Simon Kerr talks to Ian Cadby and Paul Myners about the firm's future following the Caledonia acquisition

Simon Kerr
Originally published in the April 2006 issue

“It’s taken more than a year to agree the right transaction for the future of the business,” says Ermitage CEO and CIO Ian Cadby. As it takes about a year for the gestation of a blue whale in order to produce two or three seven-metre calves that is some development time. But at last, having been put on the blocks by previous owners Liberty Group Limited of South Africa, a deal for the fund of hedge funds business was agreed in February this year. The Hedge Fund Journal went to London’s Savile Row to hearfirst hand about the new shape of the business, the new owners, and new ambitions for one of Europe’s longer standing hedge fund businesses.

“The genesis of the change of ownership ofwhat was then called Liberty Ermitage was the change of CEO at Liberty,” says Cadby. “Myles [Ruck] was very honest and upfront and told me that whilst he thought we had a very good business, he had a clear vision for Liberty and that did not include owning overseas assets.” Consequently, in December 2004 an independent corporate finance house Hawkpoint was appointed to advise on the sale. Ultimately the firm received over 20 indications of interest from trade buyers and private equity houses, and it took most of 2005 to assess all the options for the sale. The management of Ermitage had a bias in what sort of parent they themselves wanted: Cadby says “we saw a couple of factors working against a typical private equity buyer. They buy for a three year turn-around, and we didn’t want the disruption of a change of ownership all over again after three years – we had had enough of that sort of thing. The other factor was that a PE buyer wouldn’t necessarily add to the business. In particular we saw that we could gain some distribution benefits from working with other sorts of buyers.”

It was announced in March that an agreement had been reached between Liberty Group and Caledonia Investments for the acquisition of Ermitage. The company is being acquired by a new vehicle to be owned 60% by Caledonia, and 40% by Ermitage’s management and Paul Myners, who will be the new chairman. The initial consideration is £35.1m, and there maybe up to £6m further payable over the next three years, dependent upon the level of assets managed in that period. Using the maximum acquisition price of £41.1m ($71.6m) that equates to about 3.7% of hedge fund of funds assets under management. This compares with the 5.7% of current AUM that Schroders paid for fund of hedge funds outfit NewFinance Capital (including the earn-out) and the estimated 5.2% of AUM that ABN AMRO paid for International Asset Management. Both those firms were of similar size to the $1.9bn of hedge fund assets under management at Ermitage.

Caledonia Investments is a UK Investment Trust company that is listed on the London Stock Exchange, and which actively manages a focused portfolio of significant stakes in companies. Caledonia has a history of backing financial sector companies, and a pedigree of backing asset management company winners in particular. Caledonia has had interests in EXCO (one of the predecessor companies of ICAP), Close Brothers, and Rathbones, as well as the large interest in British & Commonwealth which was disposed of just prior to the market crash of 1987. Caledonia Investments used to own a chunk of Ivory & Sime and most relevantly of all, it had a large stake in Gartmore for a number of years before its eventual purchase by Nationwide Mutual. This means that newly appointed chairman of Ermitage and former chairman of Gartmore Paul Myners has been used to working with the Cayzer family and its publicly quoted vehicle, Caledonia.

Caledonia Investments has been developing its hedge fund interests since 2001, when it took a 25% stake in Polar Capital, the manager of a series of single manager hedge fund and long-only products. Caledonia backed Glenn Baggley and Alex Allen when they launched Eddington Capital (a fund of funds) in 2003. The Investment Trust contributed €25m in capital for the first Eddington fund and owns 50% of the management company. In this context the stake in Ermitage makes some sense – Caledonia could be seen as making a play on the growth opportunity of a seasoned fund of hedge fund business, as opposed to a new company. The opportunity is very much seen as capturing the growth of the fund of hedge funds business as the industry increasingly transmutes into a conduit for institutional investor capital.
Changing the investment culture

Ian Cadby and his senior colleagues have brought Ermitage forward a long way in its investment process. When Cadby and Jonathan Wauton, now Head of Fund Research, joined the firm in 2001, whatever the investment process was it resulted in one person, Ron Mitchell, making the final decisions. Mitchell’s approach to investing in hedge funds has been described as conservative. This meant that Cadby as the new Chief Investment Officer had to imbue a different investment culture as well make enhancements to the processes undertaken. Changes to the process included adopting a voting system amongst senior investment staff at their monthly Investment Management Committee. The event exemplifies a collegiate decision-making process. This helps to address the target client base of institutional investors, who are perceived to prefer a process-driven approach to investments wherein the dependence on any one individual is mitigated if not minimised.

