, getting institutional capital is difficult and takes significant time. In today's environment, institutions can take many months reviewing a small number of funds and ultimately pass on most of them. When they do commit, however, these investors typically bring significant capital to the table.

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Now I know that securing that initial investment capital will be the hardest part. This is where you need to tap into the following categories of potential investors: "Partners, Friends, Family, and Angels"; "High-Net-Worth Individuals" (HNWI); and "Seeders and Acceleration Capital."

So if you are a person without many connections to rich people with a lot of free money to invest, then it seems that it would be impossible to start up a hedge fund without actually having investing experience at a hedge fund. (Some academics have set up their own hedge funds based on academic theories and their own research, but I seem to remember reading that these don't have that good of a track record.)

So then the next question to ask would be this: Could a person, after just a year or two at a good hedge fund, manage to assemble a team together and make a pitch to investors to get a new hedge fund up and running off the ground? If a person did enough academic research on options pricing strategies for asset classes with peculiarly fat-tailed risk distributions, would it be possible to bypass the need for experience at an actual hedge fund, and perhaps form a small team (one person with marketing skills, and another with actual hedge fund experience, etc.) to help get a new firm off the ground? What would be the minimum amount of people needed to get such a new hedge fund up and running? How many lower associate hires, if any, would be needed?

These are just some thoughts I've been kicking around in my head lately...

II. STAGES OF HEDGE FUND DEVELOPMENT

A. (cont.)

The range of investors:
(from least "institutional" to most "institutional")
1. Partners, Friends, Families, & Angels
2. HNWIs
3. Seeders & Acceleration Capital
4. Managed Account Platforms, SMAs, First-Loss Capital
5. Funds of Funds
6. Family Offices
7. Consultants & Third Party Marketers
8. Foundations & Endowments
9. Pensions (Public & Corporate)
10. Sovereign Wealth


B. Investor Due Diligence & Preparing to Market

It seems the big idea here in recent years is to realize that investors have become more demanding of hedge funds that are trying to solicit capital, especially in terms of the sophistication of their quantitative analysis of projected performance.

Traditionally, a hedge fund pitch for investment was focused around giving a basic spiel about the 4 P's: people, process, philosophy, & performance. The first 3 are definitely still important, but the gist of recent developments in the industry seem to be that traditional performance analyses no longer cut it, and more advanced forms of performance analytics are now mandatory for attracting savvy sources of capital.

So before, knowing (i) your performance relative to an appropriate equity index, (ii) your gross and net, & (iii) calculating your beta and alpha, pretty much covered your bases. Now, there are more sophisticated benchmarks to measure against, delta-adjusted exposure to measure, advanced regression analysis, relative attribution calculations, etc.

To prepare to market, you have to learn how to put together a pitch book in the standard way, and be ready to answer all the questions that you know potential investors will throw at you.

Above all, you have to be able to make a convincing argument as to why you have alpha, and why anyone should believe that your process for generating alpha (more on that in the next part of this series) is repeatable. You have to assure potential investors that you are measuring risk accurately, that you are adopting best business practices, that you have successfully harmonized a team of truly outstanding partners, and that your hedge fund is not overly reliant on any single person.

Then, you have to also go over all the biggest weaknesses that your particular strategy has. You have to know your competition, and you have to be able to explain what types of investors should NOT be seeking your investment services.



Note that all of the above assumes a year or two of investing performance already in the books, so the game is different trying to get off the ground with seed capital versus trying to make the jump to more institutional forms of capital with the "capital introduction" process. Nonetheless, even before jumping to the next level, these things would probably be helpful to do work on even before investments start on Day 1.

Looks like it was from Tuesday: LINK.

It illustrates a few moves at the smaller end of the private equity sector that we had been talking about not too long ago, with Bushnell's acquisition of Primos Hunting: "In 2012, with 140 employees and revenues approaching $60 million, Will Primos sold his company to Bushnell Outdoor Products."

Apparently MidOcean Partners was the private equity firm that handled the deal: LINK.

And then Bushnell went and got itself acquired by Alliant Techsystems in September for $985 million: LINK.

