Family office consultant Joe Reilly recently sat down with an author who scrutinizes chief investment officers for his insights about hedge funds and what family offices seek from them.

Family office consultant Joe Reilly interviews Ted Seides, author of So You Want to Start a Hedge Fund?, and who currently interviews interesting CIO’s on the Capital Allocators podcast on iTunes. They talk about finding good managers for a family office, how hedge funds will look in ten years, and what makes a manager special. (Joe has interviewed a number of industry figures for this publication and is a member of FWR's editorial advisory board.)

Joe Reilly:  Do you think there is something really special about fund managers like Klarman or Cohen? 

Ted Seides: I’d make a big distinction between people starting hedge funds in the last five or ten years and the early legends in the industry. When the first generation of hedge fund managers got started, there was no promise of riches and probably a lower expected income than in a traditional banking or mutual fund career path. The guys who started back then did it because of their passion for investing. They wanted to invest in a different way without constraints.  When I interviewed Jeff Solomon of Cowen on my podcast, he talked about starting Ramius in 1994 and taking a few years to get the 20-person firm to a critical mass, of only $100 million dollars in assets under management.  It is a very different game today.  

The pioneers were doing something different, contrarian and early. They were deeply passionate about investing, and it wasn’t really about the money. Of course, it’s a money game, but it wasn’t just about the money. In the last fifteen years some people followed the same pattern, but it is harder to distinguish those who started because of passion from those whose motivation was primarily the pursuit of monetary rewards.

If you were going to set up a team for a family office to look for managers, what model would you use? 

Ted Seides: My favorite model was in the early years of Protégé, when our team was tiny with just one or two analysts.  It’s good to have a young, really smart person who can help with models and spreadsheets, and one or two people who source and interview managers. A small team is better than a lone wolf, because any one person inevitably will miss important pieces of the puzzle. Even Dave Swensen has a foil in Dean Takahashi.  And if you have two people with the right dynamic, you’ll get way beyond the 80/20 rule.  

There is also a question of possessing a sufficient skill set as a team. You need interviewing and research skills to get to the bottom of something and you need a breadth of relationships to source opportunities. To get access to the right managers, you need a small number of people who can pick up the phone, call two or three people, and head in the right direction. You don’t need to meet 50 managers to pick one or two. If you are in front of five that are among the top 10 in a space, you’ll be in pretty good shape. But you have to be able to get to the right 10.  You either need to know who they are, or have close relationships with others who do.

Who knows those people?
Ted Seides: Certain CIOs: foundation CIOs, endowment CIOs and family office CIOs who have existing portfolios in a space.  Allocators deeply ingrained in a space are the ones who generally know the best players.

How do you think about the gap between family office and endowment compensation versus the money paid at funds?
Ted Seides: I think there are market wages for all of these roles. Family offices seem to have a wide range of compensation arrangements. Direct funds compensation is decreasing, but remains in another ballpark from allocator roles.
 
One risk families come across is being too cost-conscious. When someone is hired at below-market compensation, it sets up a dynamic with poorly-aligned incentives. The more successful the person is, the more likely they won’t stay around. Incentives matter a lot. Families pursuing active management need to align their incentives with their team. If they’re not inclined to pay up for performance, they should seriously consider other viable solutions to manage their money, like investing passively.  There is no law that says a family office has to seek better-than-average returns. 

Protégé had a lot of success, but I’m sure it wasn’t all easy.  What would you say was the number one mistake your team made in manager selection at Protégé?
Ted Seides: The same mistake as everyone else - some variation of chasing performance.  Part of what is very, very tricky about investing in hedge funds is that access to managers is often tied to capital flows in the market. For example, in the ’04 to ’07 period a manager might have come out of a brand name shop, had outsized performance, and had all the qualities of a successful firm for the long-term. If you wanted to wait until their performance tailed off, they might have closed permanently as others rushed in. Knowing you had to invest at that moment in time, you can reasonable ask whether you are chasing performance or are making a long-term decision at a knowingly suboptimal moment in time.  It’s one example of many of how allocation is much harder in practice than in theory. 

Exits are important as well. What I found was that the only times we exited well, with consistency, was when we invested in a tactical strategy. You are entering something that you think is interesting at that moment in time with the intent of coming out after it works. In that case, exiting well comes after a period of strong performance. With individual managers, say a typical long/short strategy, you almost never see an allocator exit after the fund has done well. You might rebalance, but with great consistency allocators exit managers in full only after periods of poor performance. And that is a tough thing to get around.

What do you think the hedge fund space looks like in ten years? Are you down on the space?
Ted Seides: I’d delineate a difference between the hedge fund vehicle and the hedge fund business. Hedge funds as investment structures will be alive and well and larger than they are today.  At some point in time, we are going to have a market correction and the flexibility afforded hedge funds will shine. 

On the business side, fees are coming down, and will continue to come down. I’m bearish on the economics of hedge fund businesses. Revenues will be lower ten years from now even if assets under management are higher. 

More or fewer funds?
Ted Seides: It depends how you count. How many funds do you think comprise the market today? Are there 8,000 funds in total, including every fund under $20 million in AuM, or are there 400 funds that really matter?  There is an interesting dynamic in the 400 funds because of a looming demographic shift in leadership.  There have been some successful successions like Cumberland and Farallon, others that have failed like Regiment, and still others, like Och-Ziff, that are very much in flux. 

Then again if you look at somebody like Seth Klarman, who is 60 years young with at least another decade or more in the tank, the succession issue might not occur for a while. 

Over the years you have met many, many managers. Have you observed that portfolio managers are any good at managing their own money?
Ted Seides: Anecdotally, portfolio managers are happiest when their money is in their own fund. When they want to diversify, they tend to invest with managers they know and respect. I have had conversations with a lot of very successful money managers who have allocated to friends and found they suffered from the same behavioral biases that they trained themselves to mitigate as a stock picker. They get frustrated when one of their friends is underperforming. And they are very competitive, so they also get frustrated when one of their friends is outperforming them.  That doesn’t leave a lot of ways to win. Some of the best have hired a seasoned allocator to help them professionalize their diversification strategy.