Changing the investment culture in any organisation takes time. Cadby perceived that Ermitage needed the scope to invest in strategies other than the ones they were limiting themselves to when he joined the firm. Broadening the scope to include more directional strategies would give a clear signal that there was a new mind-set to risk assumption at work in the fund of hedge funds company. It would also allow the firm to run a broader range of risk and return profiles amongst the products. The firm has launched as many products during Cadby’s tenure as they had in the previous history of the firm. Amongst the strategies that Ermitage now covers (see Strategy Allocation section), CTA, global macro, commodities and some volatility strategies have been introduced in Cadby’s time. The firm also covers mortgage-backed securities strategies, structured-credit funds, and energy hedge funds.

The current range of Ermitage product falls into the three categories of market-neutral, global multi-strategy and directional (see table 1)

Table 1: Liberty Ermitage Fund Performance – February 2006*

Fund Name (lead class) Strategy CCY Launch date Annual return
since inception YTD 2006 Sharpe SD
Asset Selection Fund Class A Market Neutral USD 30/12/98 7.27% 3.43% 1.60% 2.37%
Asset Selection Leveraged SPC Market Neutral USD 30/09/04 10.11% 5.41% 1.55% 4.17%
Event Driven Fund Alpha Class Market Neutral USD 22/09/97 7.47% 3.81% 1.05% 3.55%
Classic Reserve Fund Class A Global Multi-Strategy USD 01/04/05 8.82% 2.95% 1.37% 3.24%
Diversified Strategies Fund Class B Global Multi-Strategy USD 27/01/04 7.29% 5.85% 0.41% 12.00%
Global Strategy Fund Class B Global Multi-Strategy USD 02/01/03 4.52% 1.32% 0.62% 3.66%
European Absolute Fund Directional EUR 01/12/99 10.28% 5.09% 1.31% 5.41%
Japan Absolute Fund Class B USD Directional USD 02/04/02 9.83% -2.35% 1.18% 6.30%
North American Absolute Fund Directional USD 02/08/99 4.98% 2.69% 0.44% 3.81%
Resources Fund Class A Directional USD 09/04/03 30.12% 7.37% 2.17% 10.47%
Selz Fund Directional USD 25/05/83 14.58% 3.89% 0.70% 13.40%

*The single manager Selz Fund has been run by Bernard Selz since 1984 on behalf of Ermitage.

In addition to funds of hedge funds, the predecessor company Liberty Ermitage Jersey had a long-only fund of funds business, and a wealth management advisory business (Global Wealth Management Services). GWMS, with assets under advisement of over $570m, remains part of the new Ermitage whilst the other elements of the former business are now part of the South African Liberty Group. The split explains why group AUM has gone from $4bn to around $2bn. Ermitage is now a more focussed fund of hedge funds business.
Graph of Liberty Ermitage AUM Feb 2006 (includes traditional & alternative assets under management)

Analysis of portfolios of hedge funds

Detailed analysis of portfolios of hedge funds typically takes two forms. The two approaches can be used in the same firm, but more typically fund-of-funds portfolio analysis is carried out via one method or the other. Firms such Partners Group, the Zug-based alternative assets group that is soon to go public, will only operate portfolios of managed accounts. This gives them total transparency down to the position level. The holdings in portfolios of managed accounts can then be aggregated and analysed for every type of factor risk, and at the top level of aggregation the whole portfolio can be stress-tested and back-tested. Some firms only invest in single manager hedge funds on the basis of obtaining regular whole portfolio snapshots where a managed account is not available. The same analysis of every holding of every manager can then be made, though with less apparent control/liquidity as a managed account.

Ermitage takes the other approach to risk analysis of funds of funds. The only data needed in this approach is return data, both for the funds and any markets or factors to be analysed. The method is based on a principal components-style analysis, though the methodology has moved way beyond that simple description. Ermitage uses a Riskdata product that enables it to build a proxy per single manager fund that captures those factors that are relevant in thatfund’s returns. From 25-plus factors and the HFR indices a best-fit is determined, though ultimately the proxy utilises only the five factors with the best explanatory power (minimising over-fitting). Co-integration is used to help identify the factors. The factor set includes S&P style/size indices, corporate bond and high yield indices and Fama-French factors as well as S&P equity indices and Treasury market index volatilities. Provider Riskdata insists that it can model hedge fund strategies despite their dynamic nature as their proxies are sensitive to volatility and the correlation of assets (and they include non-linear features).

