Navigating the hedge fund frontier: Insights on early-stage investing

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Voiceover: Welcome to Market Matters, our markets podcast on Making Sense, the hub for J.P. Morgan Corporate & Investment Bank podcasts. In each episode of Market Matters, we discuss the latest news and trends shaping markets today.

Kumar Panja: Welcome back to our market series here on J.P. Morgan's Making Sense podcast. I'm Kumar Panja, EMEA head of Capital Advisory Group, which introduces institutional investors to our hedge fund clients, as well as consulting with our hedge fund clients on all aspects of running their business. Joining me today is Sam Diedrich, a Managing Director and Head of Absolute Return at Partners Capital Investment Group. Sam, thanks for joining us.

Sam Diedrich: Thank you so much. It's really a pleasure to be here. I'm very excited to speak with you about early-stage managers.

Kumar Panja: So in the next few minutes, we're going to cover a lot of ground about investing in early-stage managers, both from a perspective of what managers need to do to prepare themselves and think about their place in an early-stage manager program, but also from an LP perspective, those investors that are thinking about expanding their exposure to early-stage managers in their current hedge fund programs. Okay. So Sam, I'm a portfolio manager, I'm sitting in another manager, I think I'm pretty good at what I do. I make money, and more importantly, I make money in a good risk-adjusted way. I believe that I can do this in a different construct and have my own fund and management company, but I need an anchor investor. And you have a new manager program. You can do a deal with me and I can do a deal with you. So what do I need to do for you to take my call?

Sam Diedrich: It's a great question. We get that quite a lot sitting in our seat. I think the first thing to do is really to think through and get great advice from folks like us who are involved in early-stage managers. We're unique as an allocator in that our program is specifically designed to engage with early-stage PMs. There are other early-stage partners that you should seek advice from, including people in investment banks, on the sell side, as well as potential seeders and other anchor-type investors. Before you go to, I'd say, a broader audience of investors, what you really want to have in place is a clear path and understanding in terms of how you're going to build this business. How much time you need, what the working capital requirements are, what the staging is, how long it's going to take to keep people on board, just have a real coherent story there. The second component is a similarly clear articulation of your investment process. There it's really important to understand how you're going to run your portfolio as a whole in the context of a hedge fund business. So, you have to think about drawdown management and what's going to be acceptable as an external hedge fund, versus what may be acceptable inside of your PM shop. It could be more risk, it could be less risk, but just having a clear articulation of how you compare to others and what your edge is. Then finally, I think in terms of the staging of your investment, it's important to have a clear view about will you use anchor investors? Will you use seed investors? How will you sequence your investment over time in order to build your firm? And there I think it's really important to think about and consider the value of an anchor investor in that early-stage launch because they can make a real difference in helping you build a sustainable and successful business.

Kumar Panja: Okay great. If I continue with this analogy of a portfolio manager who's thinking of setting up their own fund, I would speak to, as you said earlier, just a number of market stakeholders, some of them might be banks, some of them might be capital introduction teams at J.P. Morgan, they might be telling me that there are several early-stage investors that I should be speaking with or at least engaging with. So I have several choices. Now, it strikes us what you are doing is it's very much like a multi-PM platform expressed through using early-stage managers to build and achieve that. How do you think about the early-stage investment process?

