Originally published by www.focuspointpress.com on August 10, 2007

Institutional attention to emerging managers, specifically managers involved in alternative investments, has increased significantly since a decade ago. However, one of the key dilemmas that face large investors with making allocations in this space is the window of opportunity between the time an emerging manager becomes institutionally viable, but before that manager's offered fund closes.

Fund-of-fund manager Explorer Alternative Management, which was spun out of Circle T Partners and is an affiliate of Proctor Investment Managers, is well positioned to identify such upcoming talent. "This can be a very short window," says Stephen Scott, Chief Investment Officer of Explorer, "and that creates a problem because a lot of larger investors aren't typically comfortable, or certainly not use to making investment decisions at the drop of a hat."

Scott and co-manager Seth Platt, Explorer's Chief Financial Officer, have been focused on investing with emerging alternative investment managers for many years now. For Explorer, the definition of emerging manager begins when the general partner or the management company itself becomes a viable economic interest or business, meaning they are cash flow positive. It ends when the firm or the fund becomes institutionally viable, meaning the barriers that exist between larger investors and their willingness to invest with or hire that manager starts to go away.

'Institutionally viable' is different for every manager, however. "It is that magic point in time when the assets under management linked to a manager's track record has grown to a certain size," says Scott. "It's when the larger investors have become comfortable with investing in the manager directly, and that's when we look to end our relationship."

What makes Explorer unique amongst fund-of-funds is that it only invests vis-à-vis separate managed accounts, rather than with the manager's limited partnership vehicle. Assets are held at a single prime broker and each selected fund manager enters into a separate advisory agreement with Explorer. In addition, the advisory agreement limits the nature of the instruments to publicly traded securities.

The result is a multi-advisor fund product on a platform "that makes it structurally more comfortable for larger investors to have access to the performance of a broad and diversified portfolio of managers, with whom they would otherwise be unlikely to make direct investments with at that point in time," says Scott.

Simultaneously, Explorer is able to make a meaningful and significant investment with an emerging manager who would otherwise not have access to such capital. "It is very much a catch 22 or a chicken or the egg scenario, where a manager can't get bigger until gets bigger," explains Scott. "That is something that I have certainly heard for over twelve years now, time and time and time again. We are one of the few investors that, when we find an emerging manager, will not tell them, 'we think that you're smart, we love what you are doing, call us back when you have a $100 million or $200 million or some number.'"

The typical allocation that Explorer makes is between $5 and $10 million. Their approach to manager due diligence is based on a combination of background, pedigree and track record performance. First, Explorer looks at the risks associated with the manager's business infrastructure and decisions that they made in building out their company. Next, they look at the risks associated with the manager's particular investment process.

"We believe that those lists of risk are unique to each manager," explains Scott. "What we do is attempt to identify the mean return being generated by that investment process. Establish at what asset size that mean should be sustainable, and then make a determination by comparing the level of risk we believe we are taking with a manager, versus the return that has been produced, and what we believe they will continue producing."

Not only is Explorer monitoring the risk associated with one particular allocation to a manager, but they are also looking at the risk associated with the whole portfolio. The result is an investment methodology in which Explorer compares the expected risk-return of one manager versus their due diligence on the entire universe of funds they have done work on in the past. They do not, however, index managers or compare only long/shorts versus other long/shorts, for example.

While this approach may create a portfolio with an overlap of fund strategies, Explorer is aware of the impact this will cause to their portfolio's concentration or risk levels.

"We are very aware, prior to constructing the portfolio and prior to adding or subtracting the manager, how it will affect our beta, or long/short equity exposure, concentration in an individual sector, or concentration in an individual security," explains Scott, adding "and because of our structure, we will monitor that on a very regular basis. We focus on the volatility of the returns, the correlation of the returns, the value of risk, the risk of ruin, the risk of waking up one day and having a severe problem, which are all issues when typically dealing with the alternative space."

The other challenge when it comes to emerging managers is relying on the qualitative rather than the quantitative because there is not really much quantitative data to rely on. For Explorer, the managers they look at have on average somewhere between an 18 and 24 month track record of that particular vehicle. Average assets are between $80 and $100 million, with the low end around $20-25 million and $400-500 million on the high end.

"As a matter of fact, we are trying to tap into capacity at that point in their careers when they are underutilized, as opposed to trying to chase their capacity when they aren't fully deployed," said Scott. "The amount of quantitative work that we can do on their track record is obviously limited by the data they have available to us," he adds, "but for us philosophically, it is much more important to understand how the numbers are being produced, then really what the numbers actually are. And that is why we focus on the risk side in terms of the level of risk being taken to produce those returns."

Explorer comes across these managers though many sources. "We have worked long and hard to develop relationships within the industry, says Scott. "So it includes managers that we have graduated, that we have had a previous investment relationship with. They know us and know what we like and what we are looking for. Those are great ideas for us."

In addition, Explorer speaks on a regular basis with all the major investment firms, not only on the capital raising side but also with the trading desks to see who is doing what. While they subscribe to some of the major databases, and are also solicited by third party marketers or the fund managers themselves, the highest concentration of quality leads comes from their own work actively seeking emerging managers on a proactive basis.

According to Explorer there are three distinct periods in the life cycle of a hedge fund manager's career. First being startup with friends and family money or seed investment, the second being the 'emerging manager' phase as Explorer defines it, and the final level when the manager becomes institutionally viable. Each stage has structural barriers in the way that make it difficult to transition from one phase to the next.

"When the institutional market became serious about investing and substantially increasing their investments in alternatives back in 2002 and 2003, clearly the first place they went was to more established hedge fund managers, or larger fund-of-funds that invested with those managers," says Scott. "Interestingly, the next place they went was to the seeding or incubator structure."

Explorer thinks, however, that the emerging phase "is the largest segment of the marketplace," and that they are "seeing an increasing number of high quality managers to work with." Indeed, according to Explorer, "the quality of managers have been consistent whether it's been 1995, 2000, 2005 or today." Moreover, Scott says that "one of the benefits of working in the emerging space is that they are able to own only their best ideas, because they have more ideas than capital to work with typically."

For that reason, Explorer has not really seen a contraction in absolute performance of emerging managers over time. "Most investment strategies are more likely to be able to produce a higher rate of return on a small asset base, simply from a liquidity standpoint," says Scott. "But I don't think that is unique to the alternative space; I believe that is true of almost every investment."

What makes Explorer interesting is the benefit and value they create for both the emerging managers they have hired, as well as the large investors they work with. In effect, the Explorer fund is a conduit that assists large investors to closely monitor upcoming managers during a time in their careers when that type of investor is unlikely to directly invest.

In an apt metaphor Scott describes it this way, "referring to my limited baseball career, if you think of us as the AA and AAA league where we are trying to identify and hire major league talent, this is a way for institutional investors to have an early look and develop a relationship, or at the very least be aware of talent that is likely to become major league or institutionally viable in the relatively near future."

This article was written by Michael "Mack" Frankfurter and first published by Focus Point Press, Inc. (Emerging Manager Focus) under the title "Explorer Defines the Magic Point for Being Institutionally Viable." It is republished here by permission.