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Friday 1 March 2013

Managers of the Alternative Universe

FPM is discerning trends and themes in the fund managers metamorphic landscape. Especially vigilant of established themes as well as emerging ones . Established trends are both at once an issue of concern and an exploitable transaction opportunity for investors and rain-makers alike. The commercial premise of this article arbitrages between Established Alternative Managers (EAMs) and Fledgling Emerging Managers (FEMs).

The process of institutionalization of alternative investment managers, namely, hedge funds, private equity et al is mired in paradoxes and oxymoron. How can a once boutique nimble investment management team producing above-beta absolute returns become an unwieldy behemoth and still produce alpha? In philosophical terms:

"You cannot step into the same river twice: you will not be the same person and it will not be the same water" Heraclitus 500 BC 

These large institutional asset managers whether Ken Griffin of Citadel or Clifford Asness of AQR started as small partnerships with an edge. To FPM that’s what the ‘edge’ in hedge funds should mean! Whether it was their innate talents (almost autistic character traits of principals, such as card-counting and astute gambling skills), and / or the ability to identify, exploit and strike at big opportunistic game, allowed these once hungry-and-angry origin whizz kids to become masters of the universe while compounding 20-30% annualized returns.

The increasing amount of evidence to support FPM’s thesis of the paradox of institutionalization is mounting. We are aware of some giants from the pantheon of hedge funds returning outside investors’ money and reverting to family office status. George Soros and Stanley Druckenmiller are two prominent examples from 2011 ahead of adherence to new SEC rules on registration in March 2012; there are many others. This operational reversion to origins is obviously de-institutionalization. Though managers may cite change as being for regulatory purposes, i.e. to evade the watchful burden of increasing scrutiny from financial watchdogs, it is clear that the financial landscape since the financial crisis of 2007-08 has changed for the venerable old timers mentioned and the like.

However, some heretofore secretive asset managers have not so much thrown in the institutionalization towel as elected to join the process (which we at FPM previously highlighted as the ‘Convergence Story’). To perspicacious FPM principals this evinced ‘asset gathering’ strategic impetus rather than ‘absolute return performance’ efforts. Our due diligence in the past has distinguished between ‘asset gatherers’ and ‘performance harvester’ or ‘alpha generation’ operations. The former tend to have numerically less and even relatively lower paid investment professionals. Asset gatherers are characterized by bigger marketing department budgets, perhaps wielding big hitters in its sales force and / or using specialist brokerage / distribution outlets. By implication the star marketer would also be a partner.
For instance, the once esoteric Farallon Capital Management is marketing itself with a nine-page Institutional Investor article under the financial news service EuroMoney publications. Using the back-story of its illustrious founder Thomas Meyer stepping down at fifty-five years of age, and successor Andrew Spokes being announced as the chief. This is a process of institutionalisation via branding. In corporate lifecycle terms it is a precursor to eventual floatation and other business exit strategies. Perhaps a chance for founders to pocket or release some self-vested equity capital in 10 years or so. In February 2007, Fortress Investment Group became the first U.S. hedge fund to go public. Other one-stop alternatives managers also saw the exit door like Blackstone (BX), Och Ziff et al. Some EAMs had the exit door firmly shut in their face by the ensuing financial crisis which they strangely could not foretell from their capital markets tea leaves, though they were managing multi-billion dollars of institutional money under the premise of economic and financial savvy - Doh!

Of the many ‘pulled’ IPO alternative managers, the potent example I cite is quantitative algorithm guru Clifford Asness’s AQR Capital. His fames needs little introduction to hedge fund aficionados, and needless to say the firm is a heavyweight and managing in excess of US$50 bn at end 2012. FPM foster pioneer strategies and managers as they tend to display their real depths of spirited enterprise. Mr Asness is not only a Ph.D professor who led the group that developed statistical models in 1989 which eventually formed the Global Alpha at Goldman Sacs, but is an advocate against exorbitant fees prevailing in AI. We have tracked that he has been spearheading the charge on high fees at least since 2010. Fee reduction is a necessary feature of the convergence story between mutual fund, hedge funds, exchange traded funds et al. Whatever Mr Asness’s motives, even if not altruistic, he seemingly is admitting that his own technology-based alpha is not especially genius! Perhaps partly the rationale for AQR’s unsuccessful planned cash-out of 10% stake as early as July 2007. We commend his fee integrity (yet as a made-billionaire backstabbing late hedge fund entrants as barriers – You’re ‘Avin Laugh!). In his own words about the state of the fees from a recent conference speech:

"Most hedge fund strategies are more about very competent implementation and fair fees and terms [institutionalization] than they are about 'genius’… Hedge funds generally offer a nice portfolio (gross of fees!) of passive beta, alpha, and a middle ground we call hedge fund beta or style premia; but unfortunately, managers like to charge fees as if it's all alpha” 
At FPM we view the ‘branded institutionalization’ of the alternative investments (AI) industry trend with diligent skepticism. Concerned that a) founding principals with the innovative investment technology wits are operationally and executively not at the helm henceforth and b) merely seeing institutionalization as a stepping-stone opportunity for retirement and/or cashing out from the global institutional operations they painstakingly established and developed. In private equity investor partnering parlance ‘divorce and separation’ is the end. FPM’s reservation on this trend cogitates on the idiom that institutions are now content to invest in the golden egg but not the goose that laid it! Hence why there is naturally a lot of noise about backing fledgling emerging managers in the burgeoning alternative space.

