How To Succeed When Launching a Hedge Fund

Starting an alternative investment fund requires a strong focus on keeping operating costs down to avoid having expenses erode returns, especially in the case of smaller portfolios, says Lincoln Archibald, a managing director at Fund Launch Partners, which has helped hundreds of clients launch hedge portfolios. In this podcast hosted by IBKR Senior Economist Jose Torres, the consultant also highlights additional factors that contribute to the success of new hedge funds.

Summary – IBKR Podcasts Ep. 183

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jose Torres 

Hello, everyone, and welcome to Interactive Brokers podcast, IBKR. I'm Jose Torres, your Senior Economist. In today's episode, we're going to be chatting with Lincoln Archibald. Lincoln is the managing partner of Fund Launch Partners, a private equity firm specializing in GP stakes. 

He is currently a minority partner on multiple funds across the alternative landscape. Lincoln is a partner at Fund Launch and formerly functioned as the CFO. With prior experience from J. P. Morgan, Venture Capital, and Real Estate Development, he brings a strong analytical and financial background to his work. 

Functioning as a fund consultant, Lincoln has coached and advised hundreds of emerging asset managers over the past few years across the alternatives landscape; Venture Capital, Private Equity, Real Estate, Hedge Funds. Finally, Lincoln has been able to observe the intricacies of sound fund management and truly learn what is required to be a successful steward of investor capital. 

Lincoln, welcome to the program. It's great to see you here. 

Lincoln Archibald 

Hey, thank you. Great to be here with you guys. 

Jose Torres 

Terrific. So, what got you into this business, here at Interactive Brokers, we service a lot of those customers that would be your customers also use us as prime broker and for other reasons as well. What got you into this space? 

Lincoln Archibald 

I'd had different exposure to different parts of the alternatives. And then about five years ago, me and my partner were looking out to start our own fund. His dad is the co-founder of Bridge Investment Group, which is a $50 billion real estate family of funds. 

 We were just asking him questions every day about how to start a fund, how does this work? What's a 506 B versus a 506 C, how does this reg D filing, what should we have in our data room? Just all the questions that there's not really anything on the internet about. 

We took it upon ourselves as we were kicking off our own funds to say, “Hey, look let's codify this information and put together an educational product on Supporting Emerging Managers.” It’s taken off. So, we incubate over a hundred funds a year now. 

It started as education, quickly turned into an incubator of sorts. We incubate just over about a hundred funds a year. We just followed the needs of our clients, as they ask, “Who should I go get audits with?” “Who should I do compliance with?” “Who should my prime broker be?”  “How should I pay my partners or advisors?” Or just all the questions of fund management. And it led us to launching a GP Stakes Fund where we now partner and invest with emerging fund managers. 

Jose Torres 

So, with stock valuations extremely lofty here at 22x forward earnings, if you look at the S&P at 5,500 and $250 of earnings per share expected in the next 12 months, and bond yields not earning as much in excess of inflation. A lot of folks have looked into the alternative space to earn excess returns, call it those 10% to 20% returns, whether that's hedge funds or private credit or for the more growthy types of venture capital. Out of those hundred funds per year that you're bringing on, what's the distribution you would say across different kinds of fund types? 

Lincoln Archibald 

Yeah, about 42% are real estate related strategies. About 25% are Equity Venture Capital related strategies and about 25% hedged and then we always get some subsets of private credit or very unique, true alternatives strategies that may not have a bucket. 

I love what you said there. An interesting data point in 1950, about 6.5 million Americans owned US stock. By 1990 65 million Americans owned US stock. And then by today, almost over 150 million Americans owned US stock. So, we've seen this mass adoption of just investors on the stock market in general, right?  

And we're kind of starting to see the same adoption rate in alternatives where more and more retail investors are wanting access to alternative investments and it kind of gives a perfect place for an emerging manager to come in and take on retail investor capital to start to grow your portfolio, grow your AUM until you're more of an institutional grade fund. 

Jose Torres 

What are you seeing out there? Given that you bring on roughly 100 new funds per year, you probably have a good gauge on economic health, economic activity, the state of the investor, what they're worried about, what they're looking forward to. What have your conversations recently been like? 

