Harvester of hedge funds

The Financial Strategies division of asset manager MD Sass is an incubator of sorts. But instead of seeding innovative technologies, the firm grows asset managers with novel investment theses.

In 1985, Marty Sass and Hugh Lamle of New York asset manager MD Sass saw an opportunity to create a new product for the retirement planning market. The two realized that retirees could benefit from allocating assets to tax-deferred vehicles, such as variable annuities, rather than ordinary, taxable mutual funds. In order to capitalize on the idea, MD Sass formed a joint venture with Canadian insurance company North American Security Life (NASL) to market the new product. The business grew and thrived, and in 1991 NASL bought out MD Sass’s interest in the venture, generating a gross internal rate of return of 31.4 percent for MD Sass.

The strategy of locating an inefficient area of the asset management market and a team capable of exploiting it, growing a successful business, and then exiting the investment worked so well that MD Sass repeated it 18 times in the next two decades. Of the 18 investment managers MD Sass spun out, 15 were successful, generating a gross overall IRR of 50.8 percent and a 3.7x return on capital invested.

Some of these ventures were partnerships between MD Sass and an innovative small or mid-sized investment management company looking to grow its business to the next level. In other cases, MD Sass simply came across a team of managers with an idea and built a business from the ground up. These managers usually were not traditional entrepreneurs, but instead were investment bankers or research analysts, people who had expertise in a particular area of asset management and needed the support and infrastructure of a larger firm to implement their strategy.

?Instead of doing one deal a year, we wanted to do two, three or even four, and we needed additional capital to do that.

In many ways, the strategy is akin to that of a “venture capitalist within the investment management business,” Lamle says. But MD Sass incubates hedge funds instead of tech startups.

Plug and play
The firm made these private equity investments as they found them, off MD Sass’s balance sheet, until 2004. That year the firm brought all of its private equity investments under one umbrella fund, the $273 million MD Sass-Macquarie Financial Strategies LP.

The Macquarie Group was a keystone investor in the fund, committing $110 million. The rest of the capital came from a group of limited partners ? some existing clients and some new ? that includes university endowments, corporate pension plans, high net worth individuals, family offices and foundations. MD Sass raised the fund, its first with a general partner-limited partner structure, with the help of its own internal marketing team as well as the placement arm of Merrill Lynch.

:We wanted to accelerate the pace of investing,? Lamle explains. ?Instead of doing one deal a year, we wanted to do two, three or even four, and we needed additional capital to do that. And in the aftermath of the dot-com crash, and with interest rates very low, it was very clear that a lot of capital would gravitate towards alternative investments. You could just see the explosion in terms of private equity fundraising from 2002 onwards.?

Since 2004 Financial Strategies, or FinStrat as the team refers to it, has looked at some 650 teams of asset managers looking to start a business, seriously considered around 20, and actually funded seven. The young firms have strategies in diverse markets, among them real estate lending, energy futures, Asian equities, publicly traded telecom and utility securities and natural mineral resources.

Once FinStrat has closed with a new team of managers, that team can truly ?plug and play,? says Marty Sass, because MD Sass offers a complete infrastructure that provides nearly every resource the team will need.

?Even though they’re separate, distinct entities, they’re really part of a big family, so they can share all the resources MD Sass has to offer,? Sass says.

The new business has access to an accounting department, an operations department, a technology department, a legal and compliance department and a marketing and client services department. More often than not the startup is housed in MD Sass’s New York offices. Because the managers don’t have to worry about payroll and tax returns, they can focus all of their attention on making investments and generating returns, Lamle says.

?As they grow, we encourage them to take on some of these other functions, whether it’s risk management, their own marketing capability or internal finance, because we want to grow them to full-fledged independent companies at some point,? Lamle says. ?But in the startup and early phases, we don’t want them distracted, and we don’t want their finances squandered by having a full-time CFO when they have no clients and only a small amount of money to manage.?

FinStrat will provide the manager with working capital for things like Bloomberg terminals and office supplies. In addition, FinStrat seeds the manager with between $10 million and $25 million in ?track record capital,? money that the manager can use to execute its strategy on a prototype basis, but with sufficient diversification that the resulting portfolio is representative of what the manager would do with more substantial assets under management. By the time the manager goes out to market to raise capital from outside investors, it has already proven its ability to generate returns.

Once the manager is ready to go to market, it can take advantage of the resources Macquarie brings to the table. Because of the global scope of its operations, Macquarie can bring its entire sales team in to market the manager to international clients. Senior managing director Steve Shenfeld says the extent of the support FinStrat provides for new managers differentiates the firm from other incubators of its type.

?There are other firms in the marketplace that provide financing for a startup manager, but there are very few that can provide this full suite of services and infrastructure that makes them a more mature manager than they otherwise might be, if they were three guys in a hedge fund hotel somewhere trying to build out their reputations,? Shenfeld says. ?And in today’s market that’s a really critical thing. There’s a lot of literature about how most of the money today is going to the largest institutions, so the institutional standard by which you have to compete now if you’re a young firm keeps going up.?

