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3 Steps to Quickly Raise Your First $100 Million and Scale Past $1 Billion AUM
As you probably know, I’m the founder and managing director of Adagio Group.
We’re a boutique investment bank that provides a turnkey suite of quantitative risk analytics, advisory, securitization and distribution services to help asset managers optimize their performance and quickly scale AUM.
I recently published the book on this subject: The Shadow Banker’s Secrets: Investment Banking for Alternatives.
The changing economic climate is making it increasingly difficult for asset managers to raise capital.
So today, I’m going to distill a few of the major points from the book into the three steps to quickly raising your first $100MM and reaching institutional scale AUM while protecting your portfolio from market crises.
Let’s dive in…
Step #1: Accurately measure and optimize the risk-adjusted performance of your investment strategy to make it competitive within the capital markets.
If you strip away all the cultural trimmings around the financial services industry, why does anyone invest?
The typical answer everyone gives is that people invest because they want to make their money grow, or they want their money to generate returns.
Well, if that’s it, why don’t people just take all their savings to a casino or to the corner market and buy up all the lottery tickets they can afford? Hell, a lottery ticket can provide over a 10 billion percent return on your money in less than a week. Winning any game in a casino will at a minimum double your money within a minute or so…
Gambling is obviously not a sound investment strategy. The potential gains are big, but the probability of losing is bigger.
Investors want to pursue opportunities for their money to grow—and as quickly as possible—but they don’t want to incur a lot of risk in the process.
Then of course liquidity is the third consideration… how soon do people potentially need their money back?
At the end of the day, these are only three considerations that matter when evaluating an investment: risk, return, and liquidity… and of these three quantifiable considerations, risk is the most important.
Ironically, people have no problem talking about expected return as a number (e.g., I need 8% on my money, 10%… whatever), or liquidity as a number (I need my money back in 6 months, or 2 years…), but when it comes to risk, the conversation quickly deteriorates into misguided heuristics and storytelling… “What’s the asset class?” “ What’s your AUM?”…
Let’s talk about asset class for a minute…
Which asset class is better: public equities, private equity, real estate, energy, hedge funds, whatever… This paradigm dominates every alternative asset manager’s distribution efforts. “I have to find the people who like my asset class.”
It’s a ridiculous allocation criterion. For example, if you compare stocks to real estate via the S&P vs MSCI US REIT Index… the real estate market has a beta of about 0.85 as compared to equities.
We’ve got some of the most sophisticated quants in the world on our platform, and the best we’ve seen that can be teased out of public markets at scale is about a 20% signal-to-noise ratio.
The Sharpe Ratio for all public markets hovers around 0.2 with a maximum drawdown that is about five times greater than the expected return depending on how you parse the data.
The alpha of real estate markets is negative as compared to the S&P…
For those not familiar with quantitative risk analysis, both stock and real estate markets are bad in terms of indexed performance.
What about AUM?
Extensive research has repeatedly shown that managers with under $50MM in assets overwhelmingly outperform larger funds. As a matter of fact, there is a perfect inverse relationship between AUM and performance, yet allocators still want to evaluate asset managers based upon their AUM—as in the greater the asset manager’s AUM the more inclined institutions are to allocate. Again, this represents precisely the opposite of a good decision if performance of the allocator’s portfolio is the primary concern.
Write this down: markets and AUM don’t make good investments. Good asset managers make good investments.
So what do you do with that information? To start, don’t get distracted by and start chasing all the misguided heuristics pushed by the pedantic culture of financial services. Focus on generating what smart allocators actually need: the lowest possible risk with the highest possible returns… then teach them how to recognize it
Everyone throws the word around, but what actually is risk?
If you ask 1,000 financial professionals, 999 will give you the brook trout look. They may talk around it, but none of them can actually define it.
Risk is not story; it’s not a feeling; and it’s not a relationship. It’s not AUM or asset class or a narrative from a due diligence report. Risk is a number: it's the probability of loss weighted by the potential degree of that loss.
