HF Third Party Marketing Industry Is Seeing Strong Growth in Demand
After a tumultuous three years the hedge fund Third Party Marketing (TPM) industry is seeing very strong growth in demand from both hedge funds and investors, although this growth is not shared evenly across the estimated 500 firms in the industry due to a wide difference in the quality and reputation of TPM firms. Addressed below are reasons for the increase in demand for TPMs, the benefits of the top TPMs to investors and hedge fund managers, what has transpired in the TPM industry over the past three years and the quality difference among TPM firms in the industry.
Why the Recent Increase in Demand
The third party marketing industry is seeing strong growth in demand from hedge funds because most net flows into the hedge fund business have been concentrated in a small percentage of firms with the strongest brands. From the 4th quarter of 2008 through 2010, the definition of strongest brand meant the largest hedge funds with assets greater than $5 billion, where performance was a secondary consideration. Beginning in 2011, a small percentage of small and mid-sized hedge funds were able to break away from the crowd by building strong brands, which led them to successfully compete with their larger peers. A high quality product offering and strong historical returns are not enough for smaller mangers to attract capital. They also need to effectively communicate what their differential advantages are in order for investors to have a positive perception of the fund. In addition, they need an effective sales and marketing strategy. This is a great environment for TPMs, because there are a significant number of high quality funds that are having difficulty raising assets. Many of these managers are looking for marketing help because they realize that high-quality marketing is a critical element of a hedge fund’s long term survival.
From the standpoint of investors, the number of hedge funds has grown substantially over the years, to the extent that some investors are contacted by hundreds of managers a week. The top third party marketing firms act as a filter for high quality managers and make it easier for investors to evaluate the managers. In addition, many high quality firms are difficult to find since they do not show up in hedge fund databases.
Benefits the Top TPMs Provide to Investors
A. TPM services are complimentary to investors: fees are not typically paid by the investor or by the fund. They are paid by the hedge fund organization.
B. Screening of the hedge fund manager universe. With an estimated eight thousand hedge funds and an opaque market, it can be difficult to identify the highest quality hedge funds. The best TPMs spend significant time analyzing hedge fund databases, trade journals, and leveraging various industry relationships to identify a broad universe of managers. This universe is then narrowed down by utilizing both quantitative and qualitative screens. TPM firms then perform extensive due diligence on the top funds before making the decision to represent a hedge fund. In some cases, TPMs represent less than 1% of the firms on which they perform due diligence. If one of the firms they are representing becomes less marketable for any reason, they have the option to stop representing that organization. In-house marketers do not have this option; they need to either continue to sell the fund or find another job.
C. Easier to evaluate mangers. Investors don’t like wasting time with managers that are unable to effectively communicate what they do. A good TPM will help its manager consistently deliver a concise and linear marketing message that identifies the differential advantages across each of the evaluation factors investors used to select hedge funds.
D. TPMs can offer consulting advice relative to what strategies they think will outperform given current valuation levels and the economic environment, identify trends they are seeing among similar investors, and pinpoint where the money is going. TPMs are in a unique position since they are both doing research on hedge funds across a broad range of strategies and speaking with thousands of investors about how their assets are allocated and what strategies they currently prioritize.
E. TPMs are required to be licensed and regulated by the Financial Industry Regulatory Authority (FINRA). These firms are heavily regulated and are required to undergo periodic reviews by the regulatory bodies for compliance. Not all hedge funds are regulated, and their internal sales people in many cases are not licensed. As it now stands, third-party marketers face a much higher degree of regulatory scrutiny than hedge funds that have not registered with the SEC.
Benefits the Top 3PMs Provide to Hedge Fund Managers
A. Immediate enhancement of brand. Some of the top TPMs can add instant credibility to a hedge fund when they take them on as a client. This is achieved when investors have consistently been shown high quality funds by the TPM, which causes them to have a high regard for their hedge fund research process. This is similar to the credibility received by a new fund when launched by an existing high-quality hedge fund.
B. Consulting advice - This includes analyzing the fund offering based on the evaluation factors that investors use to select hedge funds and offering advice to improve any weaknesses. Strong TPMs are able to review all marketing materials and oral presentations to assure a consistently delivered, concise and linear marketing message that identifies the differential advantages across each of the evaluation factors investors use to select hedge funds. Finally, TPMs can provide marketing and sales consulting advice that identifies which type of investors the fund should be focused on, which conferences they should attend, and as a result of the new JOBS act, whether or not they should develop a publicity or advertising strategy.
