Hedge Fund Managers: Where To Find Their Investment Theses

Hedge funds are considered alternative investments and are usually open-ended, allowing investors to withdraw and invest capital periodically. They are not subject to the same restrictions as regulated funds, but regulations were introduced post-2008 to increase oversight. Hedge fund managers are paid a management fee and a performance fee, the latter of which has been criticised for incentivising high-risk investment management.

An investment thesis is a written document that provides information about a potential investment. It is a research- and analysis-based proposal that is usually drafted by an investment or financial professional to provide insight into investments and to pitch investment ideas.

Therefore, to read about hedge fund managers' investment theses, you can refer to the written documents that they produce. These will outline the fund's investment strategy, including the types of companies they invest in, the industries they focus on, and the average check size. They will also detail the fund's viability, potential risks, and expected returns.

How to write an investment thesis

An investment thesis is a formal written document that outlines an investor's strategy and serves as a framework to direct investment choices. It is a proposal based on research and analysis, and it is used to pitch investment ideas.

Step 1: Determine your minimum viable fund size

The size of your fund will influence your investment strategy, including the number of companies in your portfolio, your check size, the amount of capital you have to reserve, and your fund's return profile. It will also determine the types of limited partners (LPs) you attract and the portfolio management fees you can support. To determine your ideal fund size, research other funds with similar goals and benchmarks to see how they are performing.

Step 2: Pinpoint your investment focus

After settling on a fund size, outline the stage, industry, and location of your investments. This will help narrow your aim and convince LPs with interests in these sectors and stages to get on board. It will also make it easier for founders who meet your parameters to identify your fund as a potential investor and discourage those who don't. Consider at what point in a company's life cycle you want to invest, the sectors you are interested in, and the geographies of the companies you will be investing in.

Step 3: Portfolio construction

Your portfolio construction is critical to running a successful fund and shaping your overall investment thesis. It signals to LPs how you plan to allocate their capital across investments. Your strategy should include diversification, check size, investment horizon, expected returns, and investor requirements. Ensure that your investments align with your portfolio construction model, and regularly evaluate whether your investments continue to align over time.

Step 4: Rigorous due diligence at the Micro level

Conduct in-depth research and analysis of the companies you are considering for investment. Evaluate the company's growth drivers, management team, and strategy, as well as potential risks and challenges. Look at the company's current product portfolio and pipeline, its key customers and their loyalty, and its competitive landscape and positioning. Assess the management team's background and track record, their strategic priorities, and their ability to attract and retain talent.

Step 5: Align with the Macro environment

Understand the macroeconomic trends that can impact your investments. Look beyond quarterly fluctuations and identify long-term shifts that can positively impact revenues, margins, and valuations of well-positioned companies.

Step 6: Understand the overall trade setup

Consider the current setup or "state of play," which is often the most overlooked part of a stock pitch. Evaluate how the stock has performed leading up to the catalyst, how crowded the trade is, and whether the general public is bullish or bearish.

Step 7: Present your fund thesis to LPs

Most VCs prepare different versions of their fund thesis, ranging from a one-sentence elevator pitch to a full pitch deck. Sum up your fund strategy in one or two straightforward sentences, and articulate why you are better positioned than anyone else to execute your investment thesis.

Remember, a strong investment thesis is crucial for achieving success in your investments. It provides a framework to direct your investment choices and articulate the reasoning behind your decisions.