Lincoln Archibald 

All over the place, right? I mean, look it's no question that the past 18 months have been pretty difficult in regards for fundraising, right?  

But some of the best and largest funds all started out of downturns, market downturns, right? When there's a market downturn, it creates opportunities for investors. 

And in reality, this is just a long game, right? When you're managing money, you're not thinking in terms of weeks or months, in most cases. It's years. And it's those that really put their head down and go to work, are the ones that have been successful in my opinion and are just thinking people are always surprised. 

Jose Torres 

Sure. I mean, I guess, short term increments over a long period of time, you can see significant compounding, if that works to your point. 

Lincoln Archibald 

Exactly. We always talk about compound interests,  and how it's the eighth wonder of the world. And in reality, compound interest applies to your life as well.  

It applies to your experience. And those that go out and actually get in the game and start trading and start participating in the markets or start making investments Ultimately win in the long term. 

There's two core types of emerging managers that I see. There's the traditional manager, Ivy league degree, goes and works on Wall Street for 10 – 20 years. And then they spin out, they're sick of working for the man and they spin out and start their own shop. 

That's the traditional path to being a fund manager. The untraditional manager, which I think may coordinate with your audience here is somebody that just starts doing deals. 

They take their own capital and start trading, investing, purchasing a business, investing in real estate and guessing what? They make money. So, they do it again and again. and now to scale their business, they go and either syndicate deals or they start leveraging other people's money. By repeating this over the course of several years, it positions you in a spot where you're Now in a better spot than most to go out and raise a fund. 

Those traditional managers that I was talking about, those institutional grade managers, they really never managed their own money. So, from an alignment of interest it's a huge vote of confidence from investors to see somebody that has an audited track record of your own performance. 

Cause again, if you're trading at a big shop, a lot of the time they won't let you take that performance with you and leverage that performance as you're starting your own fund. So just start trading your own money, syndicate, you can start an investment club or you can start a hedge fund incubator. 

There's a lot of different products that you can start, but just start trading your own assets and get that audited track record and nothing else is going to help you grow more than that.  

Jose Torres 

That's really interesting. Two main takeaways for me. First was the compound interest component. I always talk to folks about it. It's not just about the money that's compounding. It's the experiences. It's everything you go through. It's the organization. It's education, there's so many factors that go into compound interest outside of money itself. 

Not to say that compounding dollars isn't a great thing. It's a terrific thing, but maybe we can compound all other aspects of our life into strong growth. Secondly, another big takeaway was what you said about folks managing their own money, maybe not having that Ivy League exposure early. Often more established, institutionalized kinds of managers, they may come from a family that's already integrated in finance. 

It's easy to get internships in the big shops, all that kind of stuff, whereas those folks that are more nitty-gritty that have perhaps a less traditional route, also have carry a strong set of skills. In fact, here sometimes at Interactive Brokers, we have these small investors that over five years or a decade, end up running a book that's $5 million – $10 million. All of a sudden, they qualify for a hedge fund marketplace program. Especially if they've been a client for a while. And like you said, they had audited financials that really helps them. 

In terms of some of your customers, what would have been some of the feedback that you've heard from interactive brokers and how do you sometimes recommend us when you're talking to some of the smaller hedge funds? 

Lincoln Archibald 

Yeah. I focus on micro funds. So, most of the time it's somebody managing less than a hundred million dollars on their first fund. And guess what? When you're trying to raise a hundred million dollars, it might start with just $1 million to $12 million. It's not a lot of money at the beginning. I think what emerging managers need to solve for is load cost. For example, there was a manager that came into my pipeline, that had about $20 million AUM, but he went out and chose the most expensive service providers you could possibly get. He set up this master feeder fund structure and he had all the bells and whistles, and his load cost was about a million dollars a year to run his hedge fund and only managing 20 million! 

So, your relative load costs and your dollars, you're 5% in the hole before you even start trading. Like you have a 5% catch up to even break even to start returning money to your investors at that point. That's not even including your management fees. Tack on the other fees, he was like 7% to 9% in the hole. And I was like, this is terrible. Like, I don't want to work with this group. So as an emerging manager, you need to solve for load costs. 