In fact, risk is the only variable that materially distinguishes investing from gambling…
In gambling, the probability of loss exceeds the probability of gain. With investing, the probability of gain should greatly outweigh the probability of loss.
This idea can be boiled down to one simple example…
Think of a coin flip… if I told you that I’d give you $10 if you were to correctly guess which side comes up, what would be a fair bet? The answer—as most people intuitively know—is $5.
Mathematically speaking, the chance of winning is 50%; so, if you divide $5 by 50%, you get $10, which is the fair return. If I paid out more than $10 on that $5 coin flip bet, that would be a good deal; if I paid out less than $10, it wouldn’t be.
It doesn’t matter how you feel about the coin or the person doing the flipping or what kind of story is used to predict the outcome. The probability is the probability.
Now, the math associated with measuring investment risk is quite a bit more complex… there are four statistical moments that must be weighed—mean, variance, skewness and kurtosis—and a minimum of one complete market cycle must be taken into account for risk metrics to be meaningful… but the fundamental principle remains.
Risk is a number that can be accurately measured for any asset or portfolio within any asset class, and accurately measured risk-adjusted performance is the basis for the smart money’s investment decisions.
If you can generate superior risk-adjusted investment performance, report it with the correct use of quantitative metrics, and validate it with third-party administrator corroborated valuations and annual audits, you can clearly and credibly communicate that your strategy is better than the traditional assets peddled by every financial advisor, and win the battle for distribution on merit.
The greatest opportunity to generate superior risk-adjusted performance—which means that not only does your strategy perform well during the good times, but it also performs well across market crises—exists in the arbitrage opportunities that are created by the inefficiencies of private markets like real estate and small business.
But how do risk measures that require the analysis of historical data across a minimum of a complete market cycle to be meaningful help a start-up asset manager?
The good news is that virtually any strategy can be rigorously backtested to accurately measure its risk-adjusted performance as if it’s actually been running for over a decade. In short, the strategy must be distilled into a comprehensive set of objective rules; then the appropriate data can be researched and plugged into the variables associated with each of those rules. Period returns are compiled based upon those variables, and those returns can then be statistically analyzed.
As a matter of fact, when we work with our clients, we often find opportunities to optimize their existing strategy or structure, which effectively creates a new strategy that must be backtested. So this is not just something for the newbies…
What about liquidity? Many financial professionals pretentiously dismiss private funds solely because they’re illiquid. I’ll remind them of their Series 7 or 65 education on money markets versus capital markets. Any clients with near-term liquidity needs—as in less than a year or so—should be allocated in money markets.
So if you’re advising your clients on capital markets allocations, insofar as the lock-up period of a quality private fund does not conflict with their longer term liquidity constraints, the allocation decision should be based upon quantitative risk-adjusted performance measures.
Of course, private securities lack liquidity should pay a liquidity premium, but what should that be?
It just so happens quite a bit of research has been done in this arena by the likes of Aswath Damodaran at NYU. In short, after clearing all the smoke, professionally managed private companies and institutional grade private funds are at worst worth only about 10% less than their publicly traded counterparts. In other words, if a public company that historically yielded 7.00% a year were to go private, its new fair expected return would be 7.77%… not some ungodly multiple as typical financial advisors like to proffer.
Step #2: Engineer an institutional-grade fund to bridge your strategy’s capital needs and performance with retail and institutional demand, and onboard a reputable third-party administrator and auditor.
This is not about having your local attorney pulling a set of template offering docs off the shelf and putting your name on them.
How many of you guys are real estate syndicators who can’t sell your pref with a catch-up and waterfall and are hoping to be lucky enough to have terrible GP terms forced on you by a family office?
To be successful, the structure should be designed to bridge the gap between the terms your strategy needs with the terms the capital markets need. It’s not about following the precedent structure set by every other syndicator in your asset class.