MD Sass-Macquarie Financial Strategies

Founded: Funds:
2004 MD Sass-Macquarie Financial Strategies LP, $273 million,
closed 2006, matures 2014
New York Key Personnel:
Marty Sass, MD Sass CEO
Keystone investor: Hugh Lamle, MD Sass President
The Macquarie Group Steve Shenfeld, senior managing director
Philip Sivin, senior vice president
Stephen Darke, Macquarie division director
Portfolio companies
Ascent Real Estate Advisors US real estate March 2003
Waterfall Asset Management High yield ABS March 2005
Energy Arbitrage Management Energy futures October 2005
Denahi Global Investments Asian equities November 2005
Crow Point Partners Telecom/utilities August 2006
Taurus Funds Management Natural mineral resources May 2007
Three Kingdoms Capital Asian long/short equities Jan 2008

One big family
Because its back office and administrative functions are handled by MD Sass, the FinStrat team is able to focus entirely on due diligence and executing deals. Consequently, the team is a lean one, with a highly fluid and collaborative division of labor.

Sass, MD Sass’s chief executive, and Lamle, its president, devote a significant portion of their time to FinStrat. Lamle is MD Sass’s ?chief scientist,? Sass says, spending much of his time thinking about the more esoteric types of investment strategies. Because he has experience in a broad range of markets and instruments, he is well suited to determining what about a potential FinStrat manager’s strategy is unique and differentiated from the market. He guides how the manager is marketed to investors, and also monitors their activity to make sure they are not deviating from their stated strategy or taking on an inappropriate risk, however subtle. He is also heavily involved in negotiating the terms of FinStrat’s investments.

Though Sass monitors each of MD Sass’s divisions, and also spends time watching the firm’s cash flow and setting strategic direction, he finds time to be involved in the due diligence process for each manager that has survived the first round of vetting by the FinStrat team. Often he plays ?devil’s advocate,? he says, coming in a looking for flaws.

Shenfeld and senior vice president Philip Sivin are both dedicated FinStrat professionals. Shenfeld spends much of his time originating deals and building up FinStrat’s pipeline. Sivin, who was at one point MD Sass’s general counsel, helps to structure deals and also serves as a liaison between the managers and the various departments of MD Sass. Shenfeld and Sivin are also supported by two dedicated analysts, who assist with financial modeling, due diligence and research.

Rounding out the team, Stephen Darke, division director of Macquarie Securities (US), represents Macquarie’s interest, and also offers his thoughts on whether a manager’s strategy will appeal to overseas investors. But every employee of MD Sass and Macquarie is a potential employee of FinStrat. Not only do they help to support FinStrat’s portfolio companies, but they can help in the due diligence process as well. MD Sass manages 15 strategies, as well as a fund of funds that in turn invests in 19 strategies, so the firm has experience and contacts in nearly every major sector of the financial markets. FinStrat’s partnership with Macquarie adds overseas contacts to that network, particularly in the Asian and Australian markets.

?We have the ability to dig very deeply into the underlying strategies and the backgrounds of the individuals who are seeking to partner with us, because we can speak to an international network of investment managers,? Lamle says. ?It represents a fairly unique capability in terms of how quickly we can find out about people.?

The road ahead
One side of FinStrat’s business that is still fairly immature is the exit process. In the past FinStrat has mainly exited through private transactions, typically selling its interest back to the manager itself, or to another financial institution. But this will likely change in the near future, as the public markets have created new avenues for raising permanent capital. The special purpose acquisition company (SPAC) market is another potential source for new funds that FinStrat is looking at.

FinStrat also hopes to continue to seek investments overseas. The firm has seen its business become increasingly global, partly because of its partnership with Macquarie and partly because of the changing nature of financial markets.

?Twenty years ago I don’t know if there were even hedge funds in Asia,? Shenfeld says. ?Today there are Asian hedge funds that are specifically marketed to Asian clients?We now see a lot of deal flow where the people are not from New York; their primary language is not English.?

Since 2004 FinStrat has partnered with a manager in Singapore and a manager in Sydney, Australia, its first international investments, and the team plans to continue looking abroad for talent.

FinStrat is likely to close on two investments in the next few weeks, bringing its stable of investment managers to nine. In the next two years the team hopes to partner with an additional 15 to 20 managers. With the major investment houses still reeling from subprime losses and laying off large numbers of employees, FinStrat expects to see many talented managers looking to strike out on their own.

It’s hard to tell exactly what kind of strategies FinStrat will see going forward, as its interest is often piqued by a particular management team just as much as its investment strategy. But the team does know what kind of strategies it won’t pursue.

?What we’re not looking for is a standard long-short equities fund,? Darke says. ?We’re not looking for a fund of funds, or a multi-strategy fund. We’re looking at interesting areas like healthcare hedge funds, global cleantech funds or something impressive in distressed investing. We look for a single strategy that has an edge.?