So why I like interactive brokers is because they have a more amicable fee structure to emerging managers. So, I always say, look, you don't need the biggest Bulge bracket service providers when you're just starting out, it's probably to your detriment. Unless you're going out and raising a couple hundred million dollars on an institutional fundraise. 

 If you have a really large LP base, they're going to want to see certain logos on your deck. They're going to want to see that you have a certain audit firm. They're going to want to see that you have a certain prime brokerage firm. But for most emerging fund managers, you're primarily starting by raising from high-net-worth individuals and family offices and maybe if an anchor might come from an institutional grade allocator. 9 times out of 10, they care more about you solving for load costs than having a big-name logo on your fund. 

Jose Torres 

That's interesting, our average hedge fund is around $8 million but we do have ones that are up to a billion dollars. And here at Interactive Brokers we compete in a bifurcated way. A lot of the bigger broker dealers don't accept small accounts. 

We compete with a lot of the retail broker dealers, but we also compete with the institutional broker dealers. We're hoping that our logo and all that becomes a lot bigger over time. One thing with us is we're relatively young. We were established in 1978, whereas some of those bigger broker dealers have been around for two centuries and all that. So we're working on it.  

Finally, what's some advice that you would give a younger fund manager in any kind of fund, whether it's private equity, hedge funds, real estate, or venture capital? 

Lincoln Archibald 

Yeah, I would say put your investors first at the end of the day, Like it's not about you. It's not about you making money. It's about you making your investors' money, and as long as you put that first in every decision you make, from the risk that you're taking on in different positions to your fee structure, to the partners of who you're paying and how you're paying. 

If you put your investors first at the end of the day, you're going to win in the long-term, It's inevitable. If you wake up every day and you're thinking about, “hey, how can I do good for my investors?” You're going to be all right in this industry. And there's a lot of firms out there that start to get too greedy for lack of a better word. As you start to get bigger, you might live lavishly off just your management fee income. 

And it's a terrible alignment of interest. So having strong hurdle rates and complex management fees that tear down as you grow or returning even excess fee income that's coming in back to your investors. Like if you just put your investors first, you're going to win in the long term, in my opinion. 

Jose Torres 

You mentioned something really interesting. So, one thing we've also been viewing is some hedge funds, they get so big and then they decide to turn into family offices. Sometimes they send all the existing investor money back, or they let them know that they're only going to manage it for another year. Or they keep who they have, and they block out new folks from coming in. Well, what are your views on some of the developments there? 

Lincoln Archibald 

Yeah, look, family offices are an interesting beast. Over the past decade, a lot of them started to step in and to do direct deals. And we see that a lot more in private equity, real estate, venture, where they say, “hey, look, I'm sick of allocating to a blind pool fund and letting somebody else choose the investments. 

I want to have more control.” And so we've seen family offices take a lot more approach to direct. Now, within the past 18 months, it's kind of been a reckoning here, that I've noticed a similar theme, if you will, where these family offices that stepped in and wanted to do direct. Maybe things aren't going how they planned in the portfolio. 

Things aren't going as they planned in the company or in the asset. And it is taking a ton of time, so in a lot of recent conversations I've had with family offices, they've said, look, we tried direct, it was fun, it was good, but we now know there's pros and cons with any investment structure. So, they're taking a step back and saying, “look, let's do more passive allocations” just cause it's a lot of work. It's a lot of work to manage.  

I mean, any sort of alternative asset manager, you're an active manager at the end of the day in most cases. Like, you're actively managing those investments and there's a reason that you charge fees. 

It's because there is a lot of work that needs to be done. I think we've seen that shift regarding family offices, and these funds turning into family offices. It's a natural consequence.  

Asset management is an extremely lucrative field. As managers start to accumulate their own mass amounts of wealth it's no wonder they want to go off and start a family office. I will say that the best managers, though, At the beginning, I would say the first decade, they always have the majority of their own wealth in their own investments. They never go outside of that. So, they are some of their biggest LPs in their own funds as they grow. And then they'll start to branch out into other investments down the road. But I mean, you really need to have that alignment of interest with your limited partners. 

