In today’s challenging hunt for alpha, investors are finding that entrepreneurial channels can provide novel ways to outperform institutional alternatives, writes Andrew Cohan of Macoma Capital Group.

Andrew Cohan of Macoma Capital Group outlines his thoughts on how, in today's challenging environment, a growing number of investors are discovering entrepreneurial channels as a "novel" way of outperforming institutional alternatives.

Cohan is a founding member and the portfolio manager of Macoma, an opportunistic direct investing/special opportunities partnership tailored for large family offices.  

In today’s challenging hunt for alpha, investors are finding that entrepreneurial channels can provide novel ways to outperform institutional alternatives. The issues impacting return generation are numerous and well-documented, ranging from pervasive and protracted governmental quantitative easing in the wake of 2008, extensive lowering of leverage use across strategies, aggressive governmental probes into trading practices, and systematic reforms in proprietary trading as investment banks jettisoned their top managers following the enactment of the Dodd-Frank “Volcker Rule.”

These factors have contributed to investor angst when weighing alternative investments; on one hand, they desperately want to diversify for exposure and risk moderation, but on the other, the large players in the alternatives sector have delivered mediocre results over the past several years that hurt investor belief in the alternative promise of differentiated alpha.

Investors need performance and diversification from their alternative investments.  There’s nothing complicated about these desires, but the ability to source and obtain both goals has become harder to accomplish in the sector. Investors have found their choices for finding alpha and risk reduction squeezed by a lack of knowledge of, and access to, demonstrated options across alternatives. Casualties include the sub-performing large scale offerings from established industry players which have failed to generate the types of returns and non-correlation that encourages participation from investors. 

Additionally, structural instability in equities both in the US and abroad has led to market volatility which has eroded returns, compounded by protracted low interest rates across the yield curve.  The Federal Reserve’s recent policy shift in stance from dovish to hawkish, as signaled by Bernanke in June, has highlighted the skittishness of traders throughout the markets as they anticipate the cessation of quantitative easing, which has been funneling $85 billion a month into the market coffers. All these factors have heightened investors’ illiquidity concerns in alternative investments.

The search for alpha generation has also been hurt by a reduced level of access to top investment talent formerly employed by large scale banks. Spurred by the Volcker Rule, these proprietary money managers have migrated from their former positions into either retirement from investment management altogether or into the formation of private investment channels. Investor access to this investment talent has been curtailed by this evolution into individual funds where many of these former “stars” have not been able to post the level of performance returns they enjoyed pre-2008. Indeed, a large portion of these managers are closing shop, as they were unable to attract sufficient capital or they were unable to generate incentive fees in the current market environment.

Wealthy families are willing to work at finding alternatives combined with a supportive platform

But investors take note: there are success stories. Entrepreneurs exist who are achieving results, but their visibility is limited due to small size, a lack of analyst coverage, and investor reluctance to commit money to a new enterprise. Those willing to seek alpha where it is found can take advantage of some interesting opportunities through these “under the radar” performers. Given the current state of the markets, wealthy families are increasingly interested in digging deeper to find alpha, and managers who provide a platform that institutionalizes the process are in rising demand. Following are some notable factors helpful in identifying niche talent to uncover these potential investment opportunities.

Uncertainty is the 800-pound gorilla in the room

So what are top concerns for investors about the markets today? Northern Trust’s Wealth in America Survey 2012 of approximately 1,700 family participants indicated that:

• Two-thirds believe the country has yet to get back on course since the financial crisis of 2007-2008;
• Fewer than half believe the US economy will be better off in five years;
• Only 53 per cent express confidence they will achieve their goals compared to five years ago; and
• Market stability is the top reason they feel the way they do about the future of the US economy.

This general unease contributes strongly to a desire across the wealth management sector for transparency, aligned interests between investors and the managers they choose, diversification, non correlation, tolerable risk levels for reward objectives, and, finally, alpha. They have found it increasingly difficult to obtain these objectives through the established alternative managers. So who can provide these goals in today’s market climate? Entrepreneurs with a focus on meeting investor needs within a structure that provides the non- investment related attributes combined with yield have an opportunity to become the industry’s fastest-growing stars.

It has become very clear: investors demand transparency

Transparency in both ongoing reporting and in understanding exactly what comprises the investment structure has become extremely important to high net worth investors. Investors require more details about the way an investment is entered, the ongoing status of its ability to meet their investment objectives, and how it is performing relative to its peers at every stage of the holding period. At the same time, they are not equipped in general to track and monitor this level of disclosure and the impact each investment has on their overall portfolio. They want investment partners who can deliver both the results they seek and a platform for monitoring and identifying the reporting details their advisors need to track portfolio management issues overall, including tax implications.

Alignment of interests spells the difference for a "go" or "no-go" action

Aligned interests between the investor and manager are a must-have for entrepreneurial managers to be considered by investors. As an integral part of the relationship, investors require such managers to have substantial assets invested alongside theirs. They need to see stability in strategy execution and an ability to deliver results as assets under management grow, as well as continued enthusiasm and desire of the alternative managers to commit capital to the investment vehicle in a consistent and sizeable manner. 

It has become an unfortunate industry axiom that some of the biggest and best-performing alternative managers who were successful at growing a multi-billion dollar enterprise have waned in their ability to deliver performance for their later investors. Are they unable to do so at such large scale? Are they as hungry as they were when they first started building their business?  Are they distracted by other factors or lifestyle choices now?

The reasons are likely varied and diverse, but if one believes that the markets are still able to deliver some very attractive investment opportunities for smaller players, perhaps there is some truth to the jaded belief of many industry insiders that enormous management fee income can become a hindrance for established managers to work at uncovering new opportunities in the markets.

While established players in the alternative channels have built such processes in-house in response to institutional demands from long-standing clients, smaller and emerging managers have not yet formulated this level of support for their clients in large measure.  Identifying a niche manager who combines the ability to deliver performance returns with institutional reporting details is a differentiating factor that will help launch the entrepreneurial manager ahead of his peer group much more rapidly.