C. Access to investors - Most of the major TPM firms have a large rolodex of investors and often have very strong professional relationships. Due to the multiple strategies they represent, TPM firms have the ability to meet with investors much more frequently than internal hedge fund marketers. This gives the TPM the ability to significantly increase the number of high quality meetings for a hedge fund manager and allows for better feedback and follow up from those investors.
D. Economics - Building out an internal sales force with top-quality talent can cost several million dollars, and the compensation associated with this effort remains in place regardless of how effectively assets are raised. TPMs typically are only compensated if they raise assets. If these assets are from investors the hedge fund would not have acquired on their own, then there is no cost to the hedge fund because they are receiving a majority of the fee income they would not normally have received. In addition, if the TPM can bring in assets 6 months earlier than the hedge fund would have on their own, than the increase in fee income is often enough to offset the TPM’s fee.
E. Increased probability of success - Raising assets in the hedge fund industry is not a linear process, but exponential. Part of the reason for this is that investors do not like investing in funds that are not growing. Asset-raising success gives other investors confidence to make an investment.
What Transpired Over the Past 3 Years?
Before 2008 the third party marketing industry flourished and helped many emerging managers to become some of the largest hedge funds in the industry today. This was a period of rapid expansion for the industry when it was relatively easy to raise assets for a fund and asset flows were diversified over a large number of hedge funds. It was also during this time, due to low barriers to entry, that the number of third party marketing firms expanded significantly and attracted some unprofessional and unethical individuals to the industry. This had a negative impact on some investors’ perception of third party marketers, similar to the general public’s perception of the hedge fund industry, due to a few bad apples.
From 2008 to 2011 the TPM industry was devastated for three primary reasons. To quote Thomas Paine, “these are the times that try men’s souls.” First, TPM fee revenue and asset base declined along with the rest of the hedge fund industry. Second, from the 4th quarter of 2008 through 2010, hedge fund net flows dropped off an estimated 95% from their peak and only slowly improved over this time period. The environment was even worse for hedge funds with less than $5 billion in AUM, which were a majority of the hedge funds that TPMs represent.
The final issue had to do with the public pension fund scandal led by the New York State Common Fund that was plagued with internal corruption. An official associated with the fund created a TPM firm in order to illegally get paid off by alternative investment managers for getting hired. Despite the fact that traditional hedge fund TPMs were completely innocent and most not allowed to meet with the fund since at that time they only invested in hedge fund of funds, the State of NY proceeded to blame the TPM industry in order to deflect criticism away from their own structural flaws. They first tried to get other public pension funds to ban TPMs and, when that strategy failed, they lobbied the SEC to ban TPMs. This proposed legislation was both prejudiced and insulting to the institutional quality TPM firms. During the comment period of the proposed legislation, the response from many of the leading public pension funds, who recognized the value added by the top TPM firms, was overwhelmingly in favor of the TPM industry. As a result, the ultimate “pay to play” legislation that was passed actually benefited the top third party marketing firms by leveling the playing field and making everyone play by the same rules. The new legislation applied to all asset management, alternative investment and TPM firms equally. As a result, TPMs are able to call on public funds with the exception of State pension funds in 3 states that have all had internal unethical behavior. During this time period the Third Party Marketing Association has proactively developed ethical guidelines for its members to abide by. As mentioned earlier, the top tier TPMs that made it through this period are seeing a significant increase in demand and fund flows.
Major Differences in the Quality Within the TPM Industry
Similar to the hedge fund industry, there is a significant difference in quality across the estimated 500+ firms within the TPM industry. The top TPM firms receive a disproportionate amount of attention because they have developed strong brands that enhance the credibility of the managers they represent in the marketplace. This has been achieved by those third party marketing firms that are perceived by the market as being of institutional quality, having strong investment and product knowledge, high integrity, deep consideration for the best interest of the investor and only representing the highest quality hedge funds in the industry.
Investors should differentiate between institutional quality TPMs that consistently represent high-quality hedge funds versus the lower quality organizations. For hedge funds, it is vital to hire the highest quality TPM firm possible, because it will have a major impact on how people perceive their firm. Hedge funds should use multiple factors when selecting a TPM firm, including: firm reputation, depth and quality of sales team, industry knowledge, investment knowledge, assets raised, and geographic and investor segment specialties.