The analytical framework of the Riskdata product enables Ermitage to engage in risk budgeting. The sensitivity of constructed funds of funds portfolios to the various factors is transparent and allows the fund-of-funds manager to run portfolios through scenarios. This can be back-testing of specific market environments and stress periods that have occurred, or envisaged scenarios for new extreme events in markets. The analysis applies at the single manager and multi-manager level so any fund that Ermitage has classified as “approved” (been through all qualitative and statistical due diligence and is investible) can be added to funds of hedge funds to find the effect on the risk profile of the total portfolio of funds. Somewhat unusually, this risk assessment tool is said to address event-driven strategies through the direction match probability test. As ever, the limited number of observations of large co-moves of factors and fund returns makes the analysis somewhat unreliable for extreme moves.

There are significant advantages for the approach to fund of funds analysis taken by Ermitage. This risk profiling of funds allows the analyst to see under what market conditions the funds and funds-of-funds under- and out-perform.Secondly, the data collection and handling problems are limited relative to capturing and analysing security level information that is necessary in the alternative approach. Ermitage gathers weekly fund NAVs for all funds in their investible universe (around 500 funds on the approved list). All hedge funds will generally provide weekly NAV information once the user of that information is known as credible. Not all hedge funds will provide portfolio snapshots or full portfolio transparency or managed accounts – so there is ultimately a wider choice of hedge funds for the Ermitage investment team. The approach used by Ermitage, based on weekly data, can be applied to short track records of funds. The risk profiling approach also offers stability through time: by seeking to capture most of the return factors there is still some capacity to handle style-rotating funds (but not those that switch in a gross fashion). As hedge funds typically receive allocations for performing well within a strategy and style box, style morphing funds should not be an issue.

Ermitage has developed a series of systems to assist in the key tasks of running a fund of funds. They use heatmap software from PowerView as a means to show a lot of information in a meaningful way (see graphic 1). The box sizes and colour coding can be used to reflect asset size and performance criteria for example; the user can click on a box to drill down to the next level, and the system allows sorting so that funds can be screened by the geographical location of the manager/strategy/returns to plan a trip, for example. Outliers in a peer group can be readily identified with this tool.

The performance of Ermitage funds can only improve, according to Cadby. As it is, the specialist vehicles have more commanding returns. Indeed the 2005 return of the Japan Absolute Fund (B Class USD) of 21.73% was particularly noteworthy, and qualified the fund of funds to be short-listed for a performance award. The monthly and annual returns of the Asset Selection Fund are given in Table 2 as somewhat representative of the Ermitage multi-strategy funds of hedge funds.

Table 2. Asset Selection Fund Class A Monthly Performance (%) Net of Fees

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec YTD
2006 2.25 1.15 3.43
2005 0.11 0.81 (0.16) (1.13) (0.38) 1.04 1.67 1.06 1.16 (0.78) 0.63 1.51 5.63
2004 1.42 0.45 0.39 0.17 (0.77) (0.28) (0.28) 0.00 0.17 0.39 1.67 1.37 4.77
2003 1.66 0.67 0.30 1.38 1.36 0.47 (0.64) (0.23) 1.35 0.81 0.52 0.80 8.76
2002 0.69 (0.25) 0.44 0.37 0.12 (0.43) (1.18) 0.19 0.19 0.56 0.81 1.57
2001 1.73 0.65 0.46 0.58 0.77 (0.19) 0.83 0.70 (0.32) 0.63 0.06 0.25 6.33
2000 1.85 0.95 1.30 1.42 0.28 0.70 0.90 1.17 0.89 0.20 0.67 0.54 11.43
1999 1.23 0.57 0.64 0.56 1.35 1.18 1.55 0.08 0.61 0.68 1.35 0.07 10.32

Strategy allocation

Whilst some funds of hedge funds businesses such as PAAMCO try to add value mostly from the bottom-up, Ermitage is looking to enhance returns by allocation to strategy as well as selecting managers. One of the initiatives taken to support this is the Ermitage Strategy Review, a monthly overview of 11 strategies. The Review, which clients see, gives a commentary on each strategy discussing activity in the strategy, the dynamics of the drivers of return for that strategy and a strategy outlook. The strategy outlook is captured in a score between 1 and 5, where 1 is very positive and 5 is very negative. Table 3 gives the strategy outlook score for March.

