What is Capital Introduction?

Table of Contents

1.  Tiffany’s background
2.  What is capital introduction?
3.  What makes a hedge fund attractive to investors?
4.  How does 26 Degrees build relationships with investors?
5.  What criteria do you use to match hedge funds with the right investors?
6.  How has the role of capital introduction evolved over the past decade?
7.  Challenges faced by emerging hedge funds
8.  What does a successful cap intro strategy look like?
9.  Trends in investor preferences
10.  Common mistakes made by hedge funds
11.  The role of technology in capital introduction
12.  How does 26 Degrees handle investor feedback for hedge funds?
13.  Advice for hedge fund managers looking for investment

1. How did you begin working in capital introduction, and what is your area of expertise within the field?

I worked for about 18 years in NY and San Francisco for Morgan Stanley and Goldman Sachs in PB sales (specifically, synthetic), covering some of the world’s largest hedge funds (and, in some instances, institutions who run money internally, as well as allocate to hedge funds). In these roles, you partner with your cap intro colleagues of course – so while I never had a cap intro role, I was generally knowledgeable about the field and have a lot of experience with both hedge funds and allocators.

When I came to 26 Degrees two years ago to cover emerging hedge funds in a sales capacity, it became immediately apparent that we needed to also offer cap intro services to help our clients scale. And so began the process of building out a network of HF allocators – specifically targeting family offices who we thought would be more inclined to look at smaller managers (rather than, for example, the massive pension funds who, out of necessity, tend to be more conservative). That network has now expanded to include notable university endowments, private wealth, foundations etc. And larger, more established managers on the hedge fund side.

2. How would you define capital introduction, and what role does it play in the hedge fund industry?

Once a hedge fund manager has exhausted the “friends and family” pool of potential investors, it can be challenging to reach what I would call “institutional” capital – particularly if the manager isn’t, say, a known superstar coming out of one of the household name massive multi-strats. So, how to raise money? A natural progression of the prime broking industry, which provides execution/financing/stock loan custody services to hedge funds, was to build out capital introduction as an ancillary service – although a lot has changed in the industry, post GFC, which I will get into later.

3. What are the key qualities or attributes that make a hedge fund attractive to potential investors during the cap intro process?

Let’s start with the basics – an institutional scale set up (with recognized auditors, legal, fund admin, PB), along with tight controls over both market and operational risk. (Operational risk is as important to allocators as investment risk.) It is also critical to be based in a widely recognized jurisdiction. Beyond this, while some allocators will seed or invest in very small funds, I would say that the majority are looking for an AUM that is – at a minimum – sufficient to cover majority of costs while the fund scales. Some also require a track record of some length. And although some allocators have specific strategies/asset classes/geographies in mind – others are fairly agnostic, instead targeting certain return/volume profiles. Once these threshold requirements are met – then it is all about the pedigree/experience of the team; what is their edge; what makes them unique. How are they different from the other 15,000 or so hedge funds out there? These are the sort of questions we ask our managers to help them refine their marketing pitch.

I also think it is also important – particularly as an emerging manager – to be very transparent, and to also be flexible (particularly when it comes to liquidity terms). And be SMA friendly.

Beyond all of that, we are seeing a lot of interest in uncorrelated/differentiated/niche strategies. While this was the theme of last year too, I sense that if anything, it is strengthening this year (particularly with the US family offices).

4. How do capital introduction teams identify and build relationships with institutional investors?

As I mentioned, our team’s strategy has been to build relationships with global family offices, fund of funds and university endowments – who tend to be more interested in emerging managers. And part of building this relationship is to listen to what the allocator is looking for (size, track, geography, strategy) and be very targeted in the managers we send over. We believe in a curated approach – less is more.

