The Top 10 Rules Hedge Fund Managers Should Follow to Attract and Keep Great Investors

hedge funds

To Attract the best investors, hedge fund managers should keep in mind, these investors don’t want to micromanage their managers. Integrating the following points into a hedge fund’s offering documents can greatly improve a fund’s appeal to institutional and high-net-worth investors. These points are often given equal or greater consideration relative to performance, as this will help to prevent problems in the future.

1. Liquidity and integrity

If your fund accepts money monthly, then it should provide liquidity monthly. Not all requests for redemption are based on unsatisfactory performance. Providing investors the opportunity to adjust their exposure to a fund within a reasonable timeframe is essential for managers trying to convey the message that they are able to manage liquidity risk in the portfolio. Most funds these days have market disruption clauses that provide the manager with the option to restrict redemptions during times of severe market duress. Investors want this clause, as it helps to reduce volatility. However, for a manager to need more than 20 days to generate 10%, or even 15%, cash during properly-functioning markets is absurd. A long notice of redemption period is a red flag to investors. It says a large portion of the fund’s investments are illiquid and, therefore, carry an elevated level of risk. In today’s world, a hedge fund manager definitely wants to avoid being labeled illiquid at all costs.

2. Information on a timely basis

Hedge funds should provide investors with timely month-end net asset value (NAV). Estimates within seven days of month-end are no longer a challenge, and are becoming an indicator of how strong a fund’s internal controls are. Providing investors enough time to make informed decisions as to whether any changes to their holdings are warranted is essential to attracting good investors. Today, prime brokers provide their clients with overnight valuations that are accurate. Almost all managers know their fund’s NAV (within a hundred basis points), within three days of their month-end. If a manager doesn’t have this Information, or isn’t sure of its accuracy, the message being conveyed to the investor is either the managers back office and accounting are not well organised, or the portfolio is too illiquid to value on a timely basis.

3. Fairness for all

In business, it is common to have penalties levied when commitments are broken. Investors agree to invest their capital based on the terms provided in the offering documents. The terms will often stipulate a minimum hold period. The same material often provides a targeted return and volatility the fund will generate. If the hold period is violated, a penalty is imposed by way of a redemption charge. This is acceptable, as long as the manager has also upheld their commitment to generate the targeted return and volatility. Simply put, from the perspective of the investor, if the funds performance is negative over a reasonable period of time (eg, six to eight months), or the fund experiences abnormal volatility swings relative to its historical relationship to general market volatility over a similar time frame, then the investor should be entitled to redeem without penalty, as the manager has failed to uphold their commitment.

4A.  Alignment of interests

It doesn’t get much simpler than this; an individual confident enough in their investing skills to tie their compensation to the performance of a fund should be confident enough to leave the majority of the compensation in the fund going forward. Investors have been outraged by managers who received huge amounts of money as the value of their fund went up, but lost little of that money when the same fund dropped substantially in value. If it’s ok for hedge fund managers to be partners in the gains of a fund, then they must be willing to maintain that relationship during times the fund suffers losses. In order to accomplish this, managers should only be paid a portion of the performance fees, and the remainder paid when either an investor’s capital is redeemed, or the partnership is dissolved entirely. If the manager feels that under this structure, his capital is excessively exposed to risk during the life of the fund and wishes to reduce the exposure, they can return a portion of the capital under management back to investors and receive the unpaid performance fees on that capital. Alternatively, if a manager is concerned about the level of risk their wealth is exposed to in a certain. environment, then they can move capital to cash, therefore, reducing the risk to all investors. Managers who consider their interests aligned with investors by reinvesting a small portion of the after-tax proceeds of their compensation in the fund are not exposed to the same level of risk the investor has, and any graduate of sixth grade math knows this. To imply otherwise is insulting to the investor.

4B.  The good investors want their mangers to be properly paid

Good investors don’t want money management decisions influenced by the manager’s need to pay bills. It is important that a manager be paid enough to meet overhead and be provided with a reasonable income. As a rough guide, performance fees on assets in excess of $50 million should be deferred as explained above. A firm that has $50 million under management and generates 16% net to investors per annum will generate $3 million in revenue a year. This is sufficient to satisfy overhead for a small firm. By deferring just the performance fees on assets above $50 million, the manager is aligning their interests with their investors, and providing investors with a sense of equality. As an added benefit, this allows the manager to compound their own earnings pre-tax thus increasing their wealth more quickly. The best managers will leap at the chance to do this. As a consequence of this approach, investors will have to pay tax on deferred returns (a small price to ensure alignment of interests), which will be recouped on redemption. Resistance by a manager to accept deferred compensation is a red flag to excessive greed and a lack of confidence by the manager in their own skills.

