First the Deepening, Now the Broadening

Pequot builds in growth potential

Simon Kerr
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Art Samberg has achieved a lot in his career. In his 65 years he has built several asset management businesses, made himself a fortune, and won recognition within the industry. He is a regular in the Barron's Roundtable that marks the turn of the financial year, for example. For some years he has been pursuing the Holy Grail of the hedge fund business – building a hedge fund business that survives beyond its founder. To do this he has taken a number of strategic initiatives within his firm Pequot Capital. The Hedge Fund Journal went to the New York offices of Pequot to find out first hand what those initiatives are, and meet Samberg and some of his senior management team.

The Core Fund as a template

Pequot Capital has $7.5bn assets under management, and the template for the rest of Pequot and the kernel from which the rest grew is what is now called the Core Fund (aka The International Fund). The fund was started by Art Samberg in October of 1986, and it has among the longest track records under one portfolio manager for a long/short equity fund. The Fund is diversified by industry and sector (see Figure 1 for indicative breakdowns). It is structurally long/short and has a core of US exposures with diversifying exposures outside America (Fig.2). The Fund can and does carry exposures to asset classes other than equity (Figure 3).

Databases show that the onshore fund has a compound return of 14.8% net of fees over the last 10 years. The fund has spawned a number of long/short carve-outs that share similar investment philosophies and approaches: the small/mid cap Scout Fund, the Healthcare Fund, and the Market Neutral Financials Fund.
 

 

The Core Global Fund is co-managed by Samberg, the Pequot Chairman and CEO, and Mike Corasaniti, the Director of Research. They both have MBAs from Columbia University, and Corasaniti is an Associate Adjunct Professor of the Columbia Business School. Amongst the seven analysts that work on a dedicated basis on this Fund there are five MBAs: there is plenty of intellectual capacity applied to investors' capital in this Fund and the others at the firm. However in Samberg's judgement that is not sufficient. "I look for our analysts to be capable in left-brain activity like understanding cash-flows and building models, and to have a good ability in the right-brain to be able to think-out-of-the-box, and to figure out how the unlinked can become linked. That's a real differentiating factor for us."

Analysts at Pequot are charged with being "Secular Change Hunters" who are looking for stocks where fundamentals are not reflected in stock prices. This puts the firm firmly in the category of fundamentally-driven managers, with the typical holding period associated with such a style of investor. The analysts on the Core Fund are at four levels within the firm: one Associate, one Vice President, three Senior Vice Presidents, and two Principals. The significance is that Pequot is happy to retain career analysts, that there is a career progression, and that there is the flexibility to assume sector responsibility and ultimately portfolio management responsibilities if the right aptitude is shown. The thinking of Pequot's management is that they will retain investment talent if it is nurtured and grown in-house.

A core concept is that the managers use a patient and thematic approach to investing based on a continuous micro and macroeconomic view of global industries. As confirmation comes in of an emerging secular trend, one which may apply over a number of years (even as far as 5-8 years out), then a theme can develop within the portfolio. Positions can ride the same wave (re-confirmed periodically) but played from up and down the supply chain, and taking account of closest neighbour losers as well as winners. Shorting is absolutely required at Pequot. Samberg insists on carrying substantial shorts in his hedge funds in response to previous experience.
 

 

Pequot Capital's core global strategy has evolved over time. The genesis may have been in US long/short equity, but it is as likely to have a minority of American exposures now. The investment process is summarised in Figure 4.

Research – the core of the investment process

Just as Samberg looks to identify secular change in potential investments so he has spotted such shifts affecting his own industry. Two of them are closely related and have helped shape Pequot Capital. They are research (covered next) and internationalisation (see below).

"When we carried out research in the 1990s the environment was very different, and it really suited where I had come from. Remember I am a growth manager by inclination, and have been focused on technology because of my background. Back then world growth was US-led and US technology companies were leading the world." So the growth stock boom of the 1990's and the phenomenon of the technology bubble both played to strengths of Pequot and the firm prospered on the back of them.