5. What criteria do you use to match hedge funds with the right investors?

First off, we don’t work with most managers we are introduced to. We work with managers that we think have an edge, an institutional set up, experience/pedigree, and that we like/trust, frankly. We also try not to work with multiple managers with similar profiles. The next step is to determine whether their strategy, AUM, length of track, geography (investment universe as well as fund jurisdiction), returns/volumes line up with what the allocator is looking for. It’s a very bespoke, customized process.

6. How has the role of capital introduction evolved over the past decade?

When I started on Wall Street (well over two decades ago, but who is counting), the tier-one prime brokers had large cap intro teams that did work for their hedge fund clients – and, generally speaking, the most work for those that paid the most. However, the industry has changed with regulatory costs getting significantly higher – which has meant that the big primes have increasingly focused on larger funds, with smaller/startups having a hard time getting brought on as a client, let alone getting support from the cap intro teams.

Cap intro – which has always been hard to quantify its value as there are no explicit fees in this model – has been increasingly viewed as a cost centre. You also have the trend of more allocators gravitating to the huge multi-strats (who don’t really need cap intro work). I think you put these trends together, and the role of third-party marketers and firms such as ourselves (who do work for non-executing/financing clients) has become more critical.  And to elaborate, while the traditional PB model is – as I said – to work with existing PB clients, our model is different. We don’t require our cap intro clients to prime with us – we instead engage under a best-efforts, introduction agreement. This means that we can work with a variety of strategies – including those, such as private credit, that don’t require a PB. And it means we can work with who we want to, not who we feel compelled to – complete autonomy.

7. What challenges do new or emerging hedge funds face in securing investor capital through cap intro?

It is well known that the hurdle to even starting a fund has increased tremendously over the past 10+ years. Long gone are the days when two people with a Bloomberg can launch a fund. Once your capital, plus friends/family/network have invested, it is not as easy task scaling. Many – if not most allocators want to see a 3-year track at least, $100mm. (Part of the reason for the min AUM, is that allocators are generally prohibited from being more than a defined % of a fund. [Not necessarily the case for an SMA investment.]) So, you have the proverbial chicken-and-egg problem. Building the institutional set up that I mentioned, and meeting all the regulatory challenges is very expensive if you are launching your own fund.

8. Can you describe a successful cap intro strategy or campaign you’ve observed? What made it effective?

 The client we have had the most success with has a differentiated, diversified, and liquid strategy. (Systematic macro.) They have a three-year track record with impressive returns, high Sharpe ratio. They are SMA friendly, provide good terms, and the fund structure enables a global investor base. They look good on paper. The manager has thorough marketing material – detailed marketing deck and monthly fact sheet. They clearly define their edge and distinguish themselves from peers.  The team presents well. Impressive pedigrees, high employee participation in the fund, plus a notable cornerstone investor. The team are smart, professional, transparent, approachable and likeable. And this sounds trivial, but they add allocators to their monthly distribution list (if interested) and regularly check in/follow up. They understand that they are building a business. And take a long-term view.

We reviewed our allocators’ interests and requirements and only shared this manager with allocators who we deemed an appropriate fit. The approach was targeted and tailored. We made an introduction to a USD2.1bn US-based fund of funds and they are in the process of writing a USD20mm ticket. There are also several other allocators who are tracking their performance, waiting for them to reach USD100mm.

9. What trends are you seeing in investor preferences and behaviours when it comes to allocating capital to hedge funds?

As mentioned, a primary theme is “uncorrelated/differentiated”. Some US allocators, in particular, are looking for diversification away from US (and other markets considered to be highly correlated with the US.) I sense there is increased nervousness about the US market. Among US allocators as well, we have seen a move away from any onshore China exposure. While the allocators we speak to outside of the US don’t express their concerns in quite the same way, the trend is the same. “Uncorrelated”

And on the same theme, I believe that allocators are a bit more cautious about equity L/S funds – they want to see true alpha on the long and short sides, and not a fund that, at the end of the day, is just levered beta.

