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Wednesday 9 July 2014

Unwinding Risky Hedge Funds

FPM have been active in and monitoring the hedge fund seeding and stake-buying investments. Alternatively we refer to this business line as simply asset management finance.  Specifically to understand the life-cycle phase of the hedged fund industry through tracking asset management finance activity . An FPM principal has participated in a 2007 stake-buying club deal arranged by the now virtually defunct Lehman Brothers. With our financing credentials in hedge fund operations we identify and interpret trending ideas for institutional investors to be wary of. The sell-off or unwinding we discuss refers to the hedge fund asset class. This is not the same as “unwiding risky hedge funds” in a portfolio. In this article, FPM analyze yet another re-structuring phase in hedge fund investments.

The crux of our observations is that leading Alternative Investment Brand (“AIB) shops like Blackstone Group, TPG Capital, KKR & Co and Man Group are at varying stages in their re-structuring of hedge fund seed-stake activities. We understand from resourceful relationships that the multitudinous risks building on investment bank books since the financial crisis means exit doors have and are being sought by them, while other asset management entrants seeking to open new doors! A matter of timing is difficult to predict but the context of restructuring is clear to FPM associates.  AIBs and their select investors don’t seem to want to wear the expected hedge fund proposition implosion risk or in industry parlance known as ‘blow-up risk’, anymore. So this week, the AIB bellwether Blackstone floated the idea of offloading its holding of risky vehicles via an initial public offering:

…Blackstone executives have told clients that taking stakes in hedge fund firms is a good opportunity for yield and raised the possibility of an IPO of a diversified portfolio of stakes…” WSJ MoneyBeat, 04 Jul 2014

By inference the multitude of risks festering in external hedge fund investments are greater than the promised return of finding and owning a piece of the next mega institutional asset manager, emerging from the new millennium fandangle ‘alternatives’ brand. FPM’s dissection of this product cycle is entitled “Product Convergence or Incestuous Orgy in Alternatives”. Our long-memory reminds our readers of the once poor reputation hedge funds had as highly risky institutional investments, as distinct from their regulated listed counterparts, the humble mutual fund. While that perception of hedge funds has changed with better reputation for them, the blow-up risks have not gone away due to their traditional modus operandi. A handful of institutionally evolved AIB managers with their polished-up financial public relations communications, clearly does not indicate that emerging new managers are not susceptible to blow-ups, whomever their reputable AIB sponsor maybe.

Hence why leading private equity group Blackstone, educated by its 30-years hedge fund investments experience and transparency from stake-seed investing, are now laying the IPO-foundation for arms-length engagement with external hedge funds. Passing the buck to unsuspecting institutional and retail investors eh! Also, partly explains why Blackstone is building its internal hedge fund offering and why FPM believe it is consequently internalising massive operational risk from its insider-trading association reputation alone:

"In one way, Blackstone's model resembles SAC Capital Advisors LP, the fund led by Steven Cohen Blackstone's trading teams will pitch their best ideas to a group... If it likes the ideas, Blackstone will give the team additional cash to piggyback on the trades or use the ideas in other firm products... SAC returned external money earlier this year in the wake of an insider-trading scandal."

Blackstone Group, Soros Fund Management and few others like Pequot Capital before it scandal-ridden closure, have long been vocal forerunners and ardent supporters, establishing the highly risky and questionable hedge fund strategies as an mainstream investment asset class. Since Blackstone’s formation in 1985 it has invested in hedge funds. Creating rumours that its Chinese Wall were breached, since it is a leading corporate deal-maker or private equity manager, which provided executive level ‘heads-up’ for the external hedge fund traders it backed. The famed George Soros and his management firm are also not without insider trading reputations. (See more in FPM’s “No Smoke Without Fire: Of Reputation Risk”, a case-study enterprise report of Blackstone Group’s sponsorship of systematic insider trading at Steven Cohen’s eponymous SAC Capital – a manager now renamed 72Point Asset Management and shuttered to external money)

The public offering of emerging managers FoFs proposition implies that the hedge fund convergence and implosion risks will increasingly be widely born by public pensions. Also, the IPO move suggests existing investors backing the Blackstone emerging managers’ funds are reigning-in their search for the ‘illusory and mythical’ alpha managers. Despite it being reported that J Tomlinson Hill, chief of Blackstone's hedge fund business, was quoted as intending to "dominate" the hedge fund seed-staking business.