Other than institutionalization features relating to key man, fees, cashing-out, and regulation there are other salient aspects of transparency and reputation. These cannot be irrelevant or ignored concepts, especially now in neural/viral wired-up multi-media cyber globe. Whistle blowers, disgruntled staff, disillusioned investors, anti-capitalism activist, email trails etcetera all become source of unofficial non-public information.  The prevailing reputation of a manager with small asset under management (AuM) is all important to its preservation. Otherwise even any alleged fraud can change its fortunes quite quickly, for the better or worse. Therefore with partnership self-interest they are less inclined to risk their good repute with fraud or other corporate misdemeanor mischief or downright shenanigans. Managers consciously protect and preserve the firm in positive light to the privy circle of co-participants in the ‘edge’ investment game. Degree of transparency to regulators, or institutional publicity in media is often minimal in niche partnership family-office type investment operations. Indeed investment regulation limited whom unregistered investment vehicles could market itself to (‘qualified investors’ only), and to whom the manager had obligatory reporting duties.

Since this note's premise explores why size matters in investments. Investment flexibility and alignment of interests are other considerations when deciding to park with large managers. For instance, on investment position sizing, the principals of the partnership may decide that a high conviction risk-on trade is permissible. Institutional policy tends to be compliant with oversight regulatory bodies. Bodies which monitor and dictate risk parameters to larger registered money managers. An essential feature of alternative investment mandates is the scope of flexibility in investment asset and strategies, within given private placement memorandum. This flexibility is further watered-down in larger institutions as key man / principals may delegate investment risk decisions to vested investment committees.

Blackstone Alternative Asset Management (BAAM) is the world’s largest discretionary allocator to hedge funds, with $46 billion in assets under management as of December 31, 2012.” Source: blackstone.com

For example, BAAM started out as family size operations:  In 1990, Blackstone created fund of hedge funds business to manage the internal assets and that of its senior managers of the then mainly private equity core business.
FPM’s due diligence identifies institutional managers by the degree of the managers’ alignment with its clients / investors, essentially by a ratio measuring principals’ and internal capital to that of the fund or firm AuM: 

"Most importantly, our interests are always closely aligned with our clients' with over $1.3 billion of the firm's and employees’ assets invested alongside those of our clients." Source: blackstone.com

So US$1.3 bn of “firm’s and employees” assets of a total US$46 bn in AuM is the extent of alignment of BAAM fund of hedge funds business to its clients. This is much much lower ratio than at the turn of millennium, when alternative investments and industry bellwether Blackstone Group came into institutional prominence, at the height of the DotCom bubble. BAAM acknowledges its own asset  gathering impetus on the Blackstone website “Over Ten Years of Asset Growth”. To FPM’s long memory BAAM’s current ratio of mutual investment interest is poor evidence of economic alignment between a firm and its clients. Further, asset growth is not the same as asset performance.

Often profitable niche business is kept close to one’s chest and a privy few as a closely guarded money-making secret. How many professional investors understood or had ‘the edge’ in exploitatively spotting the US housing bubble through the sub-prime market in 2007-09, and then were also able to make an ‘absolute’ killing? Certainly only handful of investors, from reading the Gregory Zuckerman book “The Greatest Trade Ever” concentrating on Paulson and Co.

Damaging reputation to a manager with large asset-base can lead to assets walking out of the door, which can be successfully public-relations-managed as an operable hemorrhage, given time. This mega asset base providing a substantial buffer / margin against sudden multi-million liquidity shocks is the implicit explanation as to “why big hedge fund gets bigger”.  In the same scenario smaller AuM hedge fund firms founder. Large institutional investors tending to pile into the perceived relative safe-haven of hedge funds and other alternatives are sacrificing absolute performance for cash preservation mandate. Understandable that strong absolute return performance is incompatible with cash preservation, but here’s the bewilderment. Even accomplished pension or proprietary capital administrators allocating to hedge funds are overlooking ‘alpha generation’ while allocating in an ‘all-about-alpha asset class!’ Further, these savings administrators believe they have to pay “2/20” fees for core low volatility portfolio cash preservation mandate. Why don’t they invest directly in cash bonds! It’s the same mockery and folly as an airline marketing its premium first class seats as plane-crash-risk-proof. All the seats are the same in the aero plane and subject to the systematic risk of it going down (unless the first class seats are re-enforced with steel bars like that cockpit of fast-car drivers or fitted with parachute ejection seats).

Performance of hedge funds as an asset class, as indicated by a benchmark index average, fared only marginally and negligibly better than equity market index, such as the S&P 500, over the recent systematic financial crisis. Then as stock markets recovered from an approximately 50% drawdown, hedge funds underperformed (and some threw in the towel unable to reach high water mark and thus earn performance fees). In the long-run the convergence story depicts falling alpha and alignment of hedge fund performance with market, asset, or strategy index. Achieving index returns by hedge fund portfolio managers (like conservative FoFs) in absolute return investments is a misnomer or sheer debauchery of AI. Similar to to turning a thoroughbred racing horse or stallion  into a rocking-horse! The tilt in favour of hedge funds comes from alternative managers being able to acknowledge gross of fees…

[ For a complete business proposal based on this note please email FPM with link]