5. Compare apples with apples

Comparing a fund’s performance to a benchmark that has little or no bearing on the fund’s returns is blatant misrepresentation, and investors see this. If a manager runs a long/short fund in resource stocks, then it should be compared with a long/short fund benchmark and a resource index, not the Morgan Stanley Global EAFE Index or the Standard and Poor’s 500 Index. If you’re a 500-pound gorilla, don’t try to hide behind a twig. Smart investors know what kind of manager they are investing in and if your monthly reports provide bogus comparisons, investors will notice the 500-pound gorilla behind the twig.

6. Time is money

Given that a manager should know within 100 basis points the NAV within three days of month-end, it seems more than reasonable to pay out 90% of redemption proceeds on the fourth or fifth day after month-end. Following a redemption date, an investor is forced to cash after the month-end. The opportunity to reinvest is gone until the following month-end. Investors suffer opportunity costs of one and, in some cases, two months’ return while waiting for their redemption proceeds. Not providing the proceeds from redemption on a timely basis is like imposing a redemption charge indirectly to the investor. At a minimum, 90% of monies should be paid to the investor within five day’s following month-end. The faster the money is sent to the investor, the more likely the investor will convey a positive experience to other investors if asked in the future.

7. Know your limitations

Managers should be open when starting a fund with regard to its ultimate size. If a manager has never run a performance-based fund, they should impose a size limit the fund will remain open to new capital to. This conveys discipline to investors. Once the limit is reached, the manager can opt to raise the limit with consent from investors. If the fund is successful, the investors will want to add to their investment, and will gladly raise the limit. It also provides an opportunity to remarket the fund to existing investors. Sometimes, sending a note to investors that the fund’s limit is near, and the fund will be closing for an undeterminable time following the limit being reached, is enough to draw more capital in. It is worthy of mention that many desirable funds are often those that are closed, whether the performance warrants it or not. lt’s the fact that investors know the manager is prudent and knows his or her limits.

8.  Communication isn’t everything, but when everything isn’t working, it’s good to have

Communicating with investors regularly is important. The communication doesn’t just serve to keep investors abreast of what the fund is doing, and how management sees the investing universe, it also helps maintain a perception of openness between a manager and the investors. When times are tough, and history proves they will be, investors are more likely to stay if they feel a strong communication link with the manager. When an investor has a concern, calling the manager who has provided an open line of communication is more likely than calling a manager who they have never spoken to. In the latter case, it is easier to just redeem.

9. Managers should keep in mind that a lawyer’s job is to represent their client.   Simply put, lawyers write the offering documents with the intent to provide a framework for what is best for the fund’s manager, not its investors. 

A manager faced with a dilemma to include or omit some provisions in their offering documents will often default to the advice from their legal counsel.  Good fund managers must seriously consider the impact the advice will have from an investor’s perspective. Using a little common sense, and putting themselves in the investor’s shoes when drafting an Offering Memorandum can be just as effective at attracting high quality investors as a great track record. High quality, high-net-worth investors will not tolerate one-sided conditions that reward failure or marginalise the investor’s best interest.

10.  Reporting insiders’ holdings of funds

It is paradoxical that managers would never consider investing in a public company that didn’t report all insiders’ holdings and provide updates to changes in their holdings promptly yet, the same managers expect their clients to do this. Very few managers provide full disclosure of their personal investments in the fund to their investors. Investors have greater confidence in managers who provide insider-investing activity in their funds unsolicited.  This policy is in line with public companies reporting requirements. A fund that resists reporting its insiders’ holdings, purchase or sale activities all but admit the managers lack confidence in the fund. It is a serious oversight by regulators that insiders of all investment funds are not required to regularly report their holdings in the funds they manage. It is just as serious an oversight by hedge fund managers if they assume their clients don’t notice.

Caravel Capital is the manager for the Caravel Cad Fund, a Market Neutral Fund which incorporates all 10 of these principals into its offering documents. The fund has just reopened to new investors after sustaining high returns with low risk with $100 Million AUM for some time.

For more information, visit: https://caravelinvest.com/

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