Tuesday, July 23, 2013


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

Tuesday, July 2, 2013

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