A New Dynamic Between Institutional Investors and Hedge Funds

There was an interesting article in Reuters about how institutional investors are getting more leverage with hedge funds.  They are asking managers to reduce fees and for more flexible redemption terms.  They are doing more due diligence;  sometimes doing six months of research before investing.  Recently, D.E. Shaw reduced fees. A manager profiled in the article actively looks for hedge funds that charge management fees of 1%-1.5%.  He also test drives a fund by investing a smaller amount before committing a large amount of capital.  The increase in investments by pension funds is another factor driving this shift.  Pension fund money is placed in the largest hedge funds.  In the past, pensions used to invest in funds through a fund of funds to escape the extra layer of fees.  They demand more transparency and a monthly redemption cycle.

An Interview with Warren Buffett of Berkshire Hathaway

I was alerted to this article of an interview by the Financial Crisis Inquiry Commission in May 2010.  The interviewee is Warren Buffett, world famous CEO and investment manager of Berkshire Hathway.  I do not think he needs an introduction here.  Some topics discussed were:

• Ratings agencies
• Credit bubble
• Invest in companies with pricing power
• Mark to market accounting
• Fannie Mae and Freddie Mac
• Derivatives
• Government intervention during the crisis in 2008
• AIG
• Management compensation

List of 10 Hedge Fund Risks

I was alerted to an interesting article written by Stuart Fieldhouse and Hans-Olov Bornemann of SEB Asset Management.  They listed the 10 mistakes to avoid with hedge fund managers.  They are:

• Fraud / misrepresentation - stealing from investors, assigning high valuations to illiquid assets
• Operational risk - counterparty risk, NAV calculations, key personnel leaving
• Concentration risk - too many assets in one sector, country or asset class
• Leverage - net and gross
• Liquidity risk - not being able to sell assets when needed
• Funding risk - mismatching borrowing and asset maturity dates
• Too many assets under management - not all managers can handle an increase in money
• Copycats - other managers following the same strategy
• Being front run - other funds trading ahead of a large fund
• Forced unwinding - funds may be forced to sell assets to make margin calls and client redemptions

Proprietary Traders and Hedge Funds

As a result of the Volcker rule, banks have begun divesting themselves of their proprietary trading desks.  Goldman Sachs has led the way.  Two superstar traders have raised $1.6 and $1 billion dollars for their own hedge funds.  JP Morgan will move its traders to the asset management division and Morgan Stanley will spin-off its quantitative team - Process Driven Trading.

The Reuters article believes that 10%-15% of the trading desks will become hedge funds.  However, investors are cautious about committing capital to them.  A Credit Suisse survey has only 52% of investors would seed a fund if it had a three year history.  Not enough is known about a prop trader's performance.  How much can be attributed to the trader and how much can be attributed to the bank's assets - name, balance sheet, execution platform, etc.?

Private Equity Portfolio Construction

The returns of a private equity fund are driven by the fund manager, how the portfolio is built and how capital is invested.  Funds that perform in the top 25% earn returns that are twice as high as the average fund.  It is important to find and retain these managers.  In a prior article, researchers had found that a successful fund manager continues to outperform.

The manager has to balance between risk and returns when constructing the fund's portfolio.  Diversification of holdings may reduce risk.  The manager may use the traditional or core-satellite method.  Traditional diversification requires investing in the best assets based on returns, risk and correlation potential.  The core-satellite method has a diverse and low risk portfolio to generate stable returns as its base.  The satellite investments are small and riskier than the core holdings.  They are to add extra return.  This approach allows diversification with extra returns, ability to customize portfolio to specific investor goals, ability to obtain desired levels of exposure to certain risks and ability to concentrate on the satellite investments.

An investor builds a portfolio by using a bottom-up, top-down, mixed or naive approach.  In the bottom-up method, the investor identifies the best managers through screening, due diligence and analysis.  Then investments are made across the highest ranked funds.  However, this may lead to an unbalanced portfolio.  As an analogy, during the technology bubble, the highest ranked mutual funds had large holdings in the same sector.  Even though an investor may have directed capital to multiple funds, there would be little diversification in the portfolio.

In the top-down method, the investor selects sectors or strategies that will outperform.  The general macroeconomic picture will be predicted to determine the asset allocation of the portfolio that will perform the best.  Capital can be spread among different countries, strategies or sectors.  A disadvantage of top-down is that there are not enough good managers to achieve the desired asset allocation.

The mixed method combines the other two.  This involves identifying the top funds and diversify across different strategies.  The naive method invests in all funds of the portfolio equally.

Generally, investing in 20-30 funds can achieve diversification.

Private Equity Fund of Funds vs. Direct Investing

There are private equity funds of funds that invest in individual private equity funds just in the same manner as hedge fund of funds invest in other hedge funds.  There are some advantages in using a fund of funds to invest. There are two primary costs involved as well.  Investors in funds of funds have to pay for two layers of management fees.  They have to pay the private equity fund and the fund of funds.  The other cost is the double layer of carried interest / performance fees.

What do investors get by going through funds of funds?  They get a diversified portfolio of different managers with, hopefully, different investment strategies.  Funds of funds managers can give smaller investors access to an investment with a large minimum commitment amount by pooling their capital.  They provide research, do due diligence, monitor investments and manage liquidity.  They give investors access to top quartile funds that would not be possible for new investors.  They make the fund raising process easier for fund managers by having a ready group of investors.

In order to pay the additional layer of fees, the fund of funds needs to outperform direct investors by 0.7% to 3.4%.

When a Private Equity Manager Underperforms

In a private equity firm, the limited partners are the investors and the general partner is the fund manager.  Since the portfolio is generally illiquid, the investors cannot sell the fund for a fair price if it is underperforming.  They may sell it on the secondary market at a discount.  Here are some other actions that they may take:

• The investor may decline to invest in the manager's next fund
• The investor may negotiate to reduce the size of the next fund or have the manager address the issues causing the underperformance
• The manager may lower the management fees
• The investor may threaten legal action or fire the manager in extreme cases
• The investor may default as a last resort