In their nearly four years managing absolute-return investments for the $140.6 billion New York State Common Retirement Fund, Peter Carey and his team completely rebuilt the third-largest U.S. public pension plan’s hedge fund portfolio, moving from a strategy that depended on funds of hedge funds to a much more elaborate one that focuses on direct investing, portfolio construction and manager selection.
By last summer, Carey thought that other investors could benefit from the insights and expertise his group had developed overseeing the $4 billion absolute-return portfolio, which was invested in 28 hedge funds. But New York Common is prohibited from managing outside money, so in November, Carey and his deputy, Robert Mazurek, announced that they had joined SkyBridge Capital II and would launch a new institutional business, SkyBridge Direct.
SkyBridge, No. 27 on the Fund of Funds 50 — Institutional Investor’s annual ranking of the world’s biggest multimanager hedge fund firms, determined by assets under management as of January 3, 2011 — didn’t have a traditional fund of hedge funds until last spring, when it bought Citi Alternative Investment’s hedge fund business. SkyBridge is one of many multimanager hedge fund firms seeking to diversify their capital bases and attract more institutional money. In doing so these firms are responding to the transformative trends dominating the fund-of-hedge-funds industry today and are working against the increasing tendency among institutional investors — like New York Common — to invest directly in a basket of hedge funds they create themselves.
“At New York Common we realized that we had basically built a fund of hedge funds in-house,” says Carey.
The firms constituting this year’s Fund of Funds 50 run a combined $525 billion, up 4.4 percent from the $503 billion that the 50 biggest firms managed when 2010 began but 40.1 percent less than the $877 billion they had as of mid-2008. The vast majority of the money is invested with the very largest firms. The five biggest managers collectively control 27.5 percent of the assets, as top-ranked HSBC Alternative Investments Ltd and No. 2 Blackstone Alternative Asset Management each saw its assets under management jump by more than $6 billion last year.
The economic collapse that began in late 2007 and accelerated when U.S. investment bank Lehman Brothers Holdings filed for bankruptcy in September 2008 hit hedge funds hard. Overall hedge fund assets under management fell from a second-quarter 2008 high of more $1.93 trillion to $1.4 trillion at the end of 2009, according to Chicago-based Hedge Fund Research. Fund-of-hedge-fund assets shrank from $825.9 billion in mid-2008 to $571 billion at the end of 2009. Although the hedge fund industry overall is nearly back to its asset total before the financial crisis, fund-of-funds assets had recovered to only $646 billion when this year began.
Much of the reason for the less robust growth of funds of funds is that the bulk of the new assets flowing into hedge funds is from institutions. A March Deutsche Bank survey of more than 500 hedge fund investors representing $1.3 trillion in hedge fund assets found that 80 percent of foundations and endowments, 83 percent of pension funds and sovereign wealth funds and an astonishing 96 percent of insurance companies increased their allocations to hedge funds last year. But 62 percent of these same investors said that none of their new allocations will be made to funds of hedge funds.
Institutional investors are increasingly balking at the extra set of fees that multimanager firms impose. The standard fund of funds adds a 1 percent management fee and 10 percent performance fee to the typical 2 percent and 20 percent that single-manager hedge funds charge. To survive, fund-of-funds firms are having to adapt and prove their worth.
“Funds of funds are partnering with institutions, and as they do that they are helping educate these investors in alternatives,” says Scott Carter, New York–based head of global prime finance sales and capital introduction at Deutsche Bank. As Carter explains, increased direct investment and fund-of-funds growth can coexist as long as new investors keep coming in, because they often start with funds of hedge funds.
London-based HSBC Alternative Investments Ltd, No. 1 in this year’s ranking, with $36.8 billion in assets, illustrates how the fund-of-hedge-funds industry is changing. Started 16 years ago and housed within its parent’s private bank, HAIL’s fund-of-funds business has principally catered to high-net-worth individuals and family offices, often based in Europe. But in 2005, HAIL began making a concerted effort to build up its institutional business, says Timothy Gascoigne, HAIL’s global head of portfolio management. He estimates that today these investors make up 40 percent of its fund-of-funds clients and the bulk of the new money flowing into its funds.
Because HAIL has been in the fund-of-funds business for so long, it is invested in some of the top-performing, hard-to-access hedge fund companies, like Tudor Investment Corp. and Moore Capital Management. Gascoigne estimates that one third of the managers with which its main fund has invested are closed to additional capital or new investors. During the crisis, when some closed funds opened, in some cases for the first time in decades, HAIL was able to increase its allocations to those managers because it had cash on hand.
It is hard to beat New York–based Blackstone Group for name recognition among U.S. asset owners. Founded in 1985 as a private equity firm, running money for traditional institutional investors such as U.S. public pension funds, Blackstone entered the fund-of-hedge-funds business in 1990 when it launched Blackstone Alternative Asset Management. Led by former investment banker and Lehman Brothers co-CEO J. Tomilson Hill, No. 2–ranked BAAM commands a massive $34 billion in fund-of-hedge-funds assets, up 22.2 percent in the past year and nearly threefold since 2006.
“For about eight years now, our clients have looked to us to provide investment solutions using hedge funds,” says Hill. “The term ‘fund of funds’ implies a static approach to investing in hedge funds utilizing a finite menu of existing products, whereas our business is focused on customized products using a dynamic process.”