What to include in an investment thesis

An investment thesis is a formal written document that provides a reasoned argument for a particular investment strategy. It is used by individual investors and businesses to support their investing decisions. Here are some key components to include when constructing an investment thesis:

• Investment Details: Clearly state the investment in question, such as a specific stock or the acquisition of another company.
• Investment Goals: Outline the goals you aim to achieve with this investment. Are you targeting a certain rate of return or looking to expand into a new industry?
• Viability and Trends: Analyse the viability of the investment by evaluating relevant trends and the overall trade setup. Consider the company's qualities, such as its return on capital, margins relative to competitors, and management of capital allocation.
• Potential Downsides and Risks: Identify potential risks and downsides associated with the investment. Address questions like "What could go wrong?" and consider unexpected events like financial crises or geopolitical shifts.
• Costs, Returns and Losses: Outline the expected costs, potential returns, and possible losses associated with the investment.
• Alignment with Goals: Evaluate whether the investment aligns with your intended goals. Does it fit with your investment strategy and risk tolerance?
• Financial Statements: Analyse the financial statements of the company you are investing in. Look at historical financial performance, growth rates, and key financial metrics.
• Growth Potential: Assess the growth potential of the investment. Consider industry trends, competitive positioning, and the company's ability to maintain or increase its market share.
• Competitive Advantage: Understand the company's competitive advantage and how it differentiates itself from its competitors. Are there any barriers to entry or sustainable advantages?
• Management Team: Evaluate the quality of the management team. Consider their track record, capital allocation decisions, and compensation structure.
• Valuation: Study both relative and absolute valuation to determine if the investment is attractively valued. Compare valuation metrics with peers and the company's own historical valuation.
• Catalysts: Identify potential catalysts that could impact the investment positively or negatively. Are there upcoming events, such as earnings releases or new product launches, that could affect the investment's performance?
• Risk Management: Develop a risk management strategy by identifying potential risks and implementing mitigation strategies. Consider the impact of unexpected events on your investment thesis.

Remember, the investment thesis should be clear, concise, and well-researched. It should provide a compelling argument for the investment decision, addressing both the potential benefits and risks involved.

Hedge fund strategies

Hedge funds are an important subset of alternative investments, and they come with various pros and cons. The basic trade-off is whether the added fees involved with hedge fund investing result in sufficient additional alpha and portfolio diversification benefits to justify the high fee levels.

Equity-Related Strategies

Equity-related strategies aim to create alpha by taking advantage of diverse opportunities to make skillful stock picks. These strategies may use index-based short hedges to reduce market risk, but most involve single-name shorts for added absolute return. Examples include:

• Long/Short Equity (L/S) strategies, which involve taking "long" positions on undervalued stocks and "short" positions on overvalued stocks to profit from upside and downside movements in stock prices.
• Dedicated short-selling strategies, which only involve short-side exposure but may hold cash to moderate short beta.
• Equity market-neutral (EMN) strategies, which focus on taking advantage of short-term mispricing between securities, applying high levels of leverage to target meaningful returns.
• Merger arbitrage, which involves investing in securities of companies undergoing mergers or acquisitions, with the potential for defined gains but also the risk of occasional downside shocks if deals fall through.

Event-Driven Strategies

Event-driven strategies capitalize on temporary stock mispricing spawned by corporate events like restructurings, mergers and acquisitions, bankruptcies, or takeovers. Examples include:

• Distressed securities strategies, which focus on firms in financial distress, bankruptcy, or reorganization, seeking inefficiently priced securities throughout the process.
• Fixed-income arbitrage, which involves taking advantage of the correlations and yield spread pick-up between different debt securities across various markets.
• Convertible arbitrage, which involves delta hedging and gamma trading short equity positions against long convertible bond holdings to extract "underpriced" implied volatility.

Relative Value Strategies

Relative value strategies seek to exploit temporary differences in the prices of related securities by simultaneously purchasing and selling different financial instruments based on near-term price movement speculations. An example is:

Merger arbitrage, which involves taking offsetting positions in two companies involved in a pending merger to profit from pricing inefficiencies before and after the transaction.

Opportunistic Strategies

Opportunistic strategies require specialized skill sets for trading in niche markets. Examples include:

• Volatility trading, which involves capturing relative timing and strike pricing opportunities due to changes in the term structure of volatility using various option spreads.
• Reinsurance/life settlements, which involve analyzing pools of life insurance contracts and purchasing those with low surrender values, low ongoing premium payments, and a high probability of the insured person dying sooner than predicted.

