Jason Ader, whose career has included stints as an analyst at Bear Stearns, Smith Barney, and Baron Capital, is both CEO and CIO of Ader Investment Management, the alternative investment firm he founded in 2003. Experienced in most areas of the alternative investing world, AIM today focuses on seeding (or re-accelerating) hedge funds less than three years old and with under $300 million in assets under management. Ader says he focuses on these managers because they tend to outperform their larger rivals.
To find out more about the advantages of investing in emerging managers and smaller funds, FINalternatives Senior Reporter Mary Campbell spoke to Ader recently by phone from AIM’s New York headquarters.
Can you tell me something about the firm?
Ader Investment Management is a company that I set up [in] 2003, so coming up 10 years, and we have been in the alternative investments business, we’ve run hedge funds, we’ve made private equity investments. The bulk of our focus today is seeding or raising capital for emerging or smaller hedge funds and we’ve raised $1.5 billion now across a number of different investment vehicles. The team here that works with me has done over $10 billion in transactions and we’ve built out a competitive advantage in our distribution—we have geographical reach spanning 15 countries and about 1,200 institutional investors and that gives us access to about $250 billion in capital targeting the alternatives sector.
And the four biggest sources of capital are Singapore, China, Abu Dhabi and Israel, of all places. So they’re not quick trips to Boston, I wish it was that easy.
When you say emerging managers have outperformed larger managers, what is that based on?
I’ll speak anecdotally from our own work at Ader Investment Management. We typically see the emerging managers, they’re much more focused in those first three years generating the returns that send a signal to the marketplace that risk is under control and that they are able to produce predictable, monthly returns. The ultimate objective of an allocator to alternatives is risk management and predictable monthly returns and we find that emerging managers have been very focused on that, and rightly so.
The ones that do the best job over the first three years in proving to the market that they’re able to achieve those goals often find themselves in the desirable position of seeing substantial flows of assets thereafter. And therein lies the problem and the challenge, because very often firms that start out as sector specialists or multi-sector specialists need to broaden out into new areas and new markets because their assets have grown. This style drift, in my view, is the primary detriment to returns after that first three-year period.
So, should hedge fund managers limit the size of their funds?
[Excluding] the rare exception where the strategy is very scalable…I think generally speaking, that’s right. I think all strategies and investors are best served by managers keeping the asset base consistent with liquidity goals, consistent with their research or trading competitive advantages. There’s a conflicting dynamic, it’s a very interesting dynamic, because managers obviously want to grow, it has positive implications for their earnings and net worth [and] allocators are most comfortable putting money into the largest of funds, but…the reality is the new managers, who have a real trading or research competitive advantage, tend to outperform over that three-year period. But very often that return is enjoyed by the manager, friends and family and early-round investors, which is where we try to focus our time and energy.
Do you worry about an investment being too large a percentage of a manager’s total assets?
It’s a risk, we’ve seen it and that risk very much played out for managers through 2007-2008. One of the things that I like for our business, as opposed to seeding, is re-acceleration capital instead of acceleration capital. We see great managers, sector specialists who really are world class in either healthcare or financial services or industrials who were $400 or $500 million in ’07 and all of a sudden find themselves $80, $100 [million] or less. They’ve held their business together, they’ve had good returns, but they had such a high percentage of their asset base concentrated in a few investors, and because of the liquidity of their strategy, they ended up losing assets. And because it becomes a self-fulfilling downward spiral, once you start losing assets and you notify your other investors about a redemption, they start redeeming and that concentration risk makes that problem worse. We probably look at 50 relevant risk factors, concentration of investment is definitely one of them and that ’07-’08 period is certainly in everybody’s recent memory as what can happen to a firm when one or two investors are disproportionate.
What are some of the other factors you consider when weighing a potential investment?
First and foremost, we like the liquidity of the strategy. We tend to see great managers but if the returns are a function of less-liquid investments, it’s typically not for us. So, liquidity is a big focus for us.
Second is volatility management. Our investors are typically looking for 10-12% annual returns on a gross basis, 8-10% on a net basis, but a 2 Sharpe ratio or better. [H]ow do you find managers that are able to achieve that by managing the downside risk? We spend a lot of time focusing on volatility management, risk management, how managers have done in periods of market draw-down or significant market increases, because we don’t like to see significant correlation and it’s something we really try to get behind in our analysis…
Third is really the competitive advantage of the strategy…[F]or 10 years, I was a top-ranked Institutional Investor hotel, casino, leisure industry analyst…”and so I have a great respect for research competitive advantages and I look for analysts like that, people who are world class in financial services, healthcare, industrial, tech. What is their advantage to others pursuing similar, comparable investment strategies? We look at trading competitive advantages, risk competitive advantages and really understanding why this portfolio is better positioned than the hundreds of other alternatives in its peer group…
Beyond that, we need to see infrastructure. We don’t want to have one or two guys or gals in a room—we need to see an independent compliance officer, CFO, COO, research supporting the portfolio manager, typically a trader or an outsourced trading operation. That’s important to us just in terms of minimizing the risk…of the business itself.
