A new frontier for hedge fund investing benefiting both managers and investors? On balance yes; albeit with increased concentration and cash management risks and a need to focus carefully on terms.
Introduction
The use of separately managed accounts (SMAs) to access hedge fund strategies has grown materially in recent years. According to a recent survey, the share of hedge fund assets under management invested through SMAs has increased from 3.4% (US$66 billion) in 2010 to 7.1% (US$315 billion) in 2024.1
We expect these numbers to continue to grow materially, both on an absolute basis and as a proportion of total hedge fund assets under management, as investors and asset allocators continue to seek access to SMAs and the benefits that SMAs offer.
The key benefits driving the growth in SMAs appear to be twofold:
- The recent success of the multi-strategy managers, who are now allocating billions of dollars externally.
- The capital efficiency offered to investors through investing in hedge fund strategies via SMAs. In short, SMAs allow investors to allocate capital in a more capital efficient manner (including in terms of netting off exposures and thus reducing margin and collateral requirements). This should enable investors to allocate the same amount of capital to a greater number of hedge fund strategies and hedge fund managers, thereby increasing diversification. Historically, SMAs were only typically accessible to institutional investors able (or willing) to set up their own operational structures and accounts to house hedge fund strategies (which included onboarding with various trading counterparties, custodians, prime brokers etc). However, intermediaries are now offering a wider group of investors access to hedge fund strategies via dedicated managed account platforms. We think this, coupled with investors' inherent desire to invest in a capital efficient manner, will likely further drive growth in SMAs.
Of course, these two drivers of SMA growth are intrinsically connected as multi-strats, by the very design of the multi-manager strategy being pursued, require their allocations to internal and external portfolio managers to be made in a capital efficient manner.
Whilst this article is focused on some of the key legal and regulatory issues to consider when entering into an SMA, we also pose a few questions around some of the potential consequences of the growth of SMA investing. In particular:
- Where is the cash buffer? With a typical hedge fund investment, an investor will invest a specific amount in the fund (for the purposes of this example, US$100 million). In a hedge fund strategy, US$100 million will be invested on a leveraged basis, such that the gross market exposure of the strategy will be higher than the US$100 million cash investment (so, if the fund was two times leveraged, the gross exposure to the strategy will be US$200 million). The margin and collateral that is required to be posted with trading counterparties to support that gross exposure will vary strategy-by-strategy but, for the sake of this example, we will assume that the margin and collateral requirement is US$30 million, leaving US$70 million of unencumbered cash in the fund. In the event of a drawdown, that cash will be used to meet further collateral and margin requirements, and thus assets will not generally need to be realized in order to do so. Conversely, in an SMA, broadly speaking, an investor simply posts the margin and collateral required to support the desired exposure. Thus, given the lack of a cash buffer, in the event of a drawdown, positions will need to be realized to free up cash to meet margin and collateral requirements (which may crystalize losses or result in the realization of positions that were considered to be attractive to hold) or, alternatively, new cash will need to be added to the SMA.2
- The 'great unwind' due to concentration risks. One of the reasons it is argued that the hedge fund industry did not ultimately pose a systemic risk to markets following the Global Financial Crisis of 2008, was because, even after accounting for trend following and position crowding, hedge fund strategies were generally being managed by significant numbers of independent hedge fund managers each operating independent pools of capital. As the multi-strats are now increasing controlling capital allocations to hedge fund managers via SMAs, and applying central risk limits to those SMAs, there is a risk that this independence has been lost. The potential risk is that, in the event of a material drawdown in the markets, a number of the 'pools' (i.e., SMAs) of hedge fund capital (with correlated risk limits) will move together, in particular in the context of realizing assets as a result of risk management limits being breached, which may further fuel downward pressure on positions (that may further trigger risk limits, and so on...).
- Central book and investment strategy replication. The other, well documented, concern with SMAs (from a portfolio manager's perspective) is that asset allocators are using the otherwise unencumbered cash for allocation to strategies that derive from or replicate (in full or part) the strategies managed by the portfolio manager (on which the portfolio manager is not being paid). Given the portfolio level transparency available to allocators of SMAs, this is difficult to determine or control (particularly in cases where portfolio level transparency is not provided simply through an endof-day trade file, but through either (i) sending trade orders directly to the multistrat for central execution or offset or (ii) providing a live feed from the prime broker to the multi-strat).
Key Benefits of SMAs to Managers
While not without their drawbacks, SMAs present an attractive opportunity for managers to raise capital. Accordingly, both established and emerging managers are increasingly turning to SMAs to raise capital (in a period where raising capital for comingled funds may be more challenging). This is proven out in the statistics, which show that 50% of equity long/short funds managed at least one SMA in 2024, up from 32% in 2020.3 Further, of the hedge fund managers managing at least one SMA, these firms manage an average of 4.5 SMAs.4 Additionally, 19% of allocators currently use an SMA.5
With regards to emerging managers in particular, SMAs represent an opportunity to get their new asset management business off the ground since managers can start managing external capital more quickly and with less of a capital investment in the business than would otherwise be required if launching a comingled fund.
