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Over the past decade, a vast majority of hedge fund net asset flows have gone to a small minority of hedge funds with the strongest brands. Evestment estimates that almost 60% of industry assets are controlled by firms with over $5 billion in assets.
Each year, many hedge fund investors are inundated with thousands of emails and phone calls from managers requesting a meeting. To filter through the overload of information, investors are turning more and more to a firm’s brand when choosing which funds to meet and ultimately invest. A brand is an investor’s perception of the overall quality of a hedge fund based on multiple evaluation factors that evolve over time. A high-quality brand takes a long time to develop, but once achieved, it significantly enhances a firm’s ability to raise capital and retain assets during a drawdown in performance.
Even though most assets are flowing to the largest firms, a strong brand is not defined by its size. Many large hedge fund organizations based in Asia, Europe or other regions outside of North America with a large regional client base might have very little name recognition in North America. There are also many large, well-established firms that have become complacent and have slowly allowed their brand to erode.
A vast majority of the approximately 15,000 hedge funds have less than $250 million in assets but only represent 3.8% of industry assets. However, a small percentage of these firms have been successful in building their brand and raising significant assets. Over time, we believe small and mid-sized managers will receive a higher percentage of assets due to increased sophistication of institutional investors, poor recent performance of many of the largest, well known hedge funds and the pressure institutional investors are receiving to enhance returns. There is a belief that some of these smaller, more nimble managers have an advantage in a performance environment increasingly dependent on security selection. This is especially true for small managers operating in less efficient markets or capacity constrained strategies. Despite these trends, building a strong brand is vital for these firms to distinguish themselves from their competition and ultimately succeed.
An example of the importance of a brand is that each year a small number of ‘high profile’ startup firms are able to raise large amounts of assets, despite the fact they may have no transferable track record. These managers’ high-quality brand was typically created at their previous firm. This may include having held a senior position at another top-quality brand named hedge fund, having spun out of a top investment bank proprietary trading desk, or having been seeded by a well-known investor. Many of these high profile startups end up generating performance below expectations. For the hedge funds not fortunate enough to launch with such fanfare, the key question is, what are the firms that have developed the strongest brands doing differently?
Regardless of the size a firm, there are three critical issues to consider in creating a strong brand and raising assets in today’s competitive environment: the quality of the fund offering, the investor’s perception of the quality of the fund offering, and the marketing and sales strategy.
The first step in the process is having a high quality product offering. In our hedge fund research process, we consider thousands of hedge funds each year based on multiple evaluation criteria and have found that about 90% of hedge funds are not very good. With over 15,000 hedge funds to choose from, it is almost impossible for these sub-par managers to raise assets from investors outside of friends and family.
The biggest mistake most of these lower-quality hedge funds make is not understanding the evaluation factors investors use to select hedge funds and subsequently create a sub-par product. These factors typically include an evaluation of a firm’s operational infrastructure, investment team and their pedigree, investment process focused on an inefficiency in the capital markets, their differential advantages employed to capture this inefficiency, risk controls, performance, service providers and fund terms. A weakness in any of these factors can eliminate a firm from consideration. The marketplace is highly competitive and hedge fund investors use a process of elimination in selecting hedge funds. This typically begins by screening the thousands of hedge funds in the market place, meeting with a couple hundred, having follow-up meetings with 50 and hiring a select few each year. In some cases, a minor adjustment can significantly improve the marketability of the fund. Hedge fund performance tends to be the initial screen which eliminates a majority of managers, but once performance has reached a certain hurdle, its weighting in the evaluation process is less important than most managers realize.
The second step in the process of building a strong brand is making sure the market’s perception of the firm is equal to reality. This requires a consistently delivered, concise, and linear marketing message that identifies the differential advantages across each of the evaluation factors investors use to select hedge funds. Many high quality hedge funds have difficulty raising assets because they do a poor job of articulating their message to the marketplace and their strengths are underappreciated or unnoticed. Unfortunately, it often takes only one poorly worded answer to get a firm eliminated from consideration.
It is important that the marketing message is clearly understood and articulated by all employees of the hedge fund. Ideally, there should be someone at the firm besides the portfolio manager who can communicate the firm’s message well in first meetings. The message should be consistently integrated throughout the entire firm’s communications including the website, oral presentations, written materials, due diligence questionnaires and quarterly letters. A well-prepared and accurate marketing presentation creates a consistency that builds confidence with potential investors.
The final step in building a strong brand is implementing a highly-focused marketing and sales strategy that broadly penetrates the marketplace while being compliant with regulatory guidelines, which is very difficult to achieve with limited resources. The hedge fund investor marketplace is highly inter-connected and investors exchange ideas about managers through both formal and, most often, informal channels. As a result, the more deeply a manager penetrates the marketplace, the stronger their brand will become. Building a strong brand and raising assets takes time and cannot be rushed. The hedge fund industry is not transaction oriented. In many instances, being too aggressive will eliminate a firm from the selection process. A majority of institutional investors require a minimum of three or four meetings with a fund before they will invest.
One way to accelerate the process is to utilize a well-seasoned, highly respected internal sales team, a top-tier third party marketing firm, or a combination of both. A major mistake many hedge fund firms make is not understanding the impact the people representing the firm have on the perception of their firm. Experienced and well-thought of salespeople often have a reputation or brand in the marketplace themselves and can have a large impact on a hedge fund’s credibility and success in growing its asset base. It can be advantageous to partner with a top-tier outsourced marketing firm that works in partnership with the hedge fund’s sales team or senior management, where the hedge fund employees perform the function of “product specialists” to significantly expand their market coverage and create a “buzz” within the industry. This strategy also maximizes the portfolio managers’ time, allowing them to spend more time focused on managing the portfolio and less time educating prospective investors in the early stages of the sales cycle. As mentioned before, the hedge fund industry is not transaction oriented. It usually takes multiple meetings for an investor to conclude their assessment of a hedge fund. It is very important to have a process in place for following up with prospects and helping them through each stage of their due diligence.
In summary, strong performance alone will not attract assets. The firms that will be successful in growing their business are ones that stay highly focused on providing a top-quality offering, clearly articulate their firm’s differential advantages and have a highly professional sales and marketing strategy that deeply penetrates the market place.