Absolute Return – “The Do’s and Don’ts of raising institutional capital” by Tom Kreitler

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Institutional capital is flowing into hedge funds at a record pace. Unfortunately for newer, smaller fund managers, most of that capital is going to the very largest managers. Investors often cite an established track record, stability of team, and firm-wide infrastructure for their decision to allocate to larger managers.

The good news for the newer, smaller crowd is that there are a growing number of hedge fund investors who are willing to look beyond the established few. In the past, this new manager discovery was the purview of hedge funds of funds and family offices, but today many forward-thinking endowments, foundations and pension funds are open minded about younger funds.

What does it take for a newer manger to draw the interest of a large institutional investor? Important criteria include great returns, a strong and stable process, a significant GP investment in the fund, and an institutional infrastructure with highly recognizable service providers.

If a manager can check all of these boxes (and only a small fraction of hedge funds truly can), they then need to ask themselves whether they can confidently provide repeatable, attractive risk-adjusted returns to investors while doing the heavy lifting required for an effective fund-raise.  Assuming the answer to this question is “yes,” a manager must know the proper way to approach and communicate with potential investors.

Since the 2008 financial crisis, hedge fund investors are increasingly demanding more from their managers. They often look for managers who understand and respond to their specific investment needs. They want their managers to be approachable partners with high levels of transparency who have open lines of communication. Managers should emphasize their transparency, open process, and client service capabilities.

How a fund manager introduces themselves to an investor is critical to their success.  In the first meeting, a manager must provide a succinct understanding of their investment approach and be able to relate that process clearly and quickly. This pitch can be broken down into the following steps: an introduction, a discussion o f the firm’s background and team, identification of the market opportunity upon which the strategy is focused, a definition of the strategy highlighting it’s differentiation from others, an illustration of a repeatable investment process to include portfolio construction, and a discussion of the firm’s institutional infrastructure.

There are a number of common mistakes managers typically make in these initial presentations. One is when the manager feels compelled to prematurely go “deep into the weeds” with their strategy, describing individual trades before providing the high level approach mentioned above. Investors are less inclined to invest with a group of smart people who put on a bunch of good trades as opposed to a team that follows a proven, repeatable process for alpha generation.

Another mistake is that managers forget to tailor the pitch to the needs of the prospective investor, and they include information in their presentation that is irrelevant. For example, a non-taxable investor is not likely to care about the manager’s tax efficient trading style. Investors often meet with multiple managers in a single day, and wasting their time with unimportant information can be a significant mistake.

A final common, but critical, mistake happens when managers ignore questions or give half-baked answers to said questions. A manager should embrace investor questions (if they’ve done their research, these should be anticipated in advance) and offer candid, appropriate responses. For example, if an investor asks how large the GP investment is in their fund, a manager should give them a specific number rather than a vague or evasive answer.

The bar is quite high for newer managers to succeed in raising institutional capital.  Managers need to understand their prospective investors’ needs and clearly articulate their ability to generate strong risk-adjusted returns to satisfy those needs.  They need to candidly and logically describe their team expertise, the market opportunity, a repeatable investment process, and an institutional infrastructure. Above all, a manager needs to be likeable. Underlying the criteria mentioned above, investors typically do business with people they like.

Thomas S. Kreitler is a Partner at Eaton Partners, a global placement agent.  He leads the hedge fund/liquid strategies team at the firm.

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