- Over 80% of qualified U.S. accredited investors plan to invest in the next 12 months on assets with favorable risk-reward profiles.
- Despite having a total AUM of $2.91 trillion, few hedge funds have established marketing departments despite overwhelming demand.
- Rule 506 c) of SEC’s Regulation D permits private investment funds to broadly solicit and generally advertise their offerings, provided purchasers are accredited investors.
- A key SEC No-Action Letter affirms data processing companies which market hedge funds on classified platforms would not be defined as investment advisers.
Over 15,000 hedge funds in the U.S have a combined assets under management of over $2.50 trillion, accounting for 84% of the world’s HF market share. Being private issuers, only institutional investors or individuals defined in Rule 501 of Regulation D of the Securities and Exchange Commission have the privilege to purchase stakes in such entities. Recent regulatory precedents, however, now allow private issuers to broadly solicit investment from this population with the issuer alone bearing the onus to verify purchasers are indeed accredited. Moreover, data companies acting as marketing agents on behalf of such issuers can broadly solicit accredited investors under Rule 506 b) of Regulation D due to a SEC No-Action letter. With over 30 million accredited investors in the U.S. and nearly 80% of this population wanting to invest in the next 12 months, opportunities to generate substantial alpha in the private investment industry exist, but with very little public exposure. As a result, there exists a dire need for data science companies to curate investment results from private investment funds to a broad group of accredited investors, and bridge their investment goals using proprietary algorithms and/or machine learning technology. (09/30/2019)
Table of Contents:
Key Research — Hedge Funds:
AUM Growth and Performance (+)
The total AUM managed by hedge funds worldwide stands at nearly $3 trillion in FY2019, with 40% of such wealth concentrated in the hands of New York hedge fund managers alone. This represents a growth of +53.1% since 2007, indicating the sector has fully recovered from the nadir of the financial crisis. Moreover, over 66% of the global hedge fund industry is controlled by that of U.S. private issuers, with the United Kingdom holding roughly 10% market share, and continental E.U. holding 3rd place after all constituents are combined. Recent SPX recovery from its local minimum in Q42018 has lead to the best quarter of hedge fund performance since Q12009, and sparked a renewed interest amongst members of the investment community who are on the hunt for alpha.
The vast majority of AUM in hedge funds comes from contributions by pensions funds, endowment plans, and foundations. Accredited individuals and family offices only account for less than 5% of total market share, largely due to the opacity of the investment process and hedge funds’ archaic technological capacity preventing solicitation on a massive scale. This is in spite of regulatory easing which broadly permits public forms of advertising. Currently, the sector is in critical need of a technological solution to capture market share from qualified individuals interested in investing in hedge funds.
Competition And Fee Structure (+/-)
Over 76% of U.S. hedge funds are operating under a “pooled investment” structure by establishing themselves as limited partnerships and having investors be paid out profits based on pro-rata contribution of LP stakes, while having capital invested at the discretion of general partners. Under this legal structure, hedge funds are severely limited in their ability to solicit new capital, as the liquidity of LP stakes are far worse than that of common stock (which would require issuers to be registered under FINRA as Investment Companies).
Source: Interactive Brokers
Despite the sheer number of sector players, very few hedge funds have dedicated marketing departments. The vast majority simply lack the expertise for sales and marketing, and must rely on either word of mouth or private connections in order to solicit new capital. The main competitor in the hedge fund marketing sector, IB Marketplace, currently contain only 629 investment services with just a fraction of them being private issuers, compared to a 15,000 strong hedge fund sector. Moreover, the service is not being effectively monetized, as currently the platform is being run free of charge. Considering IB’s main business model consist of generating discounted commissions off trading public securities, under development for the much larger private issuer sector may represent a missed business opportunity.
