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June 17, 2015updated 11 Jan 2016 1:09pm

To really reap the rewards of hedge funds, make yourself their business partner

By Spear's

In 1940, Fred Schwed’s book on the charlatanism of Wall Street asked: ‘Where are the customers’ yachts?’ The question stuck in the back of my head. As the hedge fund industry matured during the late Nineties and in the run-up to the financial crisis, the number of yachts multiplied. If you were a fund manager capable of making investors believe you would deliver returns above market beta, the money poured in and the management fee alone would buy you the yacht — and a mooring in Monaco to boot.

Institutional investors — with their large ‘tickets’ — quickly crowded out the HNW and family office investors who had been the original capital behind hedge funds. Why try to raise money from and service ten smart but small investors when you could bag one large pension fund who would probably be lower-maintenance anyway?

As a small family office investor, it was clear that we were ever lower down our fund managers’ priority lists. Having our face-to-face time with the fund’s head cut back and learning about the fund’s latest news in that morning’s Financial Times, rather than with a polite phone call, became a regular occurrence. Furthermore, we noticed the stated target and volatility of returns decaying as the fund grew — a clear sign that the manager had decided to play it safe and get rich off management fees rather than by delivering performance on our capital.

An investor must always play to his competitive advantage. Yet what advantages does private investor David have over a Goliath pension fund or ‘global asset manager’? The answer is probably every advantage other than the appeal of the size of our ticket. Private investors are nimbler than corporate or public bureaucracies and they don’t have interminable checklists that are often irrational. (One pension said it could not invest in a manager further than a $500 plane ticket away.)

How could a small private investor like us retain hedge fund exposure in our portfolio but get a bit more love? Like with many things in life, the answer was relatively simple yet not immediately obvious: if you can’t fight them, join them. Instead of simply being a shareholder in the fund, why not also be a shareholder in the fund manager’s business?

Private investors are the ideal seeders. They are perfectly suited to backing managers early. In most industries — except capital-intensive ones like nuclear power or aviation — it is private capital that helps businesses get off the ground. In asset management, it is usually the fund manager and his or her friends and family who get the ball rolling by being the first investors in a new venture. Very few institutions are unconstrained enough to capture the upside of being a fund manager’s backer.

That was the answer: we needed to make ourselves indispensable to our fund managers if we were to reap the upside and not get demoted to the Christmas card list. We would be the first investors in the fund, and also bankroll their business, in return for a minority economic interest.

Then we realised, however, that fund managers needed help even more than they needed money. We invested in building a team that would help them deal with the business side of their new firm — a good fund manager does not necessarily make a good business manager.

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To ensure a higher probability of success for our investment, we became a hands-on partner in the enterprise. This way we would mitigate the business risk that we exposed ourselves to by investing on day one and would hopefully be left with the over-performance that emerging managers generate before they become management-fee-focused asset gatherers. A fund backer should be compensated for taking the risk of being an early investor, even more so if he is also willing to help set up, manage and grow the business.

Hedge fund exposure through a seeding portfolio not only ensured more love, it also guaranteed lower fees, upside participation through exposure to the firm’s growth, and transparency. Furthermore, it turned our hedge fund investments into a yield-generating allocation. We were now getting a share of the revenue our seeded manager was earning on the capital that had followed ours.

Along the way we have learnt many lessons. Though some of those lessons came from success (or perhaps more accurately, serendipity), the majority were the result of mistakes we made. As we reflected on the days of perusing bookshelves for books to help us figure out how funds actually got started and who ended up making all the money, we thought it worthwhile to distil some of the lessons we had learned over the years and record them, so now we have our own book. It doesn’t wonder where the yachts are, but hopes that the next one you sun yourself aboard will be yours — and not your fund manager’s.

Erike Serrano Berntsen is the CEO of Stable Asset Management

A Guide to Starting Your Hedge Fund is published by Wiley

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