I was speaking with a Swiss allocator the other day about what he was looking for with regard to fund selection. The allocator had a combined $25 billion AuM and plenty of money to allocate to absolute return UCITS. The metrics were quite simple: the fund needed $125 million in the vehicle, a three year track, and a correlation of 0.4 with the equity markets. If those boxes were ticked, then any fund would be a contender for an allocation.
The problem is that the field is very limited. Most hedge funds come close to fulfilling these requirements. However, the structure (UCITS) and the AuM cancelled out a lot of opportunities to invest in good funds.
The allocator was extremely frustrated with their position. Typically, as soon as they are able to allocate to a fund, the allocation can be finished within a week because demand is so heavy.
Of course I found myself sympathetic to the allocator who must have a challenging job trying to find these funds. The market impact of a $15 million allocation is tiny when running $25 billion across portfolios.
When you understand the allocator’s predicament, you understand the gridlock that part of the industry is in. If an allocator invests more than 10% of the fund’s AuM, then they end up having a large part of the business. If a manager has a $5 million fund and $20 million managed account, then pumping $100 million into another managed account will probably make the manager invest in infrastructure to reflect those changes (or the manager buys a few Ferraris). If that account leaves, then the fund manager’s house of cards crumbles. Essentially, the allocator ends up owning the business. For many fund managers, this seems like an acceptable gamble to take since they may be able to leverage one large allocation into further allocations.
However, the allocator isn’t here to own businesses. They want to be able to move in-and-out of funds based on the fund’s merits and market conditions at the time.
How can a small fund compete for a ticket with a large allocator next to a large fund? Honest truth is that it probably can’t. When writing this article, I was thinking about using a football analogy (soccer, for us Yanks). Problem is, it doesn’t work because of the dynamics involved. In professional sports, performance is key (placement or luck is probably second) where 20-year-old “kids” get a shot at the professional league because they perform.
This doesn’t work in asset management; there are too many variables. How many new managers have been seeded with enviable AuM and failed? Probably more than 75%. How many terrific funds are stuck with sub-optimal AuM? More than I care to mention.
So what is the solution?
Well, hard work and sound business development practices. Small tickets become bigger as AuM grow. Asset raising momentum is important. If a fund isn’t actively raising money, then it is a warning sign for the allocator. Large allocators don’t necessarily want big names. We know because we have seen some allocator portfolios. Most will often admit that it is hard to differentiate between other large allocators because there are only so many large funds available. There are also so many variables when looking at funds. Size is an important one for many, along with so many other variables, like liquidity, legal structure, operational support, etc. Getting one of these variables wrong for your target market can hurt the growth of the fund.
I have heard from a lot of people in the industry that allocators won’t get fired if they allocate to a large manager. Strangely, I can’t remember ever hearing about this from an allocator. It is a very sheepish statement when it comes to professional allocators, whose living is defined by identifying talent and understanding risk. Additionally, allocating to large funds has its own challenge because the allocator has to defend the lower alpha potential caused by fund behemoths (just ask any large manager and they can run you through those challenges). Maybe a good analogy for this is the automobile market. Personally, I used to love Saab. The cars were quirky and well thought out. I loved the button that would dim the dashboard at night and the fact that the key was placed in the centre of the gearbox. It was very logical. I owned one in the early 2000’s but never purchased another one after that because I was worried that the brand would be abandoned by GM.
Allocators are probably not all that different. There is a difference between liking a fund and being able to invest in it. Allocators depend on managers to not only perform (let alone have structures that are investable), but to get enough momentum behind the business so that they can write tickets that many funds really need.