My sense is that we are seeing a bit of a barbell developing. Many will continue to allocate to the massive multi strats. And many are seeking smaller managers that are operating in the inefficient areas of the market.

10. What are the biggest mistakes hedge funds make when trying to attract investors, and how can they avoid them?

First and foremost – vastly underestimating the cost involved in setting up an institutional grade fund, and, as well, the length of time/difficulty to land a ticket. To mitigate startup costs, aspiring managers could consider joining a platform that provides the license and infrastructure – which reduces expenses and allows them to focus on their strategy, building up a track. Or, perhaps, adopt a bit of a cafeteria-style approach – i.e., start your own fund but use outsourced CFO/middle office, trading, and/or IR. And, of course, another strategy may be to join one of the large multi strats, negotiating a portable track. I think some managers don’t entirely appreciate that they are setting up a business – which, among other things, requires marketing acumen. If you don’t have these skills in-house, get help.

Second, being flexible is important. Be open to SMAs, for example, because a lot of allocators will insist on this. Consider a first-loss provider, as that is where a significant amount of early state capital comes from. Be set up to accept US-based allocators, because that is where a lot of the money is. Be realistic with terms – liquidity in particular. A three-year lock on a public equity strategy, for example, isn’t going to work.

Third, I touched on this before, but marketing is critical. Some managers seem to think that the numbers speak for themselves. They don’t. Allocators – particularly when investing in an emerging fund – are investing in the team and they want to understand how the team thinks. And, the first introduction to the allocator may just be the marketing material. Within the first 3 pages, a manager needs to define who they are, what they do, what makes them different – and why the allocator should continue reading, when they have a stack of other decks to go through. Fourth, be prepared. When the manager does get that first meeting with an allocator, by very prepared. The CIO must be in the meeting and needs to be ready to answer very detailed questions, including potentially uncomfortable ones such as style drift, a particularly large draw down etc. And should that call go well, be prepared for an extensive DD process.

A bit of a side note, but one of my favourite comments from a family office is that they want to see a manager that “has been hit in the face”. Because EVERYONE gets hit in the face at some point. So they would rather invest with someone that has experienced this. My point here is that if a manager did hit a rough patch, try to turn that into an advantage. Be transparent and explain how you learned from the mistake.

11. What role does technology play in the modern cap intro process, such as CRM systems or data-driven investor insights?

Technology naturally helps us keep track of our communication, key manager attributes, where we have made introductions etc. I think some of the large PBs have embraced it to the point where they have downsized their teams and encourage investors to access portals with access to manager databases. But really, if an allocator just wants to look at a database, there are plenty of them around – no need to limit oneself just to a particular PB’s client base. To me, technology is a tool that helps the team be more efficient and organized, but it can’t replace human relationships. And that is the cornerstone of our cap intro program.

12. How do you handle investor feedback for hedge funds that may not align perfectly with their expectations?

It is never easy to be the bearer of disappointing news. Nonetheless, my approach is to be direct. Generally, I find that the managers we work with are very open to feedback. Sometimes it just isn’t the right fit. And sometimes, there are key insights that the manager can use to improve their product, or perhaps just the way they are marketing it. End of the day, this is a tough process, and managers have to be prepared to get rejected. A lot. On the other side of the coin, the more feedback we get from an allocator, the more thoughtful we can be about the next manager we send them. It is all valuable.

13. What advice would you give to hedge fund managers looking to maximize their opportunities through capital introduction?

I would say, first, pick the right partner. Make sure incentives are aligned; they have a good grasp on what you are offering; their allocator base matches your target. Second, the partnership is a two-way street and the capital raising process is hard. This means that managers have to spend time and energy on things that they don’t necessarily enjoy – like creating robust marketing material, building a social media presence, answering emails, doing calls etc. Have regular dialogue with your cap intro partner, accept feedback, and commit to doing the work.

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Original article published by Game Changers Magazine: Issue 51 – Game Changers Magazine