This interview originally appeared in Forbes on May 2, 2016.
Have you ever wondered what it would be like to run a hedge fund? Hedge funds are both glamorized and villainized by both popular culture in TV series like “Billions” and on the political and legal arena by recent high profile lawsuits by activist investors like Bill Ackman and Carl Icahn. However, for most hedge fund start-ups, the reality is far from glamorous and requires a huge amount of work and unwavering commitment. Nancy Davis, the CIO and founder of Quadrant compared starting a hedge fund to “a very expensive hobby.” Hedge fund start-up founders should expect to put a significant amount of personal financial capital as well as sweat equity into the business for at least a year before seeing any return on their investment. Most hedge funds are small and have a hard time scaling: according to Hedge Fund Intelligence, only 305 hedge funds out of the 7,500 comprising the universe manage more than $1 billion. In other words, it no longer takes two guys and a shingle open shop. The high-level of competition, regulatory scrutiny and investor due diligence is actually good for investors and for the few committed hedge fund entrepreneurs who are passionate about markets and building a business.
Unlike tech founders, hedge fund founders have few resources to rely upon when starting a hedge fund. Thus, when I read Ted Seides’ book “So You Want to Start a Hedge Fund,” I was excited about the wealth of lessons learned he has shared with prospective hedge fund entrepreneurs. I recently had the opportunity to sit down with Ted and discuss his book. Ted is uniquely suited to this topic because he’s seen so many new managers as an allocator (the term used for institutional investors) at one of the most successful endowments (the Yale University Investment Office) and as a co-founder of a successful hedge fund of funds.
In a nutshell, we both see some interesting things happening that suggest the industry is at a significant crossroads for both hedge fund managers and investors. Asset growth is slowing. Competition is shifting from industry-wide growth, grabbed from traditional asset classes, to market share capture between hedge funds. Low cost ETFs and index funds are capturing market share and have grown from 10% of total asset under management (AUM) in 2000 to close to one third of total AUM in 2015, according to the Boston Consulting Group. Further, recent mediocre performance for the sector as a whole has everyone looking for answers. For example, NYC Employee Retirement System recently decided to fire their hedge fund managers, with one critic of the NYCERS portfolio famously announcing in the news: “let them sell their summer homes and jets.”
Size notwithstanding, there is a real demographic challenge for the industry, too. Many of these large funds are overseen by a founder (or founders) who created real wealth for themselves and are approaching retirement. In fact, firms with leaders over 60 years old manage one-third of the assets in the industry and those with principals in their 50’s comprise another third. Some of these big funds will not survive their founders’ departures, suggesting that large investment allocations may get shifted to different managers.
With this landscape in mind, Ted and I see opportunities for rising stars and for allocators facing “retirement risk” in their existing portfolio.
Q: Ted, why did you decide to write this book?
A: Over the years, I met with hundreds, probably thousands, of start-up asset managers. From my first days in the business working for David Swensen at Yale through the last decade and a half at my prior firm, I spent nearly all of my professional career analyzing and investing in early stage managers.
Managers regularly came to me seeking advice when preparing to set out on their own. I tended to say the same thing over and over, yet it always was new information to the first-timer. I realized that I had acquired a body of knowledge from the many lessons I had learned that could be valuable to many.
And I had similar conversations with my fellow allocators – what lessons had we collectively learned that suggested a new manager could break through to success and sustainability?
I decided to write down some of the familiar lessons and share the knowledge as broadly as possible across the industry. My hope is that both allocators and managers can get a leg up on understanding the patterns of success that others have experienced before them.
Q: What kind of lessons did you write about?
A: I steered clear the actual logistics of starting a fund and instead offered a few pointers across capital raising, team building, strategy creation, performance mindset, and effective allocation.
For example, most managers are very focused raising capital, naturally. So I wanted to give them some insight from an allocator’s perspective – who will allocators see, what generates interest in a fund, and how do you move that interest into real investment capital.
Interestingly, the team dynamics get less attention, but may have a bigger impact on long term success. I talk about characteristics of great teams and some common mistakes managers make when building out their organizations.
In general, I try to focus my advice on aspects of the start-up process that are common sense, but not common practice.
Q: What are your top five pieces of advice?
A: 1) Play to win
If you’re going to take the leap to start a fund, you can’t expect to succeed with “a guy, a Bloomberg and a dog.” That may have worked ten or twenty years ago, but it won’t work today. Competition with the big boys is fierce, regulation is more onerous, and allocators are more sophisticated than ever. Those taking the leap need to be prepared to invest real money, time, sweat and tears in the business for a number of years to have a fighting chance to win.
2) Be as thoughtful about the business as you are about managing money
Managers tend to be well schooled in investment analysis and portfolio strategy, but often are naïve about the time and effort required to build a business. Allocators often don’t appreciate all of the challenges a start-up manager will face either. Creating a clear business plan that lays out the path to success forces managers to consider crucial growth plans and helps allocators calibrate expectations should the manager encounter bumps along the way.
3) Clearly define roles in the organization
One of my favorite mistakes is the creation of “the two-headed portfolio manager monster.” New funds where the partners choose to share portfolio management equally have rarely survived the test of time. Managers should avoid the nearly extinct monster, and allocators ought to take a pause when they see one in the birthing process.
4) Be ready to sleep in the bed you make
Catering an investment strategy towards the perceived demand in the market can veer a manager from his real expertise. When seeking the advice of others in the pre-launch stages, managers should remember that the process is like preparing for a wedding; the many givers of advice intend to help, but they only get in the way of a blissful experience. For allocators, the art lies in divining if a manager’s heart is in the product he is presenting.
5) Play for the long-term
In all aspects of a start-up, it’s easy to be focused on short-term outcomes. Yet investing is a hard game to win in the long-term, and even harder if you get caught up in short-term results. Whether considering capital raising, strategy or performance, managers should do their best to keep their eye on the long-term prize.
Q: Why do you think these lessons are not widely known?
A: Neither allocators nor investment entrepreneurs have a lot of experience in working with asset management start-ups. The patterns of success in early stage funds are quite different from those in the larger funds more familiar to allocators. Unlike in the venture capital industry, the hedge fund industry does not house serial entrepreneurs. Once a hedge fund manager launches and the business is successful, the manager probably won’t ever launch a new business.
Q: What format did you use for the lessons?
A: Most of the lessons in the book are fairly straightforward and don’t require much description. In order to bring them to life, I used case studies from actual funds that embody the lessons. The book takes a particular vignette from the life of a fund where the manager faced an issue and describes what happened. Some are success stories, others much less so.
Q: How did you get so many managers to willingly participate, particularly the ones that didn’t work out?
A: Funny you ask that; a lot of others have asked the same question, but it never crossed my mind as a challenge in bringing the project to fruition. Some managers wanted to stay out of the public eye, which I accommodated, but many more were happy to share the lessons they learned.
I’ve been fortunate to work with a lot of terrific people, who also happen to be exceptionally talented money managers. When I began writing, I shared a draft of each case study with the protagonist and asked for their feedback. In almost every case, they generously clarified facts, offered deeper insights, and blessed the work.
None of the experiences described in the book are unique to any one manager. Quite the opposite, most of these case studies have been repeated by many funds. And while there is tremendous competition, many managers remember that they once were a babe in the woods. Rather than let a poorly prepared fund cast a pall over the industry, they’re happy to offer a little advice to help get a promising manager headed in the right direction.