And, yeah, the Q&A section does illustrate the more general point about how being introduced to more institutional forms of capital (such as from a Morgan Stanley or a Merrill Lynch) can lead to much more efficient ways to raise money...

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Q: How about financially?

A: I had about $1 million in sales in 1989, but wasn’t making money. I grew debt like crazy because I kept seeing opportunity, buying equipment and building facilities. My growth rate was over 25 percent a year, 100 percent in 1995, but you can grow yourself into bankruptcy. Sometimes you have to hold back. By 1999, I owed the bank $13 million and went back for a $10 million line of credit. I got debt free by sacrificing.

Q: What was your best business decision?

A: Moving our borrowing to Merrill Lynch where money was much cheaper than bank loans.

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Guess I have Morgan Stanley on the brain.

(My broker at Raymond James recommended MS when it fell to 12. Raymond James employees are forbidden to buy MS, so he gave me the tip on the down-low. He said it will hit 35 easy. Today it hit 36.)

III-A. Hedge Funds and Hidden Beta

There were a few links I remember reading about this online that I haven't been able to find this week, and although that's been really aggravating, it's not really a big deal, because the basic idea here is pretty simple--hedge funds tend to hide their true level of investment risk (producing hidden beta, or "alternative beta"), thus making their alpha (i.e., their returns generated by investment skill over and above what an efficient return should be for the same level of investment risk) seem much higher than it really is.

Google "hedge fund clone/cloning" and you'll see lots of interesting links about how many academic researchers think it may be possible to replicate hedge fund returns, which are more due to hidden beta rather than true alpha. (There is also a Wikipedia entry on " hedge fund replication," although it is rather minimal.)

One of the most cited papers in this field is by Jasminah Hasanhodzic & Andrew W. Lo. Of note is that Lo published a book back in 1999, " A Non-Random Walk Down Wall Street," which was a sort of very technical rebuttal to Burton Malkiel's more famous book.


Jasminah Hasanhodzic

In any case, it is now a well established truth that hedge funds tend to produce most of their eye-popping returns through various methods of hiding their true level of risk. Jaeger & Pease seem to have the most popular book on this subject at the moment on Amazon, although other academics like Jens Jackwerth have also studied the issue in depth.

Without going into any detail (which I must admit to having not studied up on myself), these are the categories of hidden risk listed by Jaeger & Pease:

-- roll yield risk
-- commodity hedging risk
-- volatility risk
-- convergence risk
-- complexity/efficiency risk
-- momentum risk
-- value risk
-- FX carry risk
-- term risk
-- credit risk
-- EmMa risk
-- duration (bond) risk
-- equity risk

So please don't ask me what any of that means right now (the author claims that only the last 2 categories typically apply to common investors), but you know... I think you can get the gist of what's going on here.

quote:

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Chris Farley

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Thank you! This is just the type of stuff I was hoping to hear, although obviously a lot of this thread is self-study and me getting thoughts in my head into concrete form.

If you don't mind answering, I have a few follow-up questions to that:

(1) Can you tell me anything about the failure rate at certain levels of starting capital? For example, is the failure rate above 50% for those who start with $20 million in AUM? Does it drop to a different level for those funds that start out with $50 million AUM? What's typical for startups?

... and here is the biggest question really...

(2) For someone who goes to work for a major hedge fund, how difficult is it to get sponsored to be a general partner of a spin-off?

and finally...

(3) Could you give a rough ballpark estimate for what the substantial upfront cost is for getting out in front of the process for attracting institutional capital? For example, say you manage to get a startup hedge fund off the ground with $15 million in AUM--how much money would it take to start getting your hedge fund ready to take the next step to attract more institutional investors?

Curious. If you plan on starting one of these firms, will you make available share loans of shares not commonly available for borrowing? Direct swaps? I'm assuming to accredited investors.

