The Challenge of Operational Due Diligence on Emerging Managers

 

Emerging hedge fund managers1 appear to be the investment idea du jour. Some investors have focused on investing in emerging — or “newer”— managers for some time, but currently,   as more institutional investors are recognizing the value of the start-up manager, this trend appears to be increasing. Nonetheless, investors are nervous about investing in emerging managers for operational reasons (despite research indicating that emerging managers have regularly produced higher returns2).  This is understandable as an elevated level of operational expertise and experience is needed to invest with start-up managers. As someone with experience conducting due diligence on emerging managers, two of the most common questions I am asked are:

  • Are the standards different for emerging managers compared to established managers?
  • How is operational due diligence different on emerging managers?

Operational Standards for Established and Emerging Managers are the Same

The question “are the standards different for emerging managers compared to established managers?” is quite simple for us to answer: they are not. As an operational due diligence team, we hold the emerging manager to the same standards as we do the more established manager, and recommend that other investors take a similar approach. Ironically this could actually be phrased in the reverse, as in the established manager is held to the same standard as the emerging one. This concept may sound counterintuitive at first, but in my view, emerging managers are often in a stronger position to establish an operationally robust organization due to their having the benefit of learning from those who have come before them. In many cases we have found that newer managers are in fact better at establishing a “best practices” firm than the experienced manager. The emerging manager is able to begin with a blank canvas and build their firm using lessons from the mistakes of managers from the past. New managers are less likely to have firm culture, tradition, old software and systems, unqualified personnel, and other sunk costs dragging them down. These issues can all be challenges for established managers who set out to improve their operations.

As mentioned above, to ensure a robust operational framework for hedge fund investments, we believe that the bar for operational standards must be the same for emerging and established managers. Complicating matters, firms have to navigate more regulation than managers who started even a few years ago. Further, it is a difficult time to raise assets. An emerging manager of today requires a larger infrastructure than the emerging manager of even a few years ago and thus probably will require a greater AUM at launch or soon thereafter. The operations team at today’s emerging manager is generally larger in number and deeper in experience than in the past as well. Today emerging managers often launch with technology of the same quality as the most experienced managers for portfolio, order management and fund accounting systems. Because of the increase in regulation the emerging manager of today will likely have greater expertise in-house than they have had in the past and will likely have a compliance consultant. There is a greater expectation of operational quality at hedge funds than a few years ago. These expectations are the same for established and newer managers, which has made it more difficult to launch a new firm and more likely for new managers to seek out a partner or seeder.

Operational Due Diligence Becomes Consulting for Emerging Managers

How is operational due diligence different on emerging managers? First and foremost, it is possible that the new manager has not yet even started trading. Therefore, the routine and important procedures of testing the manager’s processes cannot be undertaken. The resulting need to vary the due diligence team’s routine testing procedures, as well as other factors, makes the due diligence process more time consuming. Further, due diligence testing often ends up being more like due diligence consulting. It is clear from the beginning that it is the manager’s business and that they are the ones who need to make the decisions, but day-one investors have tremendous influence. Nearly every major decision made by the manager is reviewed with the anticipated early investors to leverage their guidance and experience. This may include decisions around fund and manager service providers, personnel, systems, fund structures and governance, and policies and procedures. The manager is able to leverage the investor’s experience and receive one-on-one guidance on how to establish an institutional-quality firm. Throughout this process the investor operational due diligence team should retain their right to veto the investment if the manager does not heed their advice or if they feel uncomfortable with any aspect of the operation or business. There are usually many discussion points, but still fewer than there are with an established manager. The experienced manager is more set in its ways and, therefore, is more likely to have an area of their firm not in line with best practices, which can also prove difficult to change.

There are many compelling reasons to invest with emerging managers, and investors may be pleasantly surprised to find that some emerging managers are even more operationally robust than their more established peers. It can be a more time-consuming process to invest with emerging managers, however, and early investors should be prepared to play the role of operational due diligence consultant for the manager.

1 PAAMCO generally defines emerging managers as those younger than two years old or with less than $500 million in assets under management at the fund level at the time of hire. The definition of emerging manager can differ significantly among investing entities.

2 A number of studies have been conducted on the relative performance of emerging managers, including:
​Northern Trust, No Contest: Emerging Managers Lap Investment Elephants, October 2010;

Rajesh Aggarwal and Philippe Jorion, The Performance of Emerging Hedge Funds and Managers, Journal of Financial Economics, August 2009. Philippe Jorion is a Managing Director and a Partner at PAAMCO as well as a professor at the University of California Irvine, Paul Merage School of Business. Rajesh Aggarwal is a professor in Financial Markets and Institutions at the University of Minnesota, Carlson School of Management and has, from time to time, been retained by PAAMCO as a consultant;

HFR Asset Management, Emerging Manager Out-Performance: Alpha Opportunities from the Industry’s Newest Hedge Fund Managers, 2005.

Joshua M. Barlow, CPA, CAIA is an Associate Director in Investment Operations and a member of the PAAMCO Operational Due Diligence Committee.

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