Managed Funds Association Forum 2002

The Institutionalization of Hedge Funds: Can this Sector Grow Up?

Highlights of a forthcoming White Paper from 100 Women in Hedge Funds

“We didn’t underperform. You overexpected.”

Margaret M. Eisen, CFA Dana B. Hall, CFA Sarah Dyer

Managing Director Managing Director Vice President
DeGuardiola Advisors, Inc. Lighthouse Partners, LLC Trident Investment Management, LLC

www.100womeninhedgefunds.org
Forum 2002: The Forum for Hedge Funds

The Institutionalization of Hedge Funds:

Can this Sector Grow Up?

Highlights of a forthcoming White Paper from 100 Women in Hedge Funds

Margaret M. Eisen, CFA Dana B. Hall, CFA Sarah Dyer

Managing Director Managing Director Vice President
DeGuardiola Advisors, Inc. Lighthouse Partners, LLC Trident Investment Management, LLC

www.100womeninhedgefunds.org
Defining “Institutionalization”
The “institutionalization of hedge funds” is an oft-discussed dynamic in our sector today, but any three
participants or pundits mean something completely different when speaking about it.

1. Institutionalization of the client base

2. Boutique, entrepreneurial firms making the transition to a financial services

institution

3. Traditional investment management firms offering hedge funds to retain talent

and attract assets

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Composition of Client Base is Changing Significantly
Ten years ago cash flows into hedge funds were predominantly from individuals and families. Today
institutions are the primary decision-makers investing in hedge funds.

1992 2002
HFOF
Foreign HFOF
6%
E+F4% 25%
6%
Insurance
Pension
2%
1% HNW
48%
Foreign
8%
Insurance
3%
Pension
HNW 6%
81% E+F Direct
10%

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Few Hedge Funds > $5 billion AUM
Unlike the mutual fund business where flows are typically concentrated into a small number of industry
participants, the hedge fund sector is dominated by small funds.

3500
3050
3000
2500
2000
1500
1000 842
605
500 295
135 73
0
<$50 $50-$100 $100-$250 $250-$500 $500-$1b >$1b
Million

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Financial Services Institution Candidates
There is a small but growing list of hedge fund managers with an infrastructure comparable to the typical,
traditional investment management firm. A smaller number of these firms are open to new investors and only
a few have aspirations to be a “financial services institution”.

1. Lee Ainslie / Maverick

2. Louis Bacon / Moore Capital
3. Dan Benton / Andor
4. Steve Cohen / SAC
5. Ken Griffin / Citadel
6. George Hall / Clinton
7. Paul Tudor Jones / Tudor
8. Art Samberg / Pequot
9. Tom Steyer / Farallon
10. Monroe Trout / Trout Trading Management Company

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Traditional Firms Anxious about Growth in Hedge Funds
Multi-product investment management companies are frustrated by the flight of talent as well as assets.

Firms eager to accommodate:

1. talent tempted by entrepreneurial enterprises buoyed by low barriers to entry and attractive
economics
2. investor demand for absolute return strategies

So seek to:
1. incubate internal hedge fund capabilities
2. hire talent and offer flexibility to run hedge funds concurrent with benchmarked strategies
3. buy teams or hedge funds outright

But structure proves complex and awkward:

1. economics disrupt traditional business model
2. client sensitivity to internal conflicts
3. internal conflict between haves and have nots
4. valuations are high relative to other opportunities and sustainability proves difficult

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Hedge Funds Challenge Traditional Investment Management
They push pay for performance, and eschew moribund strategies and style categorizations.

G Traditional investment management firms, driven by institutional investors

who have been schooled by consultants, focus on benchmark relative
performance, low tracking error and conformity to style

G There is a cyclical headwind facing traditional investment management firms,

creating a cyclical tailwind for hedge funds

G Institutions can’t spend relative returns

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Institutional Assets Come With Greatly Increased Scrutiny
Institutional investors have little tolerance for the “trust me from my pedigree” attitude and for an investment
process overly reliant on one or two individuals.

Sample Items from Institution’s Sample Quarterly Review Requirements

Due Diligence Checklist from Institution

G Succession Planning For each portfolio, please present a booklet

structured in the following manner
G Attribution Analysis
G Organization Chart
G AIMR Performance
G Business Status
G Substantial AUM
G Investment Guidelines
G Operational Infrastructure
G Investment Process
G Representative Client List
G Performance
G Client Service Capability
G Performance Attribution
G Details of Compensation Structure
G Current Investment Strategy
G Disclosure of Partners’ Assets and Ownership
G Portfolio Composition
G Brokers

In addition, at the first review meeting of the

calendar year, please provide the following
information
G Soft Dollars
G Proxy Voting
G Auditor Report

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Boutique to Institutional Caliber – A Perilous Path
Hedge funds that attempt to accommodate institutional demands have a narrow window for creating a
satisfactory “infrastructure” without becoming the very institutions that talent is fleeing.

G Financial services institution business model requires different skill set

G Recruiting and retaining boutique-type talent tricky

G Full disclosure / transparency may drive different investment process

G The ultimate danger -- the hedge fund manager’s conundrum: Do

these constraints cause you to invest differently than you would for
yourself?

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Investors: Be Careful What You Ask For…
Either investors or managers will have to give up something dear to them: disclosure and flexibility
respectively.

G ‘Institutionalization’ of asset growth driven by search for return and yet

institutionalization of assets may impair returns

G Rule number one when hiring for expertise: Don’t interfere!

G The institutional client’s conundrum: Is it better to handcuff Ainslie or unleash

Aronson?

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The More Things Change, the More they Stay the Same
While the popular wisdom suggests that substantial institutional interest will quickly double hedge fund AUM,
we believe it is unlikely the industry will evolve to meet all of the requirements of the typical institutional client,
and therefore not look so different from today.

Traditional hedge fund sector will be bifurcated: managers will self-select as

G boutique with entrepreneurial, independent, opportunistic culture
G robust infrastructure acceptable to institutional investors

Demand for ‘hybrid’ (best of both worlds) may be satisfied by

G consultants
G hedge fund of fund managers
G Aronson model of long/short separate account with performance fee

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