A culture based on partnership and rooted in what was one of London’s fund management icons underpins the Dalton Strategic Partnership. Its evolution out of Mercury Asset Management several years after the 1997 Merrill Lynch buyout spawned a next generation boutique asset manager that from the outset sought to keep faith with the partnership values at the heart of the City’s traditional business ethos.
Now DSP is expanding. In October, it launched the Indian Equity Long/Short Fund. And earlier this year, the senior partners in DSP agreed to raise their stake to 51.5% following the death in 2011 of Andrew Dalton, leaving the Dalton family with 25%. With the partners committed and the ownership stable, DSP is now looking at opportunities to grow further.
“We have a broad range of long-only equity funds. Therefore, we’d like to focus our resources and capabilities on growing our absolute return business,” says Spence, DSP's Managing Partner and CEO, in an interview at the firm’s offices on Princes Street, overlooking the Bank of England. “There are a number of strategies that offer opportunities. But we are moving cautiously. In our business you have to be judicious about whom you hire.”
Until now, DSP has focused almost exclusively on equities. It was a natural evolution from MAM which in its day was among Britain’s top institutional equities managers. It is unlikely that DSP would establish a range of bond funds in the immediate future, but a global macro fund, with an equity element would be able to draw on the firm’s global positioning.
“It has been well documented that these are interesting times for building businesses,” says Spence. “There is a lot of talent out there which wasn’t available a few years ago.”
Day one support
When DSP set up, it had the good fortune to be entrusted with a significant day one discretionary mandate from a former MAM client. That provided the seed capital from which the rest of the business grew. A long-only business was the first leg to be developed under the Melchior range of funds brand. Then in 2006, Leonard Charlton joined from GLG Partners where he had run an internal trading book on Pierre Lagrange’s flagship GLG European Opportunities Fund to launch the Melchior European Fund, an offshore long/short equity strategy.
In early 2010, DSP launched a UCITS version of the strategy to market to investors who had already allocated to the firm’s well established long only equities funds. The attractions of having a UCITS hedge fund became apparent after 2008 when the primacy of liquidity and transparency rose to the forefront of investor concerns.
“Traditional buyers of long only funds found when the financial crisis hit that having a combination of long only equities and bonds in their portfolios was still producing a highly volatile return profile,” says Spence. “They wanted to put alongside those traditional strategies some asset classes which had lower correlation. But they couldn’t buy hedge funds for various tax, regulatory or liquidity reasons. This provided an opening for UCITS. The proposition was that UCITS would dampen the volatility of equity exposure whilst producing reasonable returns. And the risk-adjusted returns looked pretty attractive.”
Three groups of investors have emerged for the UCITS hedge fund. The first group (being traditional buyers of long only funds) comprised a range of investors from German insurers to French funds of funds and Spanish banks. They saw the UCITS product serving a useful role in damping volatility in their multi-manager portfolios. A second group of investors was composed of wealth managers in the UK and overseas who were seeking a product that was transparent, liquid and tax efficient. The third wave of investors was more heterogeneous still in that it included Japanese pension funds, Asian family offices and retail investors drawn from the UK, Asia and elsewhere.
A more accessible product
When the UCITS fund opened in 2010 it built on a $600 million Luxembourg vehicle and a $500 million UK OEIC run by DSP. It helped that the UCITS was launched as a sub fund of these existing structures which already had substantial institutional allocations. That aided investor confidence and made the product more accessible. With experience of both product lines DSP has a clear understanding of how the rationale of UCITS and traditional hedge fund investors differ.
“One difference is that because buyers of the UCITS fund are buying it to dampen equity volatility, they are more absolute return-focused,” says Spence. “But a traditional Cayman hedge fund investor sees an investment as part of a collection of hedge funds which is an important return generator in its own right. Thus they want a higher level of risk and return.”
With encouragement from a number of clients, DSP made the (Cayman) European Long/Short Fund a double leveraged offering seven months after the UCITS was set up in 2010. It and the UCITS run the same number of positions with the same names, but the position sizes in the Cayman fund are double the UCITS ones with twice the risk budget.
“Though they are exactly the same product, they are for two different markets with two different risk profiles,” says Spence. “That was a bit of breakthrough for us because we found that the lower risk product was hugely attractive to the UCITS buyers because it blended with their high risk long only equities.