Key Benefits of SMAs to Investors
SMA investors benefit from SMAs for three primary reasons: (i) capital efficiency (discussed above (see 'Introduction'), (ii) information and control (which plays into risk management), and (iii) flexibility of terms.
Information and Control
Investors in SMAs will be able to dictate investment restrictions and risk limits at the outset and will often have broad ability to change these restrictions and limits on relatively short notice. Since SMAs are generally structured as brokerage or custody accounts representing allocations from a traditional fund structure, the investor generally "owns" and controls the account and therefore has a direct feed into the service providers (including the fund's administrator and the account's prime broker(s)). The investor will generally therefore have position-level transparency and will therefore be better able to manage its own risk and monitor compliance by the manager with these restrictions and limits. The investment management agreement (IMA) for the SMA will often contain significant reporting requirements and information rights with daily, weekly and monthly reporting required of the manager. Investors in an SMA will also often be able to reduce and increase allocations to managers (including following drawdown events) on short notice, allowing them to cut back on strategies that are underperforming and double down on strategies that are performing well. Additionally, SMA investors will commonly do significant operational due diligence on the managers to which they allocate. As a result, a significant investment (both in terms of time and resources) is made, numerous touchpoints and deep relationships can form between the investor and the manager, and the investor may therefore get increased transparency over the business of the manager.
Flexibility of Terms
SMA investors are able to set more bespoke terms than a fund investor would. While anchor investors are often able to negotiate the terms of a large investment in a commingled fund, it is unlikely that they will be able to negotiate terms as favorable as they will receive in an SMA. Generally, the IMA is based on a template provided by the investor which will usually be somewhat one-sided in favor of the investor and the manager will need to carefully review and negotiate the terms of the IMA to seek to rebalance the terms fairly.
This article will explore a number of the key issues to be aware of when negotiating an IMA for an SMA.
Key Terms in SMA Negotiations
Investment Strategy and Investment Restrictions
SMAs will have a specific investment program into which the capital will be deployed, comprised of both an investment strategy and investment restrictions and limitations, which are themselves often made up of risk limits and permitted and/or prohibited jurisdictions and instruments.
When reviewing and negotiating the IMA, managers will want to ensure that the description of the investment strategy is wide enough to capture everything the manager might seek to do as part of their trading strategy. Additionally, acceptable and restricted or prohibited investments and jurisdictions should be carefully considered in light of the investment strategy and should cover all of the instruments and jurisdictions in which the manager will want to invest in order to fully express their strategy. Since breaching these investment restrictions and risk limits is often a "for cause" termination event (and may even trigger financial penalties such as forfeiting of accrued but unpaid management and/or performance fee), managers should carefully review them (noting they are often included in schedules at the end of the IMA) and ensure their systems are setup to properly monitor and implement them (including ensuring allocations are not made without first checking approved and restricted lists).
It is also important to ensure passive breaches of investment restrictions are properly handled and cure periods are provided for. Passive breaches include subsequent movements in price and breaches caused by outside events, such as reductions in the notional capital of the SMA.
Additionally, it is necessary to examine how the investment strategy and investment restrictions can be amended by the investor – investors will often initially ask for the ability to amend the investment strategy with little or no notice to the manager. While it is unlikely that an investor would change an equity strategy to a credit strategy, the investor could amend the list of acceptable or restricted investments or cut risk limits. Therefore, it is essential that the manager receives adequate notice of any amendments. If the investor does make amendments to the investment restrictions, risk limits or investment strategy, the manager should seek to limit its liability for breaches of the investment restrictions or risk limits resulting from the change.
It is also important to look for references to investing pari passu with the manager's other clients, including any comingled fund being used as a reference, and ensure this is limited to where it is relevant. For example, the agreement should allow for deviations due to differing investment strategies (such as a subset of the primary investment strategy), risk parameters, restricted lists and position sizing. There may also be deviations for a period of time due to "ramping up" of accounts. Finally, there may be situations where trading pari passu may not be permissible, for example due to differences in applicable tax, legal and regulatory regimes.
Summary
- Carefully review the investment strategy, investment restrictions and risk limits to ensure they are suitable
- Make sure passive breaches have a cure period and do not result in a breach of the IMA
- Consider how the investment strategy, investment restrictions and risk limits can be amended by the investor
- Look for reference to investing pari passu with other clients and ensure suitable carve outs
Liquidity
Given that the SMA investor's desire for flexible liquidity terms is a key feature of an SMA, withdrawal terms can be heavily negotiated. Given the leveraged nature of an SMA, withdrawals may not simply involve the withdrawal of cash from the account, but could also include reductions in the buying power of the account through a reduction in the notional capital allocation.