Infrastructure is also expensive—is it hard to find small or emerging managers who have this sort of operation?
It’s certainly true today that [there’s] a higher threshold. When we started in 2003, it was a very different time and there’s no question the hurdle is greater. We’ve tried, in our product…to adjust for that. We’ve said, ‘How can we crack the mold for seeding and acceleration capital? Blackstone and Reservoir, Goldman, they do a good job, how can we think about taking that establishment and doing something a bit different for most hedge funds that wouldn’t fit the model of a large seeding-type transaction?’ And so, because of the higher threshold that you referenced, when we give a manager a managed account, let’s say it’s a $30 to $50 million managed account, we typically offer them higher than 2 and 20 payouts, and we pay them monthly, which gives them the cash-flow necessary for the supporting infrastructure. If they’re successful, we’ll be successful but we think that makes our product more attractive than most.
You say most of the money is coming from abroad. Do your clients in China, Singapore, Dubai have an idea of the kind of strategies they want to get into or do you propose investments to them, how does that work?
I would say almost without question, since Lehman failing, since Bernie Madoff…investors tell me first and foremost, ‘We want managers who are in the business of not losing money’ and ‘We want managers who can manage volatility.’ Those are usually the first. Then I hear the third point, ‘Well, we’d like to make targeted returns [of] 8-10% annually. So in terms of prioritization, we don’t want to lose money, we don’t want volatility and we’re happy, given where LIBOR is or given where T-bills are, with a much lower return than what hedge fund investors expected 10 years ago.’
That’s important for hedge fund managers to recognize because I think a lot of hedge fund managers think they need to produce 40-50% a year (and anybody who can do that, there is a market for that, and those are great and admirable returns) but the consumers of alternatives, it would be like Apple creating a computer that nobody wanted—the consumers of alternatives want those three attributes from their investments: don’t lose money, manage volatility, deliver us 8-10% annually.
And so, we look for managers that really can address all three of those attributes for our investor base.
And strategy-wise, are you open to any strategy or do you have a particular focus?
We specifically focus on liquid equities. We’ve seen great credit strategies or multi-strat, but for us, given our investor demand, it’s all equities, it’s all liquid…We’re right now looking at an event-driven strategy and it’s an interesting debate because the returns fit our profile, yet the portfolio construction isn’t. The event-driven strategies tend to be a bit more net long than traditional long/short strategies but they’re mostly merger-arb and so the question is, can we create, for our business model, a comfort on behalf of our investment committee in an event-driven strategy? Thus far, it hasn’t included event-driven but if we could find an event-driven strategy that fits those three attributes we would welcome it as part of our portfolio.
Do your managers tend to be based in the U.S.?
So far, they all are based in the U.S. We definitely would do Europe, Asia. We’re equipped for 24/7 risk management but there’s a deep enough pool within a few-hour time zones of New York which has been our focus. But we may bring on, August 1, a manager who is operating out of Europe and that would be our first.
How long do you tend to hold a position?
Our desire would be to hold the manager in perpetuity. We’ve set pretty strict guidelines in terms of how much leverage a manager could use, how big position sizes could be, what their maximum net exposure could be, what their maximum draw-down level could be and we’d expect our managers to operate within that rule and if they don’t, we would certainly terminate a relationship. Otherwise, as long as a manager is operating within the guidelines set in our original investment management agreement, our desire would be to continue with them.
A manager that stays within those guidelines in year four, year five, year six would be an anomaly, based on some of those returns we see out of the emerging managers, but they certainly exist and there’s plenty of managers well-known to the marketplace like Third Point or Pershing Square or Greenlight that have had their best returns in the latter years. So, it’s not impossible, but in a much bigger pool, those are the standouts as opposed to the norm.
What’s your take on the current investing environment? What’s interesting to you?
I think Europe is very interesting right now. We wake up every day and we read about the problems in Europe and the problems for the euro and the banking system in Spain. Having just spent a few days in Spain, the newspaper reports here in the U.S. and in London would lead you to believe that things are far worse than reality...
The reality is there’s a high probability Europe will survive and there are some challenges there and to the extent the euro doesn’t end up breaking apart, there’s very cheap, under-valued assets—companies, businesses—and to me, that’s an area of dislocation. And obviously, the best opportunities for investors—[if] you look back at March of 2009, some of the best American companies were trading at 20-25% of current values today…There are some parallels right now in the Portugal, Italy, Greece, Spain, Ireland, what are referenced as the PIIGS countries, are probably some of the most dislocated and the most interesting.
That being said, on the other side of the equation, China has clearly slowed. Valuations in China are far greater, the leverage within the Chinese system is misunderstood and not transparent and, to the downside, there is much more risk in Chinese-related equities as the market there slows and the government and the businesses around the Chinese economy try to adjust for changes in demand and changes in pricing.