Thursday, December 18, 2014


As I return, I present to you my favorite quote of all time:

Billy: You remember the stories John use to tell us about the the three chinamen playing Fantan? This guy runs up to them and says, "Hey, the world's coming to an end!" and the first one says, "Well, I best go to the mission and pray," and the second one says, "Well, hell, I'm gonna go and buy me a case of Mezcal and six whores," and the third one says "Well, I'm gonna finish the game." I shall finish the game, Doc. ( LINK from Young Guns II)




Picking up from Section III...

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III. STRATEGIES FOR GENERATING ALPHA

A. Hedge Funds and Hidden Beta
B. High Frequency Algorithmic Trading Strategies
C. Other Quantitative Strategies: The EMH vs. Fama-French & Shiller's CAPE
D. Recent Work of Clifford Asness and Others
E. Current Trends

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III-A. Hedge Funds and Hidden Beta (revisited)

I wanted to return to this sub-category for a bit due to a really interesting piece Clifford Asness of AQR Capital wrote on his hedge fund's website on October 24, " Hedge Funds: The (Somewhat Tepid) Defense." There have certainly been a lot of articles in the financial media over the past couple of years decrying the sub-par performance of hedge funds in recent years, such as by that arrogant blowhard Barry Ritholtz. Asness, however, rebuts the argument quite well, and explains from basic points of portfolio theory why hedge funds are still a quite useful investment class, despite the apparent lack of alpha given the level of beta in recent years. Specifically, he notes with very useful charts the correlation part of the equation that critics like Ritholtz miss, and shows that although, yes, hedge funds oversell their ability to generate alpha, there is a huge service to investors for them being able to generate whatever paltry levels of uncorrelated alpha they are still able to do.

III-B. High Frequency Algorithmic Trading Strategies (revisited)

I was going to revisit this sub-section to illustrate a link to a QuantNet thread highlighting pros and cons to using Fortran vs. C for algorithmic programming, which just tickled me pink because I learned to code using Fortran in high school, but somehow I can't find the link anymore, and I guess it's not really that relevant anyway... just something that was personally noteworthy to me in a funny kind of way.

III-C. Other Quantitative Strategies: The EMH vs. Fama-French & Shiller's CAPE

You know, there are a bunch of different approaches one could take to this topic, but at the risk of going to the same well too many times, I will once again defer to a recent piece by Cliff Asness, because his December 17 post on this subject, " Our Model Goes to Six and Saves Value From Redundancy Along the Way," addresses cutting-edge research on this topic so well, and in such a widely accessible way to the general (somewhat sophisticated) investing public, that you really can't do any better.

In particular, he focuses on recent (September 2014) academic journal publications of Eugene Fama and Ken French on their famous three-factor model, which everybody learns in business school, and which they now expand to a five-factor model. Hence the Asness title about taking the five-factor model to 6 factors, since the entire career of Asness is mostly based on his PhD thesis research on the use of momentum as a valid factor in this model, and explaining to all who will listen how it is best used in conjunction with the value factor due to the benefits deriving from the negative correlation of the premia from those two factors under differing macroeconomic conditions. Really cool stuff.

III-D. Recent Work of Clifford Asness and Others

Because I just cited Asness twice to make points in 2 of the subsections above, this is now mostly irrelevant, although he has made quite a good living from his original PhD thesis that value and momentum work best as investment strategies when used in tandem. In any case, I highly recommend reading his Cliff's Perspective section on the AQR Capital website, which is similar in a way to Bill Gross's monthly outlooks, except that Cliff's is much more quantitative, high-brow, and educational with regard to the elite levels of sophisticated hedge fund investors.

As for "others", well we just covered Fama & French above too, and most everything else besides that (at least on the quantitative side of things) is algo trading, which is just not that interesting to me.

On the activist side of things, Ackman & Icahn & Soros offer some interesting perspective. From Ackman, that he is better at what he does than what you might suspect by reading how the financial media portrays him. From Icahn, that shareholder democracy is a false ideal. From Soros, that many great investors purposefully make profits by riding momentum on the upside of bubbles, knowing full well that the underlying assets are being mispriced for the long-term by the transitory investing environment.

