INSTITUTIONS SHOULD CONSIDER DIRECT EMERGING MANAGER HEDGE FUND INVESTMENTS

Smaller institutions have conventionally looked to fund of funds (FOF) managers to fulfill their hedge fund allocations. Similarly, emerging managers have looked to FOFs for capital to grow their businesses. But these views ignore advantages of investing directly in hedge funds, and with Emerging Managers (as defined herein) specifically. We define "small institutions" as those in the $100 million to $1 billion range. They are large enough to make value-adding hedge fund allocations but may not have the resources or needs of larger institutional investors.

Also, we define Emerging Managers as those systematically overlooked by larger investors due to the manager's size, lack of track record or other reasons. Direct hedge fund investments do require a different kind of due diligence than do FOFs. However, the act of identifying compatible managers, investigating their investment and operational acumen, selecting a winner and monitoring that winner takes a similar amount of work whether one is considering a FOF or a single direct hedge fund investment.

The argument that FOFs are "cheaper" than going direct because less research is involved is debatable. Furthermore, FOF investments sacrifice control, liquidity, transparency and fit within one's portfolio. The operational risk increases with the number of sub-managers in a FOF and is compounded by the operational risk of the FOF manager itself. Direct investing in Emerging Managers offers further benefits because they often can invest in opportunities and respond to market events that a larger manager cannot, offer favorable terms and provide more customized service. For these reasons, smaller plans should involve Emerging Managers in a direct hedge fund program. 

From experience, I am skeptical that substantial differentiation exists among many larger flagship FOFs. They tend to choose many of the same underlying hedge funds, reaching similar conclusions on which ones are good, and have exposures to the same underlying investments. On the results side, many FOFs effectively shoot for the same high-single-digit returns. A plan with $10 million or more to invest in hedge funds is better off picking the best manager it can find within its parameters and should consider the additional benefits of Emerging Managers. In doing so, institutional investors will likely pay lower fees with greater liquidity, greater transparency, lower operational risk, better access to the manager and more diversification in its overall portfolio. These investors will probably enjoy better long-term performance as well.

Lesson Learned: With even a small allocation, direct investing in hedge funds can pay.

Matthew V. Steffora, CFA
Consulting Principal
NexTier Companies, LLC

INSTITUTIONAL REAL ESTATE INVESTORS: Emerging Managers Help Improve Performance

In the aftermath of the sub-prime mortgage and real estate debacle, institutional investors are rethinking their real estate investment allocations. Instead of allocating along traditional index-oriented lines, these investors are looking for value-added holdings that can positively impact portfolio performance (i.e., excess alpha). We believe real estate emerging managers (Emerging Managers) can be that source of improved portfolio performance. We define Emerging Managers as any fund management, investment management or asset management firm that is typically excluded from traditional search processes for institutional investors and plan sponsors across all asset classes regardless of their ownership structure or size.

Earlier this month, Institutional Investor reported that TerraCap Management Corp. (TerraCap), an Emerging Manager, has seen institutional interest accelerate in its distressed commercial real estate strategy, as it nears the close of its second fund. The Bonita Springs, Florida firm has received allocations from the University of Florida endowment, Holyoke (MA) Retirement System and a number of other institutional investors and family offices. According to a November 2012 article in Real Estate Alert, Terra raised their $25.7 million first fund in 2010. It was reported that this fund has earned over 30% annualized return on investment.

TerraCap is an excellent example of an Emerging Manager that has tapped into markets in which large institutional real estate firms do not generally participate. 

• Smaller sized investments. Commercial properties that are too small ($2 million to $15 million) for branded firms, but larger than investments local investors can handle. 
• Off-Market Deals. Off-market, or private, deals reduce competition from better capitalized buyers. 
• Specialized Markets Requiring Local Knowledge and Focus. Distressed and foreclosed properties require value-added activity utilizing specialized knowledge and time consuming focus. In the case of TerraCap, taking advantage of international and domestic immigration trends in the region. 

