Monday, November 14, 2011

Canadian Startup Funds Starving for Capital?

Boyd Erman of the Globe and Mail reports, Canada loses when startup funds can’t find capital:

In the shadow of the banks and pension plans that have given this country a reputation as a strong financial centre, the alternative-asset management business is still struggling to grow.

The financial upheaval around the globe is leaving smart Canadians who tried to build careers trading and running money in places like London and New York displaced and disheartened, and looking to come home to Canada to try to build a business. But for all this country’s reputation as a haven with strong finances, the refugees are finding this is a hard place to start a fund management business.

Hedge funds, private equity funds and venture capital funds all struggle with a tough environment for getting what they need to even begin to succeed. Somebody has to give them some money to manage, but the people who control most of the capital are wary.

That’s discouraging for entrepreneurs such as David Fry and Andrew Torres, the founders of Lawrence Park Capital Management. Their firm is full of people who traded fixed-income securities for big banks and funds in New York and London.

They want to be in Toronto, because it’s home and because it’s a nice place to live, and are launching a fund that will try to capitalize on the difference in prices of bonds issued by the same company but trading on different markets and in different currencies. Despite their pedigree, they are finding it hard slogging raise money. If managers like them can’t find money, they won’t stay, and Canada will miss an opportunity to create a stronger, more diversified financial sector.

“We should have the ability to attract some of this talent to Canada, and keep some of this talent in Canada,” Mr. Fry says.

What the partners are finding is that “there are a couple of trillion dollars in Canada invested in mutual funds and pension funds, but very little capital available for startup asset managers.” The hurdle is most often “size and track record. And if you have neither, or one of, it's very difficult,” he says.

Size is important because the biggest pools of capital in Canada are pension funds that are so huge they have trouble committing money to small firms. A fund the size of the Canada Pension Plan Investment Board, at $152-billion, has trouble writing a cheque for a few million to a startup firm. Too many small investments is too much work for too little potential reward.

To put it in perspective, total venture capital fund raising in Canada in the first half of this year stood at $374-million. That’s just a tad more than the CPPIB, as part of a group of venture and private equity funds, put into one investment: a stake in the Internet communications company Skype in 2009.

Track record is key for risk managers, who don’t want to put money with an unproven fund. Similarly, big brokerage houses want to see a few numbers of good returns before selling new funds to clients.

There is some academic research that shows that investing in startup hedge fund managers can be a recipe for superior returns for at least the first couple of years of a fund’s life, but few people are willing to take the chance.

The hard part is finding a way to solve the problem that doesn’t force Canadians to invest in Canada for any reason but because they are seeking the best returns. The movement in Canada has been away from requirements to hold Canadian content, eliminating limits on foreign investments for everything from individual retirement accounts to the CPPIB.

Quebec is bucking that trend. There, pension funds including the Caisse de dépôt et placement du Québec have banded together to create a $175-million fund to seed new managers.

Mr. Fry is a fan, but there’s a reason public policy has been going the other direction. Pushing big money managers to invest in Canada for an industrial purpose is fraught with problems, mainly that it muddies their main mandate, to create returns for investors. Even so, governments, if they are serious about pushing for more financial jobs, should be taking another look at how to help.

In the meantime, fund managers who want to live here are going to have to raise money abroad.

One local startup manager, Ray Carroll at Breton Hill Capital, managed to convince the largest pension manager in the U.S. to commit $100-million (U.S.) to seed his hedge fund.

If Canadians won’t see the potential in this country’s emerging asset managers, maybe it will take investors abroad to show us what we are missing.

Have written extensively on this topic and my last comment was written in June when I circled back to the Caisse and the SARA fund. My enthusiasm for Quebec's startup and mature hedge funds has since waned, especially since many got clobbered in Q3 and some closed shop.

Having said this, there are still excellent emerging managers worth investing with and if it's done properly, Canadian pension funds can potentially make a killing. Why do I sound so confident? Because I know the managers, understand their strategies and see a real need to develop alpha funds in Canada, especially here in Quebec.

The article got it wrong. Quebec's pension funds are way behind the curve on seeding emerging managers. Ontario Teachers is probably the one fund that has seeded the most hedge funds, venture cap funds, private equity funds in Canada. But even Teachers has become lukewarm on seeding in this environment and with good reason as most hedge funds will get clobbered in the coming years.

The reality is that very few hedge fund managers in Canada and elsewhere are worth seeding. Just because someone made money at some investment bank or prop shop, doesn't mean that they will make money running a hedge fund. And VC funds are even worse; the vast majority fail and Canada has lost billions in VC investments.

And this isn't just a Canadian problem. Bloomberg reports that hedge funds with assets of less than $100 million in the Asia Pacific region are turning to millionaires and family offices for investments as institutions favor funds with more than that amount and proven track records:

E Fund Management Co., which in April started China’s first officially registered hedge fund, raised $100 million from the nation’s rich. Singapore-based Iridium Asset Management started trading last year with money from the founder’s family, while Regal Funds Management Pty Ltd.’s eight-month-old quantitative fund is aiming to tap family offices, which make up 40 percent of the Australian manager’s flagship market-neutral strategy.

Europe’s escalating debt crisis and a global economic slowdown have pushed volatility on equity markets to a two-year high, making hedge funds more important for wealthy investors because of their low correlation to market moves. The money from rich individuals and families is keeping smaller managers afloat, as pension funds and other institutions that write bigger checks favor hedge funds managing more than $100 million.

“It is always hard to raise money for new startup hedge funds, but it is generally easier from family offices and private wealth,” said Zhen Liu, managing director of index and quantitative investment at Guangzhou-based E Fund Management. “They are more performance driven and more willing to try out new and novel strategies and managers.”

The lack of institutional allocations is hampering the growth of smaller hedge funds. Managers with $50 million or less made up 64 percent of the region’s funds as of August, up from 54 percent in 2007, Eurekahedge Pte said in a report in October. Most of the $18.2 billion in capital inflows since the second half of 2009 went to larger funds, the Singapore-based industry data provider said.

I would be extremely careful seeding any fund. If I did seed, I'm more comfortable seeding liquid hedge fund strategies. How would I proceed? Let's say Mark Wiseman, CIO at CPPIB, called me tomorrow morning and said "Leo, we want to start a hedge fund seeding program with $500M," I'd have no problem setting up a managed account platform for less than 50 basis points and finding three to five emerging Canadian hedge fund managers worth seeding. Moreover, if you structure these deals properly, the seeder pension fund can make money if the fund ever IPOs. That's on top of getting preferential fee structure that goes along with seeding any emerging fund.

But Canadian pension funds are in no hurry to seed Canadian fund managers. It's much funner and sexier traveling to London, New York and Chicago and paying 2&20 for leveraged beta. That's why Montreal's alpha industry is pathetic and why even Toronto's is nowhere near where it should be. But who knows, maybe more US funds and sovereign wealth funds will step up to the plate and follow CalPERS' lead, seeding Canadian hedge funds. Till that happens, Canadian startup funds will go on starving for seed capital.

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