It is important to review withdrawal notice periods and ensure they are reasonable in light of the strategy. For example, an illiquid strategy should not permit withdrawals with one business day's notice (which can be a relatively common starting point for SMA investors). Managers should also consider withdrawal provisions with their existing clients in mind. For example, liquidity is often included in most favored nations (MFN) clauses (which should be very carefully negotiated, see our later discussion of MFNs for more detail), meaning existing investors benefiting from an MFN will often be able to elect to receive the benefit of preferential liquidity terms given to a later investor. Managers should also keep in mind their regulatory obligations and ensure that preferential liquidity given to an SMA investor does not materially disadvantage investors in the manager's other vehicles, for example by permitting short notice withdrawals, a manager would be required to sell assets at an undervalue, reducing the value of such assets held in the comingled fund. Consequently, managers should seek to limit their liability for losses incurred in realizing assets to satisfy a withdrawal request, although this can be more challenging to negotiate.
Summary
- Withdrawal notice periods should align with the liquidity profile of the assets
- MFNs should be reviewed to ensure the SMA investor's favorable liquidity would not trigger a requirement to offer such liquidity to investors in the manager's other products
- Ensure liquidity terms comply with the manager's regulatory obligations with regards to preferential liquidity
- Consider potential knock-on impacts on other clients
Termination
Related to liquidity, there will often be a number of events that give rise to a termination of the IMA (and therefore the right to withdraw capital). The negotiation of termination events can be complex, as the manager will want to seek stability and longevity of capital (especially if the account is the manager's first client and the manager is seeking to build a business around it), while the SMA investor will likely want the ability to terminate the mandate quickly in certain circumstances, including if the manager is not performing or following a drawdown event.
Managers should think carefully about the interplay between termination rights and liquidity. For example, the notice period for a withdrawal should not be shorter than the notice period for a "without cause" termination as this would create a situation where the SMA investor could circumvent the termination provisions by simply withdrawing all of the assets from the account rather than terminating, or avoid withdrawal notice periods by terminating the IMA. Managers should also consider the MFNs they have given to other investors and whether or not the termination rights they are granting to this investor may trigger the liquidity aspect of these MFNs since, after all, termination rights are effectively liquidity rights.
It is also important to carefully review the events giving rise to an immediate termination right and limit these as much as possible. For example, a termination right triggered by redemptions from another fund by insiders should be limited to the principal and to an amount over a given rolling period, such as a 25% redemption over 12 months. Similarly, any "key person" events should be limited to the principal or, if not possible, the key personnel involved in the investment management of the account. The trigger for a key person event should also be carefully considered and limited to death, incapacity, or significant continuous periods of unavailability. Litigation or regulatoryrelated events should be limited to material events that have occurred, not those that are suspected, expected or threatened, and should not include routine events. Managers should also be aware of these events being triggered by allegations of wrongdoing, especially when made by private plaintiffs. "Cause" or conduct-type events should be limited to serious events, such as crimes carrying custodial sentences or serious regulatory offenses relating to the relevant person's duties to the manager and/or the account and which could reasonably be expected to have a material adverse effect on the manager and/or the account.
Managers should also be aware of the link between termination events and other facets of the agreement, for example reportable events or notice obligations such as failure to give notice of certain events can often be a termination event. As with many parts of an IMA, seemingly benign obligations can often have serious consequences if they are not complied with in a timely manner.
General considerations include ensuring that a material breach of agreement has a reasonable cure period and mutuality is generally ensured.
The manager should also consider its own termination rights. In particular, managers may wish to retain the right to terminate the IMA if the assets in the account fall below a certain threshold, as managing an account with minimal assets may be undesirable, especially where there are exclusivity, capacity, or other restrictions placed on the manager during the term of the agreement.
Finally, it is important to carefully review the manager's obligations in relation to liquidating the account if the agreement is terminated, ensuring the investor provides reasonable cooperation during this period and the manager is paid fees through the termination date (including any period for which the manager is winding down the account). Conversely, if the investor has the right to take control of the account, the manager should have no further liability or obligation to the account thereafter. In certain circumstances, termination for cause by the investor (or even termination by the manager without cause during an initial period) may result in a forfeiting of accrued but unpaid fees. The circumstances in which this forfeit occurs should be carefully considered and strongly negotiated.
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Footnotes
1. Source: Goldman Sachs, "Great Expectations. The Current State of the Hedge Fund Industry and the Outlook for 2025", Prime Insights, February 2025.
2. One question worth posing is whether investors investing in hedge fund strategies via SMAs have become more 'fully invested' in hedge fund strategies overall. That may well be the case where the unencumbered cash that would otherwise have remained in a fund investment has instead been allocated to another hedge fund strategy via another SMA (rather than being held in cash/cash equivalents for cash and risk management purposes). To the extent that such unencumbered cash is being allocated to other hedge fund strategies/managers, a draw down in the investor's overall hedge fund portfolio will increase the likelihood that positions will need to be realised to meet margin/collateral calls or that further cash will need to be added to the hedge fund portfolio (in the latter case, increasing an investor's allocation to hedge fund strategies).
3. Source: Goldman Sachs, "Great Expectations. The Current State of the Hedge Fund Industry and the Outlook for 2025", Prime Insights, February 2025.
4. Source: Goldman Sachs Prime Insights & Analytics.
5. Source: Goldman Sachs, "Great Expectations. The Current State of the Hedge Fund Industry and the Outlook for 2025", Prime Insights, February 2025.
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