The previous case of such large scale packaging and dumping was marketed as “collateralised debt obligations” investments.  Basically, CDOs were varying risky debt papers, which were securitised with enhanced ratings, packaged and offloaded by investment banks to unsuspecting global institutional investors. We know the aftermath of that folly! The structured product bubble exploded with the unravelling of the subprime mortgage debts constituting theses ‘diversified’ investments. Then, voila! global financial crisis. Similarly, FPM have tracked the incestuous cross-holding and ‘farmed’ investments in hedge funds by sponsors of the alternative investment universe. This deep knowledge database serves FPM to analyse FOFs constituting dodgy me-too hedge fund brands. By which we do not just mean beta funds masquerading as alpha investments, but those hedge funds that engage in sharp practices for their edge with inherent operational risks.

Lest we make the error known as “problem of induction” by citing one major example of Blackstone Group to generalise our point that re-structuring private equity of hedge funds is a cause for concern and opportunistic trend, we discuss a few other examples. Such as Man Group reportedly stating its intention to withdraw from further hedge fund seed-stake investments:

Man Group is winding down its hedge fund-seeding business. Via its 2012 purchase of FRM, Man inherited a seeding vehicle that launched in 2007 with $400 million but is now in run-off mode following a recent restructuring…” HFAlert.com, 04 June 2014  

Also, note that KKR & Co, a US private equity pioneering giant with over US$100 bn assets under management (AuM) announced closure of an internalised equity strategy hedge fund last month June. For the KKR Equity Strategies wind-down, their public relations cite mediocre performance of average 5% annualized since its inception in August 2011. However hedge fund analysts understand that an operational scale of only AuM US$510 mn for a behemoth asset manager outweighed costs of its Goldman Sachs lifted prop' traders. As well as poor critical mass in assets managed KES only had 20 external investors. KES was reportedly started with US$100 mn from KKR. This is another blow-up risk in hedge funds, when the main sponsoring investor pulls out leaving a funding gap or forcing liquidation into premeditating 'short-squeeze' market. Such funding gaps are an opportunity fund manager transactions facilitated by FPM.

Despite above example, the crux of the matter is that early-stage ‘baby’ hedge funds, i.e. 3-5 years of existence and less than $1 bn AuM, are generally the hallmark of better alpha investments. They apply traditional hedge fund models such as strong performance, key-man operations, outsized bets, scaled capacity and innovative risk allocation including ‘dubious risky’ practices, all contributing to enhanced risk-reward payoffs. As early-stage managers get operationally significant with wider institutional investors base they become convergence story beta plays. Hence, one reason of many why established hedge fund managers, after being effectively incubated by their larger backers, for say a 5-year period, are ripe for strategic exits or IPO. Courting, marriage, honeymoon, separation and divorce are the allegoric conventional business transactions of private equity managers, historically a.k.a. corporate financing cycle.

Man Group and other AIB managers consolidated their own business FOFs model through acquisition. (Man Group acquisition of FRM); and then by in-housing direct investment hedge fund strategies (Man Group bought GLG). And when these AIBs wanted to expand their alternative universe and diversify their performance-related income with external operational revenue-sharing through a network of investment managers they undertook seeding and stake businesses. As the benefits of owning hedge funds outweigh the perceived, potential and real reputation risks its time to bolt for the hills. Analogous to investigative expose news, hedge funds are beyond the “scoop and splash” stages and have entered the “mature and decline” stages. Don’t take FPM’s “M&A of the Alternative Kind” enterprise exposition for it, look at TA Associates, an AIB private equity firm with a 46-year history of transactions including the financial institutions space. Last month in June Man Group had entered into a conditional agreement to acquire Numeric Investors from TA Associates. Numeric Investors have US$ 14 bn AuM and was established in 1989. This exit deal is still unconsummated but TA Associates held the Numeric Investors stake for 10 years.

The mentioned triumvirate enterprise execution themes of FPM[1] are encapsulated in exploring the difficult circumstances of DE Shaw’s 20% stake sale by Alvarez & Marsal, the financial practice liquidating the Lehman estate. The liquidators of Lehman have had challenges selling the hedge fund stubs since the investment bank’s acquisition of the stake a year before its bankruptcy in September 2008. Also, within fund manager transactions we noticed another private equity giant TPG Capital venturing further afield into the Asian hedge fund seed-stake business. Remember it was only recently in the evolutionary cycle of hedge funds that investment banks were forced to offload hedge funds under Volker Rule related to risk-weighted capital. Some investment banks hived their fund portfolio into client portfolio within their asset management divisions.

[1]FPM Three Themes: 1) Product Convergence or Incestuous Orgy in Alternatives, 2) No Smoke Without Fire: Of Reputation Risk, 3) M&A of the Alternative Kind