Both hedge funds’ management fees and incentive fees have declined modestly since the 1980s standard of 2% MF and 20% IF. This can largely be attributed to industry competition, as the number of hedge funds since then has increased by more than 13,500. Nonetheless, there exist ample opportunities for data science companies to be compensated for their marketing value propositions with these margins. For sake of argument, a pricing model of $2,000/mo. to list a hedge fund with $100 million in AUM on a platform exclusive to potential investors, would only account for 1.67% of such fund’s management fees each year. If such entity was to generate $10 million in profits on a good year, the above subscription model can account for less 0.76% of the fund’s pretax profits, while delivering superb marketing content.
Market Concentration (+)
Out of the estimated 15,000 hedge funds in the U.S., over half are located in New York alone with second and third place being Connecticut and Illinois. As NY holds nearly 40% of the entire world’s hedge fund market share, this makes sales and marketing for emerging data science companies in the sector relatively straightforward. Aided by the large population density of the NYC, door-to-door marketing to solicit hedge funds into signing up for marketing platforms would be abnormally effective. Moreover, many prominent hedge fund mangers have contact details listed on data vendors such as Bloomberg Terminal along with their funds’ addresses. As 253 funds have over $1 billion in AUM, listing just 1–2 such funds with subscription fees taken from its management and incentive profits, may result in 7 figures in revenues for data science startups.
With a cumulative industry size of nearly $2.0 trillion in the U.S., the hedge fund sector remains one of the most intriguing disparities in the financial world. On one hand, individual investors deemed as “accredited” by SEC regulations have a growing demand to invest in private securities which meet their investment goals. On the other hand, hedge fund managers lack modern sales and marketing expertise as to advertise fund metrics over a broad population of potential clients. Such disparity remains a key problem which data processing companies can solve, and which stakeholders in the industry are becoming increasingly aware.
Investment in AI and Machine Learning (+)
Nearly 40% of hedge fund managers plan to implement AI/Machine learning technology as part of their core investment strategy. This is significant as a similar carryover can be applied to that of funds trying to raise new capital. Proprietary algorithms which can quickly deliver funds’ performance to a vast population of accredited investors and seamlessly match them based on investment objectives, have the potential to revolutionize the archaic solicitation methods of private issuers.
Source: Barclay Hedge
Amongst hedge fund managers, there exist a wide disparity regarding investor appetite. There are no clear winners between that of macro; long/short equity, multi-strategy, fixed income, or emerging markets strategies. Currently, there is little market consolidation as to allow investors to search for hedge funds which are custom tailored to their investment goals. This sector is thus enduring a critical technological problem which has yet to be addressed.
Source: Barclay Hedge
Source: Barclay Hedge
The industry consensus is investors’ interest in hedge funds will see a moderate increase in FY2019. It is important to note, the value of securities offerings raised by private issuers is more than 2x the capital raised in public capital markets. Even if the industry was to see growth slow down, the sheer magnitude of the total addressable market leaves bountiful room for data processing companies to grow market share.
Source: Barclay Hedge
In general, high net worth individuals are seeking consistent investment returns with low volatility and ample diversification. Hedge funds which can both cater to such criterion and can generate alpha exist, yet, very few investors are able to establish connections with them due to an archaic marketing structure demanding personal connections; word of mouth, and/or limited offerings on traditional brokerages in order to raise capital. SAAS companies which can deliver funds’ data to a broad population of HNWIs therefore addresses a critical need in the capital markets.
Key Research — Accredited Investors:
SEC Regulatory Easing (+)
Source: U.S. Securities and Exchange Commission
SEC Rule 506 c) of Regulation D came into effect in September 2013, and put an end to an 80 year long practice by allowing private issuers to broadly solicit and advertise their offerings, provided all purchasers are accredited investors. In 2017 alone, there were a total of 37,785 Regulation D offerings reported on Form D filings, accounting for more than $3.0 trillion in new raised capital. This is twice the amount of $1.5 trillion in securities offered through public channels, such as with IPOs. Whilst just 4% of such offerings was conducted pursuant to Rule 506 c) of Regulation D, this still represents a staggering transaction volume of over $120 billion. Should data processing companies charge 0.1% of this addressable market via SAAS fees, this would amount to $120 million in annual recurring revenues alone. Moreover, the SEC has also established guidelines regarding marketing service providers for hedge funds based on Rule 506 b) offerings, which would further expand the total addressable market.