But it wasn’t really bold enough for the hedge fund investors who want something a bit punchy. By double levering it, we gave them what they wanted.”
Of course one of the problems for investors in UCITS is that returns have been modest. The UCITS Hedge Index, for example, is fractionally below the level at launch in January 2010. Even funds that have made money are looking for ways to dial up returns. How this happens is a matter of some conjecture among hedge fund executives who face balancing investor preference with regulatory constraints.
“I suspect the next wave of UCITS products will have a higher risk and higher return characteristic than the first lot,” says Spence. “The tolerance permitted in UCITS is large enough to put quite a lot more risk into the portfolio. The 200% gross exposure risk (ceiling) is absolutely fine. One way managers may do it is to use emerging market equity long/short strategies. I sense we will see more emerging market UCITS funds, such as our own Indian long/short fund, which by definition will have more risk in them because emerging markets are more volatile. I think we will see greater use of net exposure ranges as well.”
A founding culture
With asset management firms, when a co-founder retires or passes away the effect can be substantial. Functions and structure may need overhauling. Investors, too, may require additional reassurance.
Following Andrew Dalton’s passing, DSP has undergone evolutionary change. The partnership culture and strategic vision that Dalton and Spence established together remains undimmed.
“This remains an investment-led firm and we remain ambitious to grow our business across our three lines – long only, hedge funds and wealth management,” says Spence. “We retain very much a partnership culture and our ability to do that has really come about as a result of the support that Andrew’s family has shown to the firm and the partners.”
As it grew, DSP began to evolve into a broader partnership compared with the early years after Dalton and Spence founded the business. Naturally, this evolution has been accelerated by the loss of aco-founder
“To my mind, and this wasn’t obvious at first, when Andrew died the culture and the sense of partnership in this firm was sufficiently strong to overcome a deeply harrowing experience for all of us,” says Spence. “That has been very substantially eased by the fantastic attitude and support of Andrew’s family towards the firm.”
A new environment
Conditions when DSP set up a decade ago were radically different from today. There was huge enthusiasm for start-ups among investors and a belief that people leaving big institutional players like MAM had big reservoirs of creative energy that would be unlocked in an independent shop. “There was a belief that this model was the right model and there were very few downsides to setting up a small boutique in a fragmenting industry,” says Spence. “That was the culture-emotional sense you got. I felt when we set up that we were going into a new world with lots of like-minded people who wanted it to work – be they investors or some other hedge funds who didn’t necessarily see you as competition.”
Dalton and Spence obviously knew each other extremely well and understood each other’s strengths and weaknesses. Dalton had progressed through the ranks with Warburg’s MAM investment management subsidiary. He thus bore the experience and qualities of those two pioneering firms. Spence, the younger of the two, only joined MAM in 1995.
“As a team, we were complementary,” says Spence. “Andrew had many qualities but above all he was a markets man. His greatest passion was the markets. He loved the dynamism of markets. But he also had a wonderful touch and sensitivity with people. He was also good at building businesses and marketing.”
Spence, meanwhile, had trained as an accountant and rose to become the group financial controller at MAM. Indeed, Spence refers to himself as “the slightly greyer partner.”
He says: “When you set up a firm like DSP you need a combination of someone with investment skills and someone who can put the nuts and bolts together. Some people saw us as a two-man team, Andrew forging ahead with exciting ideas and endless opportunities and with me while I came along behind clearing up. It wasn’t quite as black and white as that but we did complement each other.”
Spence is clear in asserting that Dalton, first and foremost, wanted to create a happy place to work and one with an enjoyable environment. The business was to be investment-led: delivering investment performance for clients in a sophisticated institutional way. “Whereas a good number of hedge funds will focus on just one strategy and seek to be outstanding in that, DSP aimed from the outset to be a genuine fund management equity business in the broadest sense. That vision has seen DSP grow to comprise 45 staff, including seven employees in marketing, selling 10 different strategies and a discretionary wealth management service.
From that flows a number of quite fundamental consequences,” says Spence. “We also wanted to have functional excellence in sales, marketing, dealing, operations and risk. We put a lot of money and effort into hiring good people to achieve that.”
“We are in some ways a mini fund management institution,” says Spence. “What’s good about this is that we have plenty of growth opportunities and it is also good that as a business we are quite nicely hedged as some product does well in bull markets and other product does well in declining markets. That means there is an operational robustness to what we do. But it also brings quite a lot of complexity to the business.”