Access to Emerging Managers and their potential excess alpha can be unlocked through direct investments in comingled funds or separate accounts managed by these firms recognizing that those investments can be made through either a fund of funds or a manager of manager platform. Direct investment, particularly with local Emerging Managers, has the benefit of engaging with the local economy. 

In conclusion, Emerging Managers have a role to play in the portfolios of sophisticated institutional real estate investors who are able, and willing, to invest outside the typical index-oriented structure. 

Lessons Learned:  Emerging manager shouldn't be ignored.

James A. Casselberry, Jr.
Senior Managing Director
NexTier Companies, LLC

CLOSING THE PENSION FUNDING GAP: Emerging Managers Have A Role

The funding gap for public pensions is enormous. This should not be breaking news to anyone. Underfunded public pension plans have been a major discussion topic over the past few years, receiving a lot of media attention and notably being detailed in a couple reports from the Pew Center on the States: a 2010 report, The Trillion Dollar Gap focused on state retirement systems and a 2013 report, A Widening Gap in Cities focused on municipal retirement systems. As you might expect, similar gaps exist for most other pension plans as well, including corporates, Taft-Hartleys and retiree health care funds.

The approaches to address these shortfalls are limited: 

• increase direct funding, 
• reduce benefits and 
• add "alpha." 

So how can smaller investment managers (Emerging Managers) play a role in the solution?

Empirical data shows that Emerging Managers, systematically by asset type, generate superior returns to their larger cousins. Therefore the demand for Emerging Managers should grow as the search for excess alpha accelerates.

Here are a few of the many examples of this outperformance: 

• Smaller Hedge Fund Managers Outperform: A Study of Nearly 3,000 Equity Long/Short Hedge Funds, 
• No Contest: Emerging Managers Lap Investment Elephants and 
• Survival of the Nimble: Why Smaller Investment Mangers Outperformed Larger Managers Despite a Challenging Market Cycle for Fundamentally Based Active Mangers. 

As we have previously discussed, Emerging Managers need to address their capacity issues in order to penetrate and thrive in the institutional investment management space and large asset allocators need to adapt their practices to allocate more efficiently to Emerging Managers.

Clearly, the pension funding gaps will not be resolved by the use of Emerging Managers alone. It is going to take public policy reform to resolve these daunting challenges if we have any hope of solving the funding calculus. Nevertheless, Emerging Managers have a role and it behooves everyone to make some adjustments and use them as part of the solution. Much more to come from our team on this topic.

Lessons Learned: Small managers can be part of the funding gap solutions.

Lawrence C. Manson, Jr.
Chief Executive Officer
NexTier Companies, LLC

EMERGING MANAGERS: The Alpha Story

Despite the ever increasing amount of evidence that smaller managers (Emerging Managers) across all asset classes generate excess alpha, small managers still experience significant barriers to market entry and growth.

The Opportunity

Large allocators of assets in the institutional investment world are increasingly seeking the higher rates of return that Emerging Managers can provide, as Emerging Managers are seeking additional assets to manage.

The Problem

Such allocators of assets and their advisors, consultants and gatekeepers, do not have efficient mechanisms or maybe even the talent and experience to weigh the business risk associated with selecting any given Emerging Manager. Emerging Managers generally do not have the organizational depth to address the traditional needs of large allocators, the so-called “elephants.”

The Observation

By and large, Emerging Managers focus their energies on their products and the respective performance, and in so doing provide excellent returns but ignore vital infrastructure issues. Nevertheless, the large allocators continue to benchmark them against their much larger cousins with respect to business risk. This generally leads these allocators and their advisors, consultants and gatekeepers to default to “larger is better,” due to less perceived business risk without further examination.

Even though Emerging Managers are simply small businesses founded by investment managers, they often do not have the bandwidth to manage their business platform without sacrificing performance. Most Emerging Manager programs were originally designed to level the playing field. However, the new age programs should be focusing on more than market entry opportunities, but rather business development and successful business transitions and exits. Why? The Emerging Manager life cycle being understood and supported will go a long way in deriving “sustainable” excess alpha that Emerging Managers are providing. Much more to come from our team on this topic.