BAAM might be among the best at the customized and advisory business, but the firm is far from alone. Most of the largest fund-of-funds managers offer a bespoke approach. The reason is simple: To justify their fees, fund-of-funds firms need to offer institutions something more than what those investors can do on their own.
An institutional quality fund-of-funds manager can make a real difference, says Kent Clark, New York–based CIO of Goldman Sachs Asset Management’s hedge fund strategies group, No. 6, with $20.8 billion in assets. “Having a research process that you can track over time, which means that performance is documented and standards are kept, is a huge advantage,” he explains. “It is about accountability.”
Smaller fund-of-funds managers, especially those below the $3.7 billion cutoff to make this year’s Fund of Funds 50, often are not in a position to customize. But they too want institutional dollars. They argue that size matters — reasoning that the sheer amount of money the very largest firms have to put to work hurts their ability to produce alpha. Managers with fewer assets can adapt more quickly and can invest with small hedge funds, whose performance can be better than those of well-known large hedge funds accessible to everyone.
“One of the things I prefer about our portfolios is that we run the gamut of managers,” says Jill Schurtz, CEO of New York–based Robeco-Sage, a $1.3 billion fund-of-funds firm started by three former Goldman Sachs partners in 1993 and now owned by Dutch firm Robeco Investment Management. Robeco-Sage, which offers customized accounts, invests in larger hedge fund firms, but it also finds opportunities with funds managing $500 million or less. Big funds of funds have difficulty giving money to such small managers, because the investments are unlikely to have a meaningful impact on their results. Some large multimanager firms can get around this in part by operating seeding businesses.
The bifurcation in the market really challenges the fund-of-funds managers in the middle — those that are too big to invest easily in managers with only a couple hundred million dollars in assets but lack the resources of the very largest firms.
At No. 25 on our list, with $7.9 billion in assets, London-based Fauchier Partners is just starting an aggressive marketing push into the U.S. Unlike many of its European brethren, Fauchier’s business is almost entirely institutional. “There isn’t any secret to being a successful fund of hedge funds,” says Fauchier Partners CEO Clark Fenton. “Conceptually, it is very simple, but it is very hard to execute. It is about picking the right managers, doing the operational due diligence to make sure there is no fraud and the investment terms are just and true, then putting the managers in the right combination and sizing up the ones that will do well. The final building block is risk management.”
But for a long time, unwary investors had trouble differentiating among funds of hedge funds — in part because of Bernard Madoff. In December 2008, Madoff admitted that the fund he had been running for more than 40 years was, in fact, a massive Ponzi scheme. Although plenty of fund-of-funds managers saw enough red flags to avoid Madoff, many others gave him money, including some of the best-known firms in the industry. For a time they reaped the rewards.
In mid-2008, Geneva-based Union Bancaire Privée was the largest fund-of-hedge-funds manager in the world, with $56.9 billion in assets. Today it ranks No. 10, with $15 billion, an incredible 74 percent drop in assets. UBP was the eighth-largest investor in Madoff. Although the firm has taken steps to improve its due diligence process, and is starting to raise new assets, it is having a difficult time winning the confidence of institutional investors.
Madoff proved too much for another investor — Ivy Asset Management Corp., which in 2002, with $6.2 billion in assets, was the seventh-largest firm in the first Fund of Funds 50. Ivy was shut down last year by its parent, BNY Mellon Asset Management. With that, BNY Mellon has plummeted to No. 49 from No. 17 on the list, losing 64 percent of its assets.
Last spring, as the fate of Ivy was being decided, one of its partners reached out to the founder of New York–based SkyBridge, Anthony Scaramucci, to see if he would acquire what remained of the business and the team. Scaramucci started SkyBridge as a hedge fund seeding firm in 2005. His phenomenal networking skills notwithstanding, New York–based SkyBridge managed less than $2 billion when 2010 began, almost all of which came from family offices and high-net-worth individuals.
To grow the business, Scaramucci knew he needed to do something big. So although he passed on Ivy last April, he announced that his firm was acquiring $6.1 billion in funds of hedge funds from Citigroup. The deal gave SkyBridge a fund-of-funds group with a strong track record and significant institutional business, including separate accounts and advisory clients.
“There is a tendency to think of funds of funds as a separate and distinct business,” says Raymond Nolte, SkyBridge’s CIO, who headed the fund-of-funds group at Citi. “Our vision was to create one continuum in the alternatives space to deliver access to hedge funds in whatever form the client wants.” He anticipates that institutional investors will realize the value of such a full-service business.
SkyBridge will have to contend with investors like the $12 billion West Virginia Investment Management Board, which chose the direct route when it first invested in hedge funds a few years ago. “Given the long-term rate of return we expect and the role hedge funds play in our portfolio, they start to lose their attraction if we have to pay the extra 1 percent or so to invest through a fund of funds,” says executive director Craig Slaughter.
No one knows better than SkyBridge’s Carey how hard running a direct investment portfolio can be, particularly at a budget-strapped public fund. The difficulty involves not only manager selection, but also constant monitoring and back-office and due diligence work. Additionally, public funds often cannot make the kind of quick allocation decisions that a fund of hedge funds can.
“Investors are going to realize that you have to manage these portfolios,” says Carey.
What SkyBridge and other fund-of-funds managers are hoping is that, after trying the direct approach, some institutions will discover that the professionals do it better.