Succession and transition
DSP certainly isn’t the first alternative investment firm to face the succession challenge. But it is fair to say that hedge fund firms, overall,have a patchy record of securing a successful transition to a new generation. One example is offered by Tiger Management, which closed with some alumni getting seeded and others going into business for themselves. Soros and some other legacy hedge fund management businesses have evolved into family offices. For hedge funds generally, succession and transition remains problematic.
At DSP, however, the succession to a new generation of talent looks to have been secured. The Dalton family and executive partners own 76.5% of the firm, effectively guaranteeing stability for some years to come. And Andrew Dalton’s son, Fred has been working in the firm for three years. Spence is adamant that the partnership ethos will continue to be central to the firm’s evolution.
“I do think a partnership culture and the relationship between investor and manager that comes from a partnership culture is a good one,” he says. “But that partnership structure can be threatened when a generation wants to retire. If mechanisms can be established for equity to be transferred from one generation of partners to the next that is much better for investors than selling out to a huge corporate structure, which brings with it all the questions of conflicts of interest and alignment.”
Spence isn’t the first seasoned financial executive to note that money managers in large institutions, including investment banks, have no real links to shareholders. It is now a truism to say that any linkage doesn’t really go beyond allocated capital or a short-term compensation structure. Even the links with a customer’s best interest can become strained as evidenced by continued controversy over practices at Goldman Sachs and other investment banks. The contrast with portfolio managers in alternative investment firms like DSP is apposite.
“At DSP, our partners’ capital is invested in the business and in the funds,” says Spence. “We can’t afford to take risks which may pay a short-term bonus but damage the business in the longer term. Our lives are this business. I think it is very important that we perpetuate the partnership culture. London is quite unique in that respect.”
Hedge fund products
For its hedge funds, DSP has tapped talent that was originally blooded at Goldman Sachs. Though Charlton may have come of age with GLG, he got his start at the investment bank as an equity trader in a role that featured extensive research and active trading of the short book. Indeed, his track record shows an average 1% alpha generated from the short book every month. From this, Charlton very soon realised that in order to make money in all market conditions it was necessary to carefully manage risk while also generating alpha from both the long and short portfolios.
This thinking remains at the heart of the strategy today with Charlton continuing to spend as much time trying to find good short ideas as good long ideas, using leverage conservatively and maintaining a low net exposure to equity markets (see Table 1). Since launch, the strategy’s gross exposure has averaged 87% while net exposure has stayed within a narrow band of +/-20%. The tight risk management has seen the strategy run through the Melchior European Fund/MST European Absolute Return Fund rack up annualised volatility (calculated daily) of just 3.8% matched with an annualised return of 6.96% (see Fig.2). For investors seeking diversification, the correlation to the DJ Stoxx 600 is an attractive 0.03.
Capturing alpha in India
Pant’s approach is to look across the entire capital structure of companies, while focusing on equity, using a fundamental bottom-up approach. The level of dispersion among stocks in the same sector is much wider in India than in developed markets. In Europe, for example, correlation is generally 60-70% among stocks in a sector but just 30% in India. The higher dispersion provides an attractive backdrop to capturing alpha. Pant intends for the fund to have a net long bias to tap into India’s structural growth, but doesn’t expect it have more than 50% net exposure.
“If I look over the last five to seven years the Sensex or Nifty have gone up seven-fold,” says Pant. “These are once in a life time occurrences. I’m convinced the growth from here is going to be pretty strong but it is now a well understood story.”
The first aim is to play the dispersion within sectors as winners compound gains and competitors that are also-rans decline in value. The second goal is to reduce the volatility and keep high liquidity.
“In the coming years, there will be more dispersion,” says Pant. “The market will also go higher, but it will be pretty choppy. So returns adjusted for volatility in the large cap space are more interesting to play with a relative-value approach than by going outright long.”
The fund’s core book comprises plays on infrastructure companies and financial players that are lending ahead of what Pant believes is an imminent cyclical upturn. He is also keen on Tata Motors, arguing that investors have failed to appreciate the operational leverage (and very strong performance) of its Jaguar/Land Rover business which is mainly located outside India. A third theme is to tap into the growth among private sector banks. Their market share is a fraction of the state banks, but Pant expects this to converge over time.