Sam Diedrich: Well, first of all, absolutely, I agree. Managers should be speaking with reputable capital introductory teams, such as J. P. Morgan, where you have access to, really what’s going on and the pulse of what investors are looking for, what kind of products are resonating, what’s in vogue. How to structure investments, how to structure teams, how to structure the pitch. All sorts of good advice as well as access to tools like Edge, for example, the tool you have for connecting managers with investors, that really, they can leverage and get access to some of the connections they’re looking for. In addition to your second point, in terms of using early stage manager investments to build a multi-PM platform. That’s exactly right. That’s essentially what we’re doing in our structure. I've been investing in early-stage managers for really my entire career on this side of the table. There's a lot of key advantages as an investor for engaging with early-stage managers. Studies have shown, for example, that it's during the first few years of a hedge fund's life that you see the most outperformance. I think that can be driven both by capacity constraints that appear later in a hedge fund's life, as well as just the motivation and hunger that we really tend to see in an early-stage manager's lifecycle. Another key advantage is just terms and being able to structure things that make sense for an investor. And one of the key advantages there is structuring. When we're investing in early-stage managers, what we really focus on is investing through an SMA structure. What that allows us to do is maximize the outperformance in early-stage investing that we see while minimizing a lot of the additional risks that go along with early-stage investing. Those additional risks are usually in the form of operational, business, access to preferential terms from their counterparties, given that they're small and new. That's where our SMA structure can really solve for a lot of those things. We have access to a great counterparty term given our scale. We have the operational framework that we can put in place, or manage, or help managers put in place. Given our transparency, risk controls, and the risk guidelines and framework, we can really control some of the downside that could appear within that early-stage program. So our early-stage program uses SMAs as a way to manage a lot of those additional risks.

Kumar Panja: It's like very much this old adage of, you're happy to underwrite investment risk, not happy to underwrite business risk.

Sam Diedrich: Exactly. And with early-stage hedge funds as well as more established hedge funds, there can be significant business risk. Hedge funds are a vulnerable business model. If we can add some ways to mitigate some of those risks, both parties we think are better off.

Kumar Panja: Let's pick back up this SMA because our observation has been that SMAs have been in existence for decades, but the driver behind investors using SMAs has changed over time. Initially, it was control or transparency, now we see there to be a proliferation of SMAs usage, especially also in the early-stage manager environment. Do you see that as well?

Sam Diedrich: I do. Thinking even prior to the crisis when I was using SMAs for early-stage investing, there really wasn't a lot of other competitors out there using SMAs in that same way. Some of the key advantages that we were really focused on at the time were control and transparency, as you said. That has definitely evolved over time. Not only have they become more prevalent on the LP side, but now we see that the majority of hedge funds out there are either running SMAs or willing to run SMAs. Just the breadth of opportunity set is much higher, and to the point that even most multi-PM platform hedge funds now are using SMAs to complement their internal programs.

Kumar Panja: When we speak with a lot of managers, they have more than a reticence about taking on a separately managed account because they feel that, particularly in the early-stage of a manager, they feel as if they want to reduce complexity in their business. They have either heard or they observe that having a minimum of two pools of capital if not more, adds to complexity. Has that changed? Do you want to challenge that thinking that managers might have?

Sam Diedrich: I think that is a common misconception really out there. When you think about launching a hedge fund, the sequencing of investors is really important to think about. If you could launch a single vehicle, have hundreds of different clients all at full fees, that's clearly profit maximizing. What we often find is that is not the case and people actually have to stage their building of their business over time. Often in the early-stage involves anchor investors, seed investors, strategic investors. In that strategic investing landscape that used to be dominated by traditional fund of hedge funds, and they would engage early in hedge funds as a way to differentiate themselves to their end clients. Those business models have really been vastly reduced in the last 10 years to the point now where they really are not able to anchor in the way that they traditionally did. A new class of investors has appeared, which is the SMA investor, which are increasing in number, sophistication. As that investor class has increased, the support around that, and the willingness, and the ease of which those SMAs can be implemented and executed has also increased. For example, banks, J.P. Morgan has really been one of the ones leading the way there in terms of making it easy for SMAs to be operated both by the manager and by the LP. When you're a manager, and you're launching a new hedge fund, and you're looking at all these different anchor investing options, I think the SMA investor is a great option because one is they typically do not take part of your economics as opposed to a seeder. That can be a great benefit. Second, the SMA investor is going to be committed to your business just because it's going to cost them time and effort to set up these SMA accounts and to maintain them. For these relationships not to work out in short order is very costly for your investor. They're therefore committed to the relationship. The SMA investor through owning the positions has full transparency of what's going on. They understand what you're doing and are therefore more likely to be able to see past small hiccups that could occur as you execute your investment strategy. Then finally, it does take a certain level of sophistication and size to have a successful SMA program. The class of investors that you're accessing when allowing for SMAs, generally you're going to be with a more sophisticated end of investors. Again, that likely is going to lead to a little bit more resiliency for that relationship should you encounter any unforeseen challenges.

