'The Deal' Has Been Corrupted

This is the second leg of the SumZero Allocator interviews, a series of discussions with respected leaders in the institutional investment space. My name is Nicholas Kapur, and I am SumZero’s COO and head of the firm’s internal fund manager program called Cap Intro.

Today I am honored to be joined by Mr. Charles Honey, a Partner and Portfolio Manager at the Richmond, Virginia-based investment manager Private Advisors. Honey helps oversee nearly $5B in firm assets comprised of both single-securities and third-party investment managers, many of whom fall into the ‘small and emerging’ category, a niche SumZero cares about deeply.

Private Advisors is a long-standing member of SumZero’s Cap Intro program, an internal platform designed to direct high-quality exposure toward member fund managers for the purposes of capital raising. To learn more about how the firm approaches the manager selection problem, we reached out to Charles and the broader Private Advisors team to dig in. Mr. Honey's official bio follows:

Charles Honey manages the long/short equity hedge fund business at Private Advisors. Charles focuses on sourcing, underwriting, and monitoring of long/short equity investments, including funds, co-investments and direct equity positions. Prior to joining Private Advisors in 2007, Charles was the Managing Partner of Rapidan Capital, a long/short equity hedge fund that he co-founded in 2002. Charles held Managing Director roles at Morgens, Waterfall, Vintiadis & Company and at Trainer, Wortham & Company. He began his career in 1993 as a trader and research analyst for Woodward & Associates, a New York based hedge fund. Charles received a B.S. from Washington & Lee University.

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NICHOLAS KAPUR, SUMZERO: Charles, first, a sincere thank you for making yourself available for this series. It is great to have you. Private Advisors has a respected history as an investment manager, particularly with regard to getting into high-quality small funds from early on. What attracted you to the space?

CHARLES HONEY, PRIVATE ADVISORS: Well, I appreciate the opportunity to speak with you. We are big fans of SumZero and these interviews you have been doing, so we are honored to be included. Private Advisors has been investing in long/short equity managers since 2001 and have always had the view that for this strategy, in particular, size is the enemy of returns.

We also have the view that the best managers close to new investors early in their life cycle, so if you wait around and aren’t willing to invest when the manager is emerging and small, you will miss a lot of great opportunities.

NK: Well, I believe you are also on the right side of a bunch of academic evidence in thinking that, which I would bet is not a total coincidence.

You were an analyst and a portfolio manager for 14 years before you began investing into funds. How did this experience color your perspective? What did you learn from being ‘in the business’ that you may not have been able to ever learn from the outside?

CH: I think the biggest thing you learn as a PM and/or analyst is empathy for how hard the stock picking business can be. You know the level of focus and attention to detail it takes, but more importantly the right temperament you need to succeed. Investing is great when you nail the analysis and pick a big winner. However, no matter how talented and smart you are, eventually everyone gets served a slice of humble pie. In fact, if you look at every great investor’s track record, there is undoubtedly a period of time where they were in the bottom quartile.

How managers deal with the frustration of losing will dictate how they perform over the long haul. That perspective allows us to be patient and take a longer-term view of our partnership with managers.

NK: Speaking of performance, and to paraphrase a recent analysis by Verdad Fund Advisors, “backtests suggest ~90% of the variability in fund performance could be explained by just the single variable of assets under management.”

You mentioned a minute ago that you believe fund size to be the enemy of performance. All else equal, what is it exactly about ‘getting bigger’ that makes it harder to perform?

CH: I’ll admit that there are likely some strategies such as distressed credit, macro or multi-strategy funds where there are scale advantages. However, in long/short equity, we have found two areas where ‘getting bigger’ really hurts your ability to perform.
The first is on the short side of the portfolio. If you are truly a long/short investor and run a decent size short book, then your ability to short successfully and generate consistent alpha on that side of the portfolio will go a long way to determining your overall performance. We also know that the best short opportunities are in the small and mid-cap area of the market. Occasionally, you get a Nokia (NOK:US) or a Valeant (BHC:US) but, in every year, there is more dispersion in small-caps, and thus hundreds of stocks in the Russell 2000 that decline significantly.

Based on our research, a larger fund running a short book much greater than $500 million runs out of liquid opportunities to short in the Russell 2000 very quickly. Our view is giving up that opportunity set on the short side for more assets under management is a poor trade off for the investors.

The second aspect where size is the enemy of returns comes down to complexity. I call it the institutional imperative. As AUM rises, managers feel a strong need to grow their teams as well. As these teams become larger, managing them becomes more complex, and the dilution on the portfolio manager’s time impacts performance. There are virtually zero cases where an analyst team increased significantly and performance improved, yet we see it happen all the time.

NK: Last time we chatted, we talked about the history of the hedge fund, and the original rationale for hedge funds needing to charge higher fees. You mentioned that the “deal has been corrupted” since then. Can’t resist digging in. What exactly do you mean, and why should hedge funds be charging more?

CH: When I entered the hedge fund business in 1993, it was largely a cottage industry with smaller funds run by managers who started funds because they wanted to do more than just buy long or hold cash. The deal was: I’m going to run less money than I was running at my prior long only shop so I can be more nimble and utilize the additional tools of shorting, options and leverage to generate better returns.

In exchange for managing a smaller asset size, I’m going to charge a performance fee, so when I do well I can pay myself and my people the money they might be earning if we were running a larger pool of capital. Not to mention the better alignment of incentives when you earn your money on performance not just management fees. I’d also add that management fees then were closer to 1% not 2%.

As hedge funds became an “asset class” and institutional money flowed in, these “entrepreneurs” were now running huge pools of capital, but they didn’t adjust down the fees that originally were intended to motivate the smaller manager.