Table 3: March strategy outlook

March Outlook
Event Driven – 1
Distressed Debt- 4
Fixed Income – 3
Volatility Strategies – 2
Multi-Strategy Arbitrage – 2
Japan Long/Short* – 2
European Long/Short* – 2
North American Long/Short* – 3
Commodities* – 3
CTA – 4
Macro – 2

*Strategy specific funds of funds from Ermitage in these strategies

Sample commentary:Event Driven – March Outlook 1

February was another encouraging month for the strategy. We continued to see good levels of corporate activity with $297bn of announced transactions. Around 70% of the activity was in Europe where some very large utility transactions, namely Endesa SA/E.ON AG and Suez SA/Gaz de France, as well as continued consolidation in the telecommunications sector drove activity. We have also seen political intervention in France and Spain to block bids for national champions. It will be interesting to see whether the EU takes action against either government. Within the portfolio, our European focused managers generated the best returns over the month.

Distressed Debt – March Outlook 4

Returns in the distressed space were broadly positive in February, with supportive bond and equity markets providing a positive backdrop. We continue to see stress in certain market sectors, notably autos and airlines, which are creating some new opportunities in the distressed space, although the new pipeline is slow. Default rates are ticking up from historically low levels, but most of our managers feel the next distressed cycle will not begin until 2007 at the earliest. The lack of new pipeline is making it difficult to put money to work and we remain cautious on the near term outlook for the strategy.

Does this process of allocating to strategies work for the clients, that is, does it add value? Ian Cadby is very confident that the investment committee (consisting of himself, Group COO Mark Hucker, MD of Wealth Management Andrew Whelan, Executive VP Hedge Fund Research Jonathan Wauton, and Executive VP Investment Strategy Research Sarah Allen) gels well and works as a decision making forum. The analysis available is based on too short a period to carry much weight, but is expected to be used for marketing when the length of track record makes it more substantive. Recent evidence for the two largest funds is shown below in table 4.

As you would expect, the top down contribution varies from strategy to strategy and fund to fund over time, with most added value potential with-in funds that employ a broad range of strategies.

Strategic investments and seeding

Ermitage states that it is a top seeder of new hedge funds in Europe, as well as being in the top 100 global fund of hedge funds by assets. The seeding is done through the Strategic Partners Fund, a fund of hedge funds thatinvests mainly in European-based, early-stage hedge fund managers. The Strategic Partners Fund has been backed by several large European and American institutions. Through this vehicle Ermitage provides seed capital and product distribution for new hedge funds in return forreal or synthetic equity stakes in the management companies. Caledonia Investments will put £5m into this fund as part of its commitment to Ermitage.

The growth of the fund of hedge fund industry has peaked at the aggregate level. For the first time in some years there were net withdrawals from funds of hedge funds in the fourth quarter of last year. The asset gathering of Ermitage has followed a typical pattern – hedge fund AUM up 60% in 2003, up by 40% in 2004 and essentially flat last year. Ian Cadby sees that we are still in a secular bull market in alternatives: “we have just experienced a minor cyclical downturn within it,” he confidently states. “There are still a lot of investing institutions that have yet to commit at all to hedge funds, and allocations from existing investors are still going up. Forour part, we think that the planned change of ownership of Ermitage made it difficult for the gatekeepers (consultants) to put us forward last year. This year it is different: already we havehad our first US pension client, and having successfully broken into the US endowment business in 2004, we now are being short-listed for an increasing number of US endowment mandates.”
Table 4

6 months (Sept 2005 – Feb 2006)

Fund Strategy Top-Down Strategy – Selection Added Value Out/Under performance of Equal weighted invested basket vs peergroup Bottom up Manager Selection Added Value

Asset Selection Fund

Asset Selection Fund 0.05% 1.18% 1.7%

European Absolute Fund

(L/S Equity) n/a 0.8% 0.36%

The previous owners of Ermitage sanctioned a great deal of spending on systems at the company. The investment team is now up to 17 professionals and the process of a Hedge Fund Committee (that includes input from hedge fund analysts) in combination with the Investment Committee (senior decision makers) works smoothly. More importantly Ian Cadby has now instilled a broader and deeper investment culture in his time as CIO. “We think we are in the sweet spot for the industry,” he says. “We are large enough to have the resources to address the needs of an institutional client base, but not so large that our unit size for investing in hedge funds is too big to be restrictive. We can and expect to grow our assets to $5bn over the next few years from the current platform.” With the change in ownership and the resulting reinvigoration from equity participation Ermitage looks well set to go for this level of maturity. How feasible is this? Well, a blue whale reaches maturity at five years of age and is 20 to 21metres in length, that is three times the length at birth. So Ermitage’s scale of growth from their re-birth would be quite natural.

