Why Funds Fail.
By Ole Rollag.
We have all come across our fair share of fund failures. However, I have always found that failures are more interesting than successes, probably because success is never really properly scrutinised. In the asset management industry, most onlookers would say that success is based on performance. But, if this is the case, why are there so many funds with impressive returns that just aren’t able to raise capital?
From what we have seen, here are some reasons why funds fail:
Lack of Working Capital.
This is by far the biggest issue, in our opinion. We have seen managers launch funds with $500k and no working capital, as well as funds with $50 million from personal, family, and friends’ money; none of which is invested in a business development manager. The first example is fairly crazy (although we have seen a few succeed); the second is a serious schoolboy error.
It is odd that many industries like software, equipment manufacturers, and other B2B firms are willing to spend a lot of resources to make sales, but this mentality has not permeated into the hedge fund industry. As a rule, asset managers prefer spending resources on product improvement and not on getting the product to market (it probably should be both). How can a multi-millionaire asset manager be expected to succeed if she puts most of her own personal wealth into her fund, but not into the business itself?
Lack of Sales.
This is probably the biggest underlying failure and can be split up into a number of areas. The biggest two issues that we see are with poor product design, and poor market understanding.
1. Poor product design:
a) Legal structuring. All too often, clever lawyers recommend a structure that isn’t appropriate for the product or the market that the fund caters to. For example, a long only fund domiciled in the Cayman Islands destined for retail – clearly a bad idea. There are also many less obvious no-go’s: popular European onshore structures, e.g. FCPs, marketed to UK retail (for those who care, FCPs are tax transparent, as opposed to SICAVs. This creates a scenario where taxes are calculated per position- a nightmare for the UK onshore fund shareholder. SICAVs are tax black, which means they are taxed via a treaty with the other EU Member State). There are a lot of expensive mistakes made here. After so much time and money is spent creating a product, we find that most managers are very hesitant to change it. This kills the momentum. We tend to forget that time is money.
b) Liquidity or fees. Liquidity mismatches are also business killers. Managers investing in liquid markets that insist on lock-ups are understood (or tolerated) by many allocators. However, the opposite is a killer. Illiquid assets in a highly liquid fund structure will worry the allocator. The underlying assets need to coincide with the liquidity of the vehicle.
Fees that are too high are also a deal breaker. Investors realise that these fees compound to a very large sum over several years. If a substitute product can be offered for lower fees, then many investors will choose the lower fees. If the fund is genuinely unique, and the alpha is pure, then fees are much less of a problem.
2. Poor market understanding:
a) A product not differentiated enough, or too differentiated. Niche products vs. commonplace products are almost equally challenging. Common, crowded products need to differentiate and often involve a lot of investor meetings. Niche products have less overall demand, but the buyers generally have a higher interest level. The sweet spot is probably somewhere in the middle – another blog, perhaps?
b) Marketing to the wrong market. We are constantly surprised by how often we get this wrong. Adapting is key. A fund developed for HNWIs might actually be more appropriate for pension funds. On the other hand, a new long only US equity mutual fund has so many established rivals that the manager may be forced to look for a client base that caters to smaller funds. If the product ends up being better suited to a different audience than originally intended, then accept it and change the marketing strategy.
c) Not knowing how you fit in. When I was a volatility fund manager, I was confident that what we were doing was amazing. I thought investors just didn’t ‘get it’ because they didn’t instantly realise what a great product we had. In hindsight, I see that we never really gave them a good reason as to why the fund should be in a portfolio, or how it would complement a larger portfolio. A fund provides a solution: less correlation, lower volatility, good returns under certain conditions, exposures to certain countries or sectors, etc.
Lack of Commercial Instinct.
This ties into the main theme of this post: the business of asset management versus the profession of the fund manager. It is perfectly acceptable to be a very good investor and a poor businessperson. However, once you realise this, you need to hire and trust someone who will make up for your deficiencies. If an investor will put $100 million into a managed account if you hire a compliance officer, then why on earth would you not do this? We see a lot of managers that are not commercially flexible. We equate this attitude to Seinfeld’s Soup Nazi episode. Very few of us can have the luxury of being the Soup Nazi. We are at the service of our clients and depend on healthy, honest relationships.
Partnerships seem like a good idea, and often they are. However, managers can have a very hard time learning how to share. We can never stress enough how tough this business is, and it isn’t surprising that good relationships can be destroyed if not everyone is prepared for it.
We put this last for good reason. This is probably the most complex reason for failure, and we have seen many managers throw in the towel too early with this one. Some of the largest, most successful managers started out very poorly due to timing. Put simply, the market conditions might simply be unfavourable to the manager’s style. Most investors can assess fund managers in a similar fashion to how we would judge CEOs. There are wartime CEOs and peacetime CEOs, just as there are great bear-market and bull-market managers. Strangely, we have seen a lot of managers close, citing poor performances, when they were in the top quartile of their peers. Managers tend to give up quicker than investors. If the fund has a five-year track record, has been through a bull- and bear- market, and is in the bottom half of the league table, then there is probably good reason to close. However, one lousy year should not make or break a fund. Poor performance is usually the least understood reason for why funds fail. It is an easy reason for everyone to accept.
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