That’s what I mean when I say the deal has been corrupted. It’s been a great wealth creation tool for the larger managers, but it has not been as good a deal for the investors.

NK: I think that is an important history lesson for those of us who did not see the shift occur.

Switching gears a bit, in your November 2017 investor letter, you cite the significant contribution made by your managers through unpopular stocks. If a fund manager’s attribution is largely been driven by FANG stocks, let’s say, how much of a disqualifier is it? If a manager can demonstrate mastery with names that ultimately become widely-tracked, is that really a bad thing?

CH: If you are seeking differentiated returns, it certainly helps to have differentiated ideas, but owning popular names isn’t necessarily a disqualifier. If you look at the performance of the Goldman Sachs VIP list over longer periods of time, it has outperformed the indices. The companies are popular for a reason, so it makes sense that they are creating shareholder value.

The issue you have is in the short run when volatility spikes and investors de-risk you see outsized declines in the most popular names, which makes performance for those funds even more challenging. So in the worst market performance months, the funds you are counting on to help hedge your market beta are not performing as you would hope. While outperformance on the back of popular or crowded names is not necessarily a disqualifier, we are careful that our portfolio is not full of managers crowded in the most popular names.

NK: Well, what then would be a disqualifier for you when considering a fund or a manager?

CH: We focus on fundamental long/short managers, so quantitative strategies or black boxes are an immediate disqualifier. We also avoid managers who rely on a lot of gross exposure or swing their exposures around drastically.

We believe in the John Wooden quote, “Don’t mistake activity for achievement,” so managers that have hundreds of names in their portfolio and high turnover are also low on our priority list.

NK: OK. Let’s reverse that: What, to you, is a character trait that offers the strongest indicator of long-term success in a manager?

CH: I spoke about it earlier, but having the right temperament is a critical determinant of success.

You also need to have a lot of grit and be highly competitive. Hedge funds have attracted some of the brightest minds from the best schools, but the problem is many of these folks have been such high achievers that they don’t know how to deal with adversity.

You are entering a business where the best stock pickers are wrong over 40% of the time. That can be a hard pill to swallow for the person used to getting straight A’s their entire life. Being a good investor requires loving the grind day in and day out. I can promise you it’s not nearly as flashy as Billions, the series on Showtime, would lead you to believe.

NK: Hah. I should hope not. To turn a bit toward strategy here, your fund has built a history of making meaningful co-investments alongside your external fund managers. How do you decide where and when to take action on a single-stock (or bond) basis? Where is your ‘edge’ in this space and how do you know when to say ‘no thanks’?

CH: When you are looking at building a co-investment program, it’s important to remember that even the very best managers never bat anywhere near 1000 on their best ideas. So we keep a very high bar for ideas and say ‘no thanks’ far more often than we say we are interested. I also believe it’s imperative that you supplement the manager’s thesis and research on an idea with your own work.

If we can’t isolate and understand the critical variables that will determine success in an investment, then it’s an easy pass for us. When you outsource all the analysis to your managers, how do you know if it’s time to buy more or most importantly when to sell?

In terms of creating an edge, our biggest successes have come from having a differentiated insight on the business or its future versus some short-term edge in information, which frankly is very hard to sustain in today’s market.

Private Advisors has been investing in the Low Mid Market private equity space for 20 years and we often lean on those relationships to gain insights into the quality of businesses or management teams. It also helps when you can take a longer-term view and be a bit contrarian.

I can’t tell you how many times we have gone through an investment idea with a manager that sounds very compelling: a great business, great management team, cheap valuation, but some short-term issue that is keeping investors away because the next quarter might be “sloppy”. If you are willing to look around corners and think creatively beyond the next few days, weeks or months, we think there are attractive opportunities.

NK: Given your focus on earlier-stage/smaller managers, it seems prudent to ask: Where does your search for investment talent begin? Where are the next generation of great investors spending their time right now?

CH: SumZero, of course! In all seriousness, we are excited about the level of talent in the hedge fund industry. Whether it’s a younger analyst striking out on their own or a more experienced investor leaving a larger shop, what we are finding is a consistent supply of good stock pickers.

Sometimes you have to be willing to look outside the major financial hubs, but they are out there and we believe they will continue to come. A lot has been said about how hard it is to launch a fund because of increased compliance costs etc. We agree with that to some extent, but the quality of outsourced service providers has made it possible for the small shop to get up and going much easier than 20 years ago.

If you love public investing, your choices are limited to be an analyst for a larger shop, going to a platform, or starting your own fund. The challenge with platforms is they don’t cater well to the investor who takes a longer time horizon. So, if that’s the way you like to invest, and you want to try your hand at being a portfolio manager, you are likely going to have to start your own fund. That phenomenon creates an endless supply for investors like Private Advisors to evaluate.

NK: Love to hear the the talent pool is beefy (I agree), and extra points awarded for the unsolicited SumZero plug there. Final question: What advice would you give to someone considering the launch of a new fund? What do you think is the most important thing these individuals can do to increase the chances of them being a viable target for a respected institution like Private Advisors?

CH: My advice when launching a fund would be to keep it simple. Complexity is a killer, so start with a small team you know and trust. Expect that it will take longer to reach your asset goals than you first imagine, but don’t get discouraged. Keep your head down and put up attractive returns and folks like Private Advisors will find you.

Offering attractive terms to reward early investors will certainly increase your chances, but it requires taking the long view of building your business. I like to say there are two types of hedge fund managers: Those that lay in bed at night and define success as AUM levels, number of analysts, office décor, conferences attended, etc. and those that just think about their CAGR. We prefer the latter.

Download the Private Advisors Q&A Here