Kumar Panja: Then just going back to one of the things we mentioned before, the portfolio manager is thinking of engaging. When is the right time for them to engage? Do we get this question all the time? Again, some managers will instinctively have a view themselves before they come to us, others will be seeking advice for the optimum time for them to start a conversation. As you would advise, how would you advise managers in that position?

Sam Diedrich: Sure. We're a little bit unique as a manager focused on early-stage opportunities in that we welcome these conversations even before the idea is fully formed. A lot of times, we are helping strategise with them. How do I build this business? What are the key things that I need to be thinking about? How do I stage this? Before you go to a broader audience, though, I think what you really want to have is a clear business plan where you can articulate who I'm going to hire, how they're going to come on board, timing details, when I'm going to launch, et cetera. The second thing is having a clear articulation of your investment process and edge. I think those are the bare minimums before you really start to engage with a broader audience.

Kumar Panja: Some of this approach is a reflection of your own early background not in finance, but in engineering. How much has that informed you and shaped your decision-making and the process that you have been able to bring?

Sam Diedrich: I think my background in engineering has really prepared me well for managing risks and creating portfolios that meet different mandates. That very much colors our approach to investing in hedge funds and in early-stage hedge funds. I spent some time doing engineering research principally focused on signal processing, communications, signal detection, estimation theory, control theory. One of the first places I was fortunate enough to work for some period of time was the Jet Propulsion Laboratory in Pasadena, California, when I was very much starting out in my career. It was super exciting. I really enjoyed being part of a greater mission and working alongside all these esteemed and smart colleagues. At the time, we had just come as an organization, come off some incredible successes with the Pathfinder mission, which was a mission to Mars that was one of the first of its kind and was incredibly successful. While I was there, we had some unsuccessful follow-up missions that I think were an important lesson to me. Thinking through that experience, what it really ingrained on me is that failure is proof that you are doing something that is cutting edge. If you're 100% success rate of everything you're doing, you're extremely successful for, it means you're probably not taking enough risk. What's the excitement in that? Those years were definitely formative, as well as in the way that I view the world and the frameworks that I bring to investing.

Kumar Panja: That’s a really interesting early start to your career, Sam. So, how do you apply this rocket science, this engineering framework to manager selection?

Sam Diedrich: When trying to decide whether or not to include a certain return distribution strategy, a PM, a manager within a portfolio, what I'm trying to do in that assessment is try to decide and get an intuitive sense for what that distribution of return looks like in a forward-looking way. Certainly there's some characteristics that I look for. What's the volatility? What are some of the risk-adjusted returns I can expect? What is the drawdowns? That is informed by historical track record, but also trade structure, market structure, behavioral elements to how these strategies are managed over time, trading strategies, et cetera. What I'm really trying to do is map out with a high degree of confidence what this distribution of returns looks like in a forward-looking way. Similarly, when I'm making decisions around exiting a strategy, trade, PM, manager, what I'm really thinking about is in what ways could I have been wrong in my mental map of that distribution? When I go into a strategy, I recognize that I'm buying the distribution. I'm not buying the half of the distribution that I want, I'm buying the full distribution. Just because I'm seeing a drawdown, just because I'm seeing some challenges is not necessarily an indication that there's been a mistake or something like that. What I'm really trying to map out is are the observations, the P&L is one of them, but there can be other changes in trade structure, changes in characteristics of the portfolio, am I still within the realm of the distribution that I underwrote or is it now something different?