Multi-Manager Strategies

Multi-manager strategies offer diversification by allocating capital across different fund managers. Examples include:

• Funds-of-funds (FoFs), which invest in other types of funds, including hedge funds, with the goal of allocating capital across different funds rather than selecting individual investments.
• Multi-strategy funds, which have more variance due to higher leverage use but offer potentially faster tactical asset allocation and improved fee structures.

Specialist Strategies

Specialist strategies trade in niche markets and aim to generate uncorrelated, attractive risk-adjusted returns. An example is:

Global macro strategies, which focus on discerning and capitalizing on trends in global financial markets using a wide range of instruments, such as equity indices, fixed income, currencies, and commodities.

Hedge fund risks

Hedge funds are a risky investment choice. They are loosely regulated by the SEC and require a high minimum investment or net worth. Here are some of the key risks associated with hedge funds:

Operational Risk

Operational risk refers to the potential for loss due to inadequate or failed internal processes, people, or systems, as well as external events. This includes fraud, misleading reports or valuations, conflicts of interest, systems failures, and unauthorized trading activity. Start-ups and younger funds are particularly vulnerable due to a lack of experienced staff and infrastructure to handle operational matters effectively. Thorough due diligence is essential to mitigate these risks.

Investment Risk

Investment risk in hedge funds relates to the behavior of markets and the robustness of the fund's strategy. Hedge funds often employ risky investment strategies, such as investing in debt and equity securities, commodities, currencies, derivatives, and real estate. They may also use leverage, which increases the potential for gains but also heightens the risk of losses.

Liquidity Risk

Hedge funds are considered illiquid investments as they often require investors to keep their money in the fund for at least a year, known as the lock-up period. Withdrawals may also be restricted to specific intervals such as quarterly or biannual periods. This lack of liquidity can make it challenging for investors to exit the investment if needed.

Manager Risk

The reputation and expertise of fund managers play a significant role in attracting investors to hedge funds. However, it is important to evaluate the background and reputation of these managers. Conflicts of interest, such as benefiting certain investors over others, may arise and impact the fund's performance.

Valuation Risk

Hedge funds may invest in highly illiquid securities, and the valuation of these assets can be complex and subject to significant judgment. This can affect the fees charged by the fund manager and the overall performance of the fund.

Regulatory Risk

Hedge funds are subject to less stringent regulation compared to mutual funds, particularly those domiciled outside the main financial market countries. This lack of regulation can increase the potential for unforeseen issues and heighten other risks.

Counterparty Risk

Hedge funds often borrow from banks and brokers to leverage their investments. However, this also exposes them to the risk of their counterparties failing to meet their obligations, which could lead to losses for the fund.

Strategy Risk

Hedge funds employ various investment strategies, and the success of an investment may depend on the effectiveness of the chosen strategy. If a strategy fails to deliver the expected results, it could impact the fund's performance and lead to losses for investors.

Hedge fund fees

Hedge funds typically charge clients both a management and a performance fee. The "two and twenty" fee structure is standard in the hedge fund industry, and also common in venture capital and private equity. "Two" refers to a 2% management fee charged on the total assets under management (AUM) per year, regardless of the fund's performance. "Twenty" refers to a 20% performance or incentive fee charged on profits made by the fund above a certain predefined benchmark. The performance fee is the biggest source of income for hedge funds.

The "two and twenty" fee structure has been criticised by investors and politicians in recent years, particularly as hedge funds have struggled to perform optimally since the 2008 financial crisis. As a result, some investors have sought out hedge funds that charge lower fees.

Some alternative fee structures include:

• "Founders shares", where investors are offered lower fees during the early stages of a fund's business.
• A promise to reduce fees when the fund reaches a specific milestone.
• Discounts for investors who are willing to lock up their investments for a specified time period.

Frequently asked questions