Source: SEC Letter of No-Action To Lamp Technologies LLC
In 1998, the SEC issued a Letter of No-Action to Lamp Technologies LLC, outlining platforms containing offerings of private issuers would not constitute a statutory general solicitation under Rule 506 b) of Regulation D, nor render such issuers or its agents under the enforcement of the Investment Company Act and Investment Adviser Act of 1940. Hence, data service companies are able to see their total addressable market increase by 2,400% by moving into the private securities market relying on Rule 506 b) offerings. Moreover, Lamp Technologies LLC was acquired before the start of the financial crisis by a Top 10 brokerage for undisclosed terms, likely due to fears of competition with the acquirer’s own business model.
Growth of U.S. Accredited Investor Market (+)
Using two of the most common definitions by FINRA, an accredited investor is either 1) an individual with a pre-tax income of over $200,000 (or >$300,000 with a spouse) in the past two fiscal years with reasonable expectations for such earnings to continue, or 2) have a net worth of over $1,000,000 less the value of one’s primary residence. It is important to note, such definitions are finite and are not benchmarked to that of inflation. Hence, each year, due to a mixture of asset compounding and wage growth, the number of accredited investors in the U.S. meeting this definition should increase substantially.
Source: SCF Data
Since 2013, the number of accredited investor households in the U.S. has seen over +6.60% CAGR. With an average of 2 adults per households, this implies the total number of accredited investors in the United States are estimated to be more than 30 million, or approximately 8% of the country’s entire population. Furthermore, the revision of the minimum requirement to qualify as an accredited investor is not a key issue in the upcoming U.S. 2020 Presidential Elections, unlike healthcare and trade disputes. Therefore, there exist reasonable expectations for such growth trends to continue in the next 4 years, until capital appreciation warrants the increase of barrier to entry for this elite group of individuals.
Source: Seeking Alpha
Accredited investors in the U.S. have a wide variety of investment interests, from publicly traded equities, pooled investment funds, treasuries, options, commodities, and/or crypto-currencies. In fact, based on data from Seeking Alpha, nearly 85% of investors who are likely to meet the FINRA definitions plan to invest in the next 12 months, with more than 65% engaged in active investing. Furthermore, both accredited individuals and private issuers such as family offices have seen their prominence on Grayscale increase by 600 bps or more. With the overall population of both private issuers and accredited investors increasing, as well as their appetite to conduct mutual securities transactions, there exists a dire need for data service companies to bridge the marketing gap between these two affluent populations.
The total assets managed by the world’s hedge funds amount to over $2.91 trillion with nearly 4-% of such assets controlled by New York hedge funds alone. When accounting for all private issuers, such as venture capital, and REITs, the total volume of securities issued under SEC Regulation D 506 b) and 506 c) are likely to have surpassed $3.0 trillion for FY2019. Since 1990, the hedge fund industry has seen both asset management fees and incentives remain stable at 1.5%/17%. Over 30% of hedge funds are planning to expand into AI/Machine Learning technologies to aid in their investment goals, with equal demand for a diverse set of strategies such as long/short equity, fixed income, commodities, etc. Currently, the leading competitor to data processing agents who act as hedge funds’ marketing departments is Interactive Brokers Marketplace. However, this platform remains under-monetized due to underestimation of the accredited investors market in the U.S. There are an estimated 30 million individuals meeting this definition in FY2019 with over 85% of planning to invest in securities within the next fiscal year. With SEC regulation easing as to allow the broad and general solicitation of securities from private issuers, and a recommendation to take no action action against data science companies acting as marketing agents for firms under Rule 506 b) of Regulation D, there exists a critical need for companies such as Decheque to match the two affluent populations based on a custom set of investment goals, risk tolerances, and time horizons.
This article was written by Woodrow Sun — CFO, Decheque Technologies Inc.
Originally Published on Decheque.com — September 29, 2019
Disclosure: The research done here is property of Decheque Technologies Inc. It does not constitute investment advice.