Lessons Learned: Emerging managers shouldn't be ignored.

James A. Casselberry, Jr.
Senior Managing Director
NexTier Companies, LLC

SUCCESSION PLANNING: A Must, Not an Option for Investment Managers

Inc.com had a tongue in cheek, but interesting article yesterday discussing an issue being dealt with by both business owners and…Kim Jong-un. While the comparison is humorous, the topic discussed is exceptionally important: Succession Planning.

Succession planning for most businesses is difficult. Any plan needs to be well thought out and comprehensive, but this can be an emotional and uncomfortable process. Although, what likely makes your clients even more uncomfortable is your not having an adequate plan in place.

We've all been told to plan for the scenario, if a senior executive suffers an unexpected illness or is “hit” by the proverbial bus. Even if there is a clear line of succession, how much of the value in a firm is tied up in that person, including their relationships and knowledge? Furthermore, companies, especially service business like investment managers, should be planning for a healthy transition when it is time for a generation to retire or leave the firm.

In either case, when an executive leaves, without proper preparation, clients leave and a firm loses value, and in the case of investment managers, lose assets under management. Companies, especially service business, like investment managers, need to ensure that the next generation is not only capable, but has been involved in decision-making, particularly the future direction of the organization and the investment process.

A departing executive is one scenario, but the need for succession planning is even more important when contemplating a liquidity event to capture the legacy value of your firm through a potential transaction, including but not limited to merger, acquisition, recapitalization and/or divestiture. Succession planning is a series of steps to be implemented over time. The process may start with a simple rebalancing of the equity interest amongst the partners and other important employees to reflect changes in the strategic direction of your firm. On the other hand, it could be as involved as modifying the formation documents of the firm to include the repurchase arrangements amongst the firm and any equity stakeholder upon the termination of their respective relationship with the firm along with a related financing plan and a specific personnel development plan for the next leadership of the firm approved by the governing body of the firm.

The benefits of creating long-term stability for an organization are undoubtedly worth the work of preparing a succession plan.

Lessons Learned: Succession Planning isn't optional.

Lawrence C. Manson, Jr.
Chief Executive Officer
NexTier Companies, LLC

WELCOME

Welcome to the new blog of NexTier Companies, LLC. We will be writing about a number of topics within the investment management industry, but first I want to introduce you to our firm. 

Jim Casselberry and I started this firm because we felt there was a need in the institutional investment management space for a talented and experienced team to provide consulting solutions to the industry. In particular, we feel we can assist emerging managers to understand the institutional landscape, to prepare for institutional investment manager search scrutiny and to capitalize on access to the institutional marketplace.

As we have begun talking with other participants in this industry ecosystem, it has affirmed our belief that our business offering can make, both traditional and alternative, investment managers more effective and successful.

Our senior consultants, including Jim and I, average 25 years of business experience working at traditional and alternative investment managers leading their investment process, serving as consultants to many of the largest institutional investors and working at institutional investors allocating and selecting Managers, across all asset classes. This experience makes us uniquely qualified to assist emerging managers in finding, developing and implementing best business practices to achieve success.

Our staff has worked with or for an array of different organizations, including JP Morgan Chase, Northern Trust Company, BlackRock, Inc., PIMCO, the City of Chicago, General Motors and a myriad of other corporations, endowments and foundations, investment advisors and consultants, public pension plans and federal, state and local governments

Send any questions, comments and topics you would like to see covered to socialmedia@nextiercompanies.com. Stay up to date on what is happening with us at nextiercompanies.com.

Follow us on twitter @nextiercos. Thanks for reading, and see you soon.

Lessons Learned: Add value and people will listen.

Lawrence C. Manson, Jr.
Chief Executive Officer
NexTier Companies, LLC