Whether you are presently working for a fund, looking to join a new fund or wanting to get a better idea of the competitive landscape in today’s Hedge Fund marketplace you may want to understand what Institutional Investors look for when investing in a fund.  This knowledge can be extremely useful in analyzing the potential of your fund and can be pivotal when pursuing other fund opportunities which may be presented to you.

Measuring a Hedge Fund’s Performance and Asset Base

Institutional Investors will look very closely at the fund’s track record.  This includes examining the fund’s performance, the fund’s standard deviation and other quantitative results.  Institutional Investors are looking for a fund’s track record to be at least three years long and to consistently beat the fund’s benchmark. Most Institutional Investors do not have the stomach for large swings in monthly performance, and hence the fund’s standard deviation is also a critical measurement of performance.

Ideally, a fund will receive guidance and approval from a consultant when setting the fund’s benchmark.  It is extremely important that the benchmark is relative to the fund’s strategy and investment goals.  While this sounds elementary, it is amazing how many funds do not use a qualified benchmark.  When examining a fund, if you believe the benchmark being used does not correlate with the fund’s strategy and goals, ask an investment consultant for their professional opinion. These are the same individuals Institutional Investors get advice from when performing their due diligence, so consulting them can be very informative for you.

Besides performance, experienced Institutional Investors will also examine the fund’s asset base, both in its size and client breakdown.  Institutional Investors often have an investment guidelines setting the minimum assets a fund can hold to be a viable investment option.  And, while most Institutional Investors must place a large sum of money into any one investment to make it viable, they are at the same time restricted by their guidelines in regards to the percentage of a fund’s total assets the investment can be.  These investors also want to understand the number of clients that have assets within the fund, and what the typical client investment size is.  Again, this information is often required due to the Institutional Investor’s specific guidelines.

The Importance of Infrastructure

In the past few years, examining a fund’s infrastructure to verify the fund is properly managing both its business and risk has become an intricate part of the Institutional Investor’s Due Diligence Process. A funds’ infrastructure includes:  Accounting, Operations, Risk Management, Compliance, and Technology.  All of these areas are represented in the current business practice of running a fund, and are very important to the funds ability to raise assets. Rarely do you see a Hedge Fund today which only consists of a Portfolio Manager and one or two analysts.  Most funds now need to have a Chief Operating Officer, Chief Financial Officer, Risk Manager, and a Marketing professional to be seriously considered by an Institutional Investor.  These funds need to have professionals whose sole responsibility is to oversee these specific areas.  Their duties may span multiple departments, but they cannot intermingle investment and infrastructure responsibilities.

Along with a strong internal infrastructure the fund should align themselves with the proper service providers.  The stronger the service provider the better.  Investors want to make sure that the fund is using the best of breed service providers.  This does not always mean that the service providers must be the biggest or most well known, but that they need to have a reputation for excellence, financial stability, and strong customer service.  A weak service provider diminishes the entire product and becomes a detriment to the fund.

Stability within the Fund

Another area of concern for a fund is employee retention.  Institutional Investors do not like to see funds with high turnover.  In their eyes, turnover represents a basic foundation problem within the fund, and no one wants to invest in a fund which continually experiences brain drain.  Employee turnover causes your team to be less productive, and means that more time is spent on keeping up the standard norm than on creating alpha or identifying new investment ideas.

Fund ownership is very important to the Institutional Investor as well. This information can be difficult to obtain but if you gain access to these details it can be very useful.  Institutional Investors wants to see that the main partners of a fund have a significant percentage of their own net worth invested in the fund. Furthermore, these investors prefer to see that valued employees also have ownership in the fund.

Conclusion

If you have decided to make the Hedge Fund industry your profession it is very important to understand what is important to the Institutional Investor.  Although Institutional Investors are not the only players in the alternative investment channel, their investments/ assets are critical to the growth of any fund. Employees/professionals who understand what Institutional Investors are looking for and can thereby identify the funds with the greatest Institutional Investor potential, are those that enjoy the ride and receive the greatest financial rewards and professional upside.