Kumar Panja: This is interesting. This is picking up this point about probabilistic thinking or Bayesian thinking because it allows you to, as you say, accommodate the return profile, which may not be positive or as positive through time, and managers will necessarily obsess about having a constantly positive and increasingly positive return stream over time. It gives you the ability to look at a portfolio and be accommodative of a strategy's or a portfolio manager's variance in performance over time. I guess what we're saying is the thinking leads you to be rather than trying to be right, you strive to be less wrong with time. Is that right?

Sam Diedrich: I think so. You have to acknowledge that you're going to have a failure rate in the process, and you're trying to design an overall process and approach that acknowledges that, and embraces that, and manages that. Don't get me wrong, this is a performance business and we have to perform for our clients. When we make investments, we expect that on average, they will outperform and perform over time. That being said, as I mentioned before, just because something has having a hard time, it doesn't necessarily mean that we're doing the wrong thing or we've made the wrong decisions. In fact, the converse is true where if everything is going right, that's also a warning sign because it means that maybe you don't have a differentiation. You're really relying on one type of return driver in your portfolio. If the market conditions change, if the environment changes, you could really be vulnerable.

Kumar Panja: I'm sure that's a huge relief to many managers or aspiring managers who are listening to that kind of view of the expected return profile of managers. Just looking at then the program itself because obviously the fuel behind the program is your LP base, can you talk to us a little bit about how LP should be thinking about if they want to incorporate new managers into their program? They perhaps are not large enough and not resourced enough to do it themselves, how should they be thinking about putting this into their hedge fund portfolio?

Sam Diedrich: The business model that we've built here at Partners is really focused on partnering with early-stage PMs and helping them build a business that's sustainable and successful. By doing so, what we get out of it is we get access to differentiated returns, we get access to high-quality risk-adjusted returns on terms that suit our overall program, and using structures, specifically SMAs that allow us to maximize cash efficiency and maximize our risk-adjusted returns, our risk management frameworks, and do so in the most cost-efficient way. We do see many other LPs following this approach. SMAs are becoming increasingly popular, as I mentioned before. It does take a lot of sophistication and operational heft. There's complications involved in managing these programs. You have to think about this holistically. It comes down to what's your differentiated pull on talent, how are you differentiated versus other early-stage investors, to managing the portfolio as a coherent portfolio that will meet the objectives and returns of your clients. The way that we've structured that is we use a multi-PM hedge fund structure in order to maximize our probability of achieving that mandate. To our clients, our portfolio looks as though it is a well-diversified, low beta, multi-strategy hedge fund. We're able to use that structure in order to provide early-stage trading capital and working capital to managers.

Kumar Panja: What about then the value proposition to managers?

Sam Diedrich: I think when you're a manager and you're looking through that early-stage pipeline of investors, you have a few choices. One is a traditional seeder, and they can be a really important partner for you. Seeders are really important if you need working capital to get to the starting line. If you need someone to come in and invest in the business and get you to the registration, get the people hired, get the operations in place before you accept external capital. Anchor investors can come in typically after the business is set up. The advantage of working with an anchor investor is they don't typically take part of the economics. We would fall into the anchor investor camp. Our goal in partnering with early-stage managers is to gain access to those strategies at what we feel is an ideal time in order to maximize our risk-assist returns and access premier talent within our SMA program. We differentiate our offering in the philosophical approach, I suppose, that we take with that early-stage relationship in that we don't require a revenue share, we don't require part of the economics. We don't demand exclusivity, we embrace the fact that a PM is going to want to build a hedge fund business that has multiple clients and is more sustainable over time. We do what we can to help and really partner with those PMs in that phase.

Kumar Panja: Thank you, Sam. This has been really helpful. I know that it's been very positive in terms of the message to those early-stage managers or those that are looking to perhaps start their own business in the coming months or years. Very, very helpful. Thank you for your time, Sam Diedrichs. Thank you.

Sam Diedrich: Thank you so much for allowing me to be here. I really enjoyed it.

Kumar: Thanks very much for listening. Tune in for further podcasts. My thanks, again, to Sam Diedrich for his time and insights. Until next time.

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