The capital stack should be engineered as a max-min problem on risk-adjusted performance with an understanding of unmet demand in the capital markets, and the lock-up has to not only account for the capital needs of your strategy but also account for the market itself… what happens if the planned exit falls at a market bottom? What should the gate look like to sustain a potential market bottom allowing you to exit without you and your LPs getting raped?
As an example, for the last several years we’ve been almost exclusively engineering fixed-income structured products with real yield at treasury level risk to wrap underlying alternative asset strategies that would naturally issue equity because there is currently a $20 trillion plus demand for quality fixed-income.
Beyond illiquidity, the most common and legitimate objection to private funds is that they’re typically poorly managed and lack transparency, which creates significant counterparty risk. This does not have to be the case, and often enough, it’s not.
Combined with a financially engineered structure, this objection can be addressed by employing a third-party fund administrator, issuing quarterly financial reports, and having your fund audited annually by a nationally recognized accounting firm. This gives private fund managers arguably better transparency than their publicly traded counterparts with their highly manipulated 10-Qs and Ks. Ask me know I know sometime…
Once all this is done, only then is it time to raise capital…
Step #3: Quickly raise as much capital as you can responsibly deploy through innovative distribution infrastructure and compliant navigation of the regulatory environment.
As many of you know from experience, for most people, trying to raise money for their asset management business from friends and family can only get them so far…
Raising capital is the process of selling financial instruments within the capital markets. To raise capital at scale, you have to think and operate like a financial institution, then beat them on merit.
After friends and family are tapped, the natural progression is to spend hundreds of thousands of dollars hiring wholesalers and key accounts managers that work RIAs and family offices for years, or pursue the much more expensive independent broker-dealer route and never raise a penny. The reason for the high probability of failure through traditional distribution is that RIAs and IBDs don’t make decisions based upon merit. They make decisions based upon a mix of regulatory fear, personal profit motive, and ignorance… they follow the industry standard heuristics.
As an emerging manager, you’re not going to win on the heuristics established by the firms who rely on them as a means to maintain their position at the top of the industry.
You’ve got to execute an alternative distribution strategy to gain traction… meet the money in the grass roots on the terms that it needs…
What do people need that the market is currently not providing them? Are they even aware of what they need?
The challenge asset managers face when trying to raise capital is that what passive investors and allocators actually need is almost always very different from what they’ve been indoctrinated to believe they need… and this creates tremendous opportunity.
The task from a marketing perspective is to break the widely held false beliefs held within the capital markets… This takes rigor—as much or more so than what was required to develop and run your investment strategy.
Most people are absolutely terrible at marketing, however. Marketing is not advertising. Marketing is built on research… understanding the frustrations people face with the solutions they currently use and are motivated to move from when they see a better alternative.
The first step in that effort is to thoroughly understand the psychology of the patrons of competitive investment products. About 18% of that crowd is sufficiently frustrated with their current investment solution to move to an alternative if they knew something better existed.
The good news about human psychology is that when you show a person that you thoroughly understand the frustrations associated with their problems, they’ll assume you have the solution without ever having to even mention it.
So understand the frustrations of the capital market participants and make your messaging a mirror of their psychology… when you do it right, you’ll never have to ask for a dollar.
If your risk-adjusted performance is strong enough, you can use innovative feeder structures to compliantly navigate the regulatory environment like feeder corporations and investment clubs organized around a shared risk-adjusted performance appetite to bypass the dysfunctional middleman and access capital at its source.
Particularly investment clubs when structured and operated properly allow a great deal a flexibility on the marketing front.
Once you’ve achieved sufficient AUM through nontraditional distribution, you can then start engaging smaller funds of funds, pension funds and endowments where you’ll find a much warmer reception for rigorous quantitative risk analytics and engineering. From there, your AUM will snowball as your performance is insulated from market volatility.
To get introduced to the 100,000+ accredited investors and 10,000+ financial institutions in our ecosystem, take The Shadow Banker’s Secrets: Investment Banking for Alternatives Masterclass (upgrade your free book order) to learn the technical fundamentals you’ll need, then schedule your private consultation.