III-E. Current Trends

You know, the more I think about it, the more I realize that I just don't understand a lot of what goes on in the industry, most especially what goes on related to short-term trading prop desks. I know that several of the posters here are traders of some form (a few energy traders, right?), and there are interesting stories out there (see e.g., how Andrew J. Hall managed to make money in 2014, despite being long oil LINK, because he was also long on the US dollar), and there are great historical stories and advice, like how George Soros won big betting against the Bank of England on the value of the British pound (and about how Soros claims that betting WITH bubbles on purpose during the run-up is how he makes a good bit of his profits), but really, prop trading is still a foreign world to me.

But I do understand basic trends and concepts related to the trade, such as the carry trade related to the Japanese yen, and event-driven M&A investing, or activist investor LBOs (a topic near and dear to my heart, especially as it relates to dudes like Carl Icahn, Kirk Kerkorian, and William Ackman), and I do certainly recognize the current bloat in the hedge fund industry.

Regarding the current bloat, and the concomitant sub-par returns that we have been witnessing in the industry, it seems clear that a major shake out is in the cards, whereby the wheat will be separated from the chaff, and a lot of clown impostors will go bust once the era of disinflation and easy money starts to come to an end. That much is well known.

What is (slightly) less well known is the degree to which the big fish are eating the small fish in the hedge fund world. So not only is the industry bloated and producing a lot of mediocre funds, but there is also a clear trend towards superior alpha being generated by the behemoths of the industry rather than by the smaller fish. Does this mean that being nimble and imaginative and fresh will no longer work going forward? I wouldn't say that, but it does give me pause as someone who is trying to break into the hedge fund industry as a small-time entrepreneurial player. The data seem to be saying that the world already has enough people like that as it is.

Wednesday, December 31, 2014

I've come a long way in the past year. I remember in mid-December 2013, when it first started to dawn on me that the living expenses stipend from my super awesome elite thesis sponsorship was not going to come through for me as I had anticipated, and I was totally crestfallen. I scrambled frantically for a way to find another part-time job, but things were just not breaking my way, and so I had to accept temporary defeat and take the first job I could get in Houston before moving onto the next city. I remember talking about the situation to someone back when everything was going down, and somehow my imagination started to take over, and it kept bringing me back to the famous quote Gen. MacArthur made as he escaped from the Philippines in 1942.


"The President of the United States ordered me to break through the Japanese lines and proceed from Corregidor to Australia for the purpose, as I understand it, of organizing the American offensive against Japan, a primary objective of which is the relief of the Philippines. I came through and I shall return." -- General Douglas MacArthur, March 21, 1942 ( LINK from Melbourne)


And return he did, on October 20, 1944.


Will I ever return to Switzerland to get my blue chip M.Sc. quant degree? I don't know.

It took MacArthur 31 months to return to the Philippines, but he was an arrogant prima donna, and sometimes it's best in life to simply walk through the right open doors and take whatever opportunities arise. Somehow I did manage to talk my way into landing a job as a quant at a top bank in the U.S., and perhaps with my career starting to take off, maybe I will find a way to shift into the hedge fund world without needing an actual quant finance degree, and never look back. Or maybe I'll just stay put for once in my life and learn to be content without always looking for the next place to jump. Honestly, I have no idea where I'll be in a year, but at the same time, things are looking up, and there are a lot of different possibilities out there. I think I'm too worn down from the last 4 years or so of my life to call any of these possibilities "exciting" anymore, because I know now that everything is a grind, but I'm glad to have them nonetheless, and I think that it was my praying and going to mass every week that helped me most during the hard times to help me get where I am now. As things stand my life is still wide open, and new people and career options keep getting dangled in front of me every other week, and for that I should be thankful--feeling a little frayed and burned out maybe, but definitely still thankful.

If I can say anything about the process of creating this thread, it's that I am more at peace with my efforts up to this point in my life. Whatever happens, happens. I'm just glad to be where I am right now, and although the topic of hedge funds is starting to get a little old, unexciting, and boring to me now, maybe that's a good sign. If I'm going to transform myself from being a slacking dilettante to being a legitimate professional, "taking the romance out" of my field is definitely a necessary first step. Mission accomplished.