Jose Torres 

And another interesting thing you mentioned is active investing. Some conversations that I've been having with some of our customers recently has been that the passive indices have really outperformed a lot of active managers because NVIDIA run, has been so concentrated where if you had a passive investing style and just the S&P 500 or the Qs you've been rallying like crazy, but if you're an active manager and you're maybe prudent on your positioning and you don't want to have too much of NVIDIA, all of a sudden you end up underperforming, so that's one important development that I've been noticing recently.  

Overall, folks have been saying that active investments aren't worth it. I disagree. I think active investments are actually better than passive investments. It's just that we haven't really seen much downside recently or sustained downside. 

So, hedge funds are naturally more cautious. They naturally have hedges on, but like passive investing, there's really no hedging. Your only hedge is really dollar cost averaging, which, in theory is not really hedging. You're just buying overtime. Any thoughts there? 

Lincoln Archibald 

Yeah. It's a great point hedge funds do best in times of high volatility, when there's high, market downturns, that's when active managers get to really boast about their performance or even in a flat market. 

It allows them to better capitalize on the market. But look, I think it all changes, just wait a couple of years or even a couple of months and the story is going to be different. It's constantly evolving.  

I think there's benefit to both in anyone's portfolio in all reality. Not investment advice for any way, shape or form, but I think everyone should have passive long only exposure in the marketplace. 

I think an investor wants that, but when you look at portfolio construction, I mean, alternatives serve a very unique value prop to your portfolio. Like you've already got your long only exposure.  It comes back down to like, “hey, what is your thesis?” “What's your investment policy statement?” and really, “what value are you delivering to an investor's portfolio?” If that's risk mitigation, great. 

If that's inversely correlated to your long exposure. Great. If that's overexposure on, doubling down on bull runs. Great. Whatever it is. Like, I just think that you need to be crystal clear in what your strategy is and know your value prop, know where you're playing. I think too many investors and early fund managers just try and be an everything burger. 

They try and provide, “oh, you want yield?” Great. “Oh, you want growth?” Great. “you want all these characteristics of an investment?” Great. They are just catering. They're subjecting the integrity of their investment thesis to cater to, investor needs, asks, or wants. 

At the end of the day, I think it's so much better when a manager comes in and knows exactly what he's looking for. I don't pretend to be an expert at all investment strategies, right? In any way, shape or form. Now, I allocate across alternatives. I allocate to private equity, venture, and hedge funds. I'm not an expert at all those things in any way, shape or form. Like I'm an expert on running and starting funds at the infancy stages. I think the best managers have an extremely high conviction in their investment strategy and have thoroughly thought through the value prop that they are delivering to their LPs. 

They're confident about what they know, and they're humble about what they don't. And they seek education, guidance, and mentorship in areas where they lack experience and depth. But at the end of the day, they're the expert investors. 

There are three main roles to a fund that we always talk about. There's your expert investor, somebody that's your CIO, right? They're making the investment decisions. There's your fund manager, think like a COO or a CEO, it's somebody that's running the business. 

If you're running a hedge fund, it's a business just like any other. If you're starting a new, startup, like there's accounting needs, there's HR needs, there's infrastructure needs for a hedge fund. And then there's your capital raising department. 

And I think, again, the best emerging managers are confident about what they know, and they're humble about what they don't. They aren't afraid to seek help in the areas where they lack expertise. So, sorry, that was kind of a long deviant from your question there. I kind of got off course of your original question. 

Jose Torres 

Yeah no, we certainly appreciate the insights. Any final thoughts before we wrap up? 

Lincoln Archibald 

Just advice to emerging managers is just play long game. And just don't think about this over the course of weeks or months, but let your experience compound, have good performance year over year and prioritize that above anything else. 

Those that prioritize that, it's inevitable that you'll be depending on your goals, but like those are the firms that reach, scale. Those are the firms that reach mass volume. And so just prioritize that. 

Jose Torres 

Well, thank you very much, Lincoln. Thank you for tuning in to Interactive Brokers IBKR podcast. Please hit the subscribe button and you can follow us on Apple Music, Spotify, YouTube, etc. Thank you. See you next time.