The new Chairman of Ermitage

Paul Myners has an extensive background in banking and finance as Chair and Director of a wide range of financial institutions – he has been a non-executive Director of mmO2, Orange and Nat West and is now Chairman of Marks and Spencer. He is a Director of Gartmore Global Trust plc and Chairs the Guardian Media Group and Aspem Re, the largest independent re-insurance company in London. Paul Myners is also a member of the Court of the Bank of England and Chairman of the Tate Gallery. He was awarded the CBE in the 2003 New Year’s Honours for services to innovation to finance.

Fund commitments of Strategic Partners Fund Inc.

Manager Name Launch Date Date of SPF Investment Total Manager AUM $

Cumulus Asset Management

Cumulus Weather Fund 01/10/05 01/10/05 $25m

Harmonic Capital

Macro II 15/07/03 15/07/03 $435m

Highland Capital

Asian Opportunities 01/07/04 01/07/04 $70m
Asian Equities 01/05/05 01/05/05

Picus Capital

Venator 01/07/04 01/07/04 $36m

Volteq Capital

GED Long/Short Equity 01/09/05 $36m


Convertible Arbitrage 01/12/03 01/01/05 $45m


Commodities 01/11/04 01/03/06 $11m

Paul Myners’ name has been associated with several landmark reports on money management issues – the 2001 Myners report on institutional investment commissioned by the Treasury, and more recently (February 2005) the Myners report on pre-emption rights published on behalf of the Department of Trade and Industry. Lest it be forgotten, he was asked to be involved in these investigations and reports related to the asset management industry because he has vast experience in the industry. Paul Myners was Chairman of money manager Gartmore from 1987 until 2001. In the 1990s when the UK market for pension fund investment was dominated by four firms Gartmore was one of the four. The firm also had retail investment products and was the first mainstream UK asset manager to launch a hedge fund. “I was involved in the decision-making to launch the Alphagen Capella fund,” says Myners. “Hedge funds was an area where I had had more exposure than many who were in the traditional asset management industry.”

Paul Myners had worked at Rothschilds prior to Gartmore, and Banque Privee Edmond de Rothschild have managed one of the longer established fund of hedge funds in Europe. Leveraged Capital Holdings has a history stretching back far enough to cover the time when the giants of the industry were still Soros, Robertson and Steinhardt. Myners was part of the investment committee that met to select and review managers. “I do have a hedge fund claim to fame – I was one of the men who fired George Soros,” confesses Myners. This was at a time when Quota and Quantum were still pumping high returns, and the LCH fund had substantial fund assets with Soros. “He had done so well that the holdings had become a huge part of the fund, “ explains Myners, “and quite sensibly we were looking to trim the holding. When we discussed this with Soros he said we could sell all our holdings or none of them. So we consequently redeemed the whole of our holdings with him, but we really didn’t want to.”

Ermitage CEO/CIO Ian Cadby is clearly looking forward to working with Myners: “we wanted a high profile chairman, and in discussion with Caledonia the idea of asking Paul came up, and to our delight he said yes. We had asked around, and the feedback I got was that he was a visionary, and that he could be quite punchy. I thought that was what we needed. The management team here is grown up enough to be challenged on our strategy, and we don’t want just a figurehead.”

For his part Myners has developed a modus operandi for non-executive positions. “I’m here to constructively challenge. I like to be the honest friend – you know, the one who tells you the truth. My way of being on a board is to agree the parameters with the executives, and then let them run the business.”

Paul Myners has also had some recent exposure to investing in hedge funds via other non-executive positions. “I’ve been involved in a Bermuda re-insurance company that had investments via hedge funds. It makes a lot of sense to me for that sort of liability profile to invest in absolute return vehicles.” He discloses “I’ve wanted to do something in the hedge fund area for some time. In fact I’ve looked at three or four fund of hedge fund groups here (in Europe) and in the US. I see Ermitage as very well set up for the rising demand from institutions that is out there. Ermitage has the right sort of investment processes and the proprietary research tools that you need to run money for major institutions. As I’m an investor with management in the company I can also say that I think the company has been bought at a fair price, and it has the scope to grow after a period of investing in the necessary infrastructure.”