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Wednesday 27 June 2012

Product Convergence or Incestuous Orgy in Alternatives - Part 1

With the mushrooming institutional growth of alternative investment managers, investment in the general partner is also an asset play. Such investments are separate from the conventional buying of hedge funds or other alternative vehicles as a limited partner. Private placements of alternative vehicles and fund manager transactions arena is a quietly burgeoning one, with dips. There are many global bank desks and specialised others (FPM follows Park Hill Group), who are placing and recommending hedge funds et al to global limited partner investors. At global banks within their Financial Institution Groups 'rain-makers' provide advisorial transactions in the actual management firms of theses hedge funds. (FPM follow veteran specialists like Norton Reamer at AMF and Berkshire Capital). We at FPM suggests the financial services focus in privately-held management firms is, industry-phase wise, more prevalent than M&A activity in listed / public asset management firms; even though one of the largest hedge fund managers is the UK-listed Man Group Plc with assets in excess of US$ 50 bn, and who have been at the helm of major transactions including mergers with GLG and FRM, over recent years.

M&A in fund managers, or as we dub it for broader scope ‘Fund Manager Transactions’ (FMT), is both endemic and reinforcing of growth and development of so called “alternatives investments”. Institutionalisation of initially boutique alternative management companies over the last 20-25 years has given hedge funds, private equity, real estate, infrastructure and commodity investments a wider investor-base through greater acceptance into pension, endowments and other public portfolios. Remember, initially these alternative vehicles existed for mainly high net worth individual’s or ultra-wealthy private family portfolios.

 There would be a different set of financial structuring and consequences were transactions occurring in the mature and declining phase of the alternatives industry. Instead, FPM notices transactions which are spawning hedge funds. Such spawns can become bubbles. The AOL and Time Warner merger at height of the Dotcom bubble is a reminder of unintended consequences of trendy transactions.   We feel a sense of a milieu’s seismic shift with outweighing negative outcome from this ‘splash’ phase of growth of alternative investment managers. The author understands that a ‘feeling’ comes before knowing,  but in financial terms FPM are flagging that asset-manager investments which are already reeling from the financial crisis shock, will generate widespread losses for the end-investor. As a case in point, Goldman Sachs’ private equity vehicle ‘Petershill’ consisting of hedge fund manager stakes was put up for sale in April this year due to operational, as well as performance problems.

Few would argue that our ‘feeling’ is poignantly prophetic in the current climate of financial services reform from decades-long near-implosion excesses. Another example of creative-destruction in alternatives: On shutting down one of hedge fund sector’s oldest and biggest multistrategy platform to date in July’12, Stark Investments' co-founders, Brian Stark and Michael Roth, stated “…it has become apparent to us that the financial markets have changed systematically over the past few years…” The manager started operations as far back as 1986 and at its height had US$14 bn AuM! (See link below for full story).

The starting point for creative-destruction is the mutual expectation from capital flow in terms of its demand and supply from counterparties. It is not just characteristic but almost a necessity for start-up or expansion hedge funds to have had a significant investor / partner, long-term or for specified period. Diversification of revenues and myriad other reasons suggest capital supply for businesses exist. Indeed there are specialist publicly traded private equity vehicles known as BDC’s (Business Development Companies) in the US. Similar to REITs which are vehicles that focus on real estate holdings. FPM’s radar first registered Ares Capital Corp (ticker: ARCC) as BDC.

Therefore financial intermediaries arrange stake buyers of alternative asset managers. They take the form of cornerstone or minority strategic investor / partner etcetera. Which is a matter of determining the degree of affiliation to the usually independent partnership-structured asset managers.  So clearly, with increasing institutional interest in alternative managers it is implicit that stake-buying activity is also rife.

This boom in alternative manager has systemic consequences due the ‘shadow banking’ status of them, and implications of the degree of regulation on them. Since the capital concerns of large banks presented liquidity and solvency issues from the credit crisis, a lot of the void created is now practised by hedge funds and the like.

A trend in manager-stake buying heightened to perhaps unhealthy asset-bubble levels, unfolding since the new Millennium, when "alternative investments" became an umbrella label for any investment strategy other than long-only equity and fixed income. And realistically there was an emergent systematic sophistry of the traditional long-only investing. A 'game changer's' sophistry related to having an edge in understanding and managing corporate, macro variables and/or events allied to regulatory-environment. Cynically, the ‘money game’ being a mileu's socio-politico environment and resulting legislatures and economic capital flows can be fixed!

Alternative managers are attempting to transform themselves into global players akin to the transformation of brokerage firms and traditional asset managers in the latter half of the last century. Some of them are exhibiting bubble-proportion problems in capital reserve ratios from capital destruction in the last asset boom-bust cycle. “Big is no longer beautiful!” is we believe a catchy euphemistic way of saying something is “old and non-dynamic”. FPM believes Lehman Bros. and Bear Sterns’s financial failures from sub-prime-mortgage-loans investments supports not only the thesis of diminishing trust in big banking model of global financial services; but also that size of firm does not equate with fail-safe. Ultimately, those venerable banks are prototype scenario for the creation and destruction of capital wealth. In Lehman’s case, human and financial capital built over 158 years to when the bank declared bankruptcy in September 2008. Lehman’s ‘immigrant-idealized’ origins started with an elder-sibling opening a dry-goods store, and evolving into commodities-trading / brokerage operations, as an all-male sibling founders by 1850. And growing into a global financial services behemoth with assets of US$600 bn, and eventually felled by its mortgage loans business and its systemic financial inter-connectivity.

Equally as giant trees grow and wither over longer periods, so it is with shorter cycles in other assets, such as boutique hedge fund managers. Who clearly may or may not become best-of-breed giants, but certainly the risk is that “the bigger they are the harder they fall!” Regardless of its longevity and venerability; Lehman was also the 4th largest investment bank in the US, before its collapse.

So it is poignant to note that, Hedge Fund Research Inc., reported that “…775 funds closed in 2011, the most liquidations…” of hedge fund investment vehicles since 2009. There were approximately 10,000+ single manager hedge funds and, according to PerTrac at end-2011 there were 13,395 hedge funds including funds of hedge funds. A research study estimate for the mean annual attrition rate in hedge funds is 8.67%[1], which we think is reasonable. 

We believe the creative-destruction cycles are quicker in the alternatives space. The relative rate of growth of assets in hedge funds versus it procreator or predecessor, closed-end mutual funds, is a stark statistic FPM possesses. Remember, closed-end long-only funds were the origins of hedge funds, ETFs and multitude other pooled-assets vehicles. The first such collective investment scheme in the world is Foreign and Colonial Investment Trust, started in 1868. Coincidentally, the first fund of hedge funds is known to have started almost 100 years later in 1969.  

[1] Hedge Funds: Attrition, Biases and the Survivor Premium by Robert J. Bianchi and Michael E. Drew

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