"The research required to participate in the opportunities then were wholly different from now. At that point we could afford to be intermediaries of research assets provided by banks and brokerages, but that is no longer the case." Samberg shares the commonly held view that Wall Street research has deteriorated: "there has been an unfortunate dumbing down," he says. "Now we get a 12-page piece of research with 6-pages of disclosures. So the written material is not something we lean on. We still use sell-side analysts as a resource but not their written recommendations."

Pequot Capital does use external research sources, such as independent industry specialists, and also some that operate as a function of Web 2.0. There are research capabilities that scour the blogosphere for references and information to turn to commercial advantage. Pequot uses services like Monitor 110, but the core of the research process is the in-house effort.

"One of the keys of our investment philosophy is our own proprietary research," expounds Samberg. "Fundamental company analysis is the cornerstone of Pequot Capital's approach, and it cannot be outsourced." Across all asset classes the firm's research is based on meetings with individual company's management, suppliers and customers. The disclosures from these meetings (as many as 50-60 a day) are married up with the on-going industry analysis and an understanding that comes from following a group of industries for a very long time. The firm still retains areas of particular focus and expertise even as it has added staff (over 100 investment professionals and 20 traders now) and added new funds (17 strategies plus over a billion dollars in private equity/ventures).

Pequot has made what Samberg describes as a huge investment in its own analytical capability. There are analysts dedicated to each team that runs a strategy. "These are trulygifted people in their own right," says the Pequot Chairman and CEO. "What we do is surround the rare investment talent (the portfolio managers) with quality people with complementary skills to help him or her express their unique abilities." Finding and recruiting the right people is an enormous effort on the part of the firm. Candidates are interviewed carefully according to Samberg, and as a consequence Pequot has a good hiring record.

Although Pequot Capital sees itself as a platform for investment talent in the hedge fund format, and has expanded the strategies managed at the firm, it is only the strategies, the investment decision making, which is autonomous. Art Samberg is particularly keen that the staff participate in a collaborative culture at the firm. He sees synergistic benefits in sharing the insights generated within the teams. "I consider a silo structure to managing an asset management firm to be destructive. The teams here must collaborate, and we have taken initiatives to foster that."

Typically there are three research retreats held each year at Pequot; one of them last year was combined with a skiing trip. Pequot investment staff gather from the offices in Connecticut, New York, California and London. At these retreats the senior staff will share their views of the world, and various ideas are prepared in advance by ad hoc teams. There may be 3, 4 or 5 groups put together specifically and drawn from across the strategy teams to present to the assembled cadre of managers and researchers. The idea is that back at their respective offices the members of the various teams can feel they have a virtual call on the time of the members of other teams, to tap into their knowledge and contacts.

There are also regular meetings scheduled for each investment group. On a monthly basis each of the 11 teams has a structured dialogue with senior Pequot management. Each team talks through what has changed in their portfolio and the rationale behind the changes. "We want to minimise 'Group Think' within each team, as that way lies certain failure," according to Art Samberg. "We like to create a discussion, maybe through some tough questioning. We need strong people here that are able to express their opinions from a rational standpoint (rather than an emotional one)." The teams themselves have to be small – less than ten members. "That size gives a span of control," says the Pequot CEO.

Other mechanisms for sharing and facilitating the collaborative culture are the database, calendar and morning meetings. The research database at Pequot is the repository of most of the written knowledge of the firm. All the meeting notes and company models constructed are held centrally so that they can be shared with any of the investment staff. The utility of the firm-wide calendar goes beyond co-ordination and avoiding duplication: investment staff can join meetings set up by other teams, and follow up using the notes of others if they are unable to attend. The morning meetings of the teams are open to staff from other teams. For example it makes sense for the Private Equity/Venture staff to know what is going on in the technology team.

Internationalisation

There was a carrot-and-stick combination at play when Art Samberg decided to broaden activity at Pequot beyond America. The CEO describes the carrot: "Three years ago we decided to embrace the opportunities available outside the US. We have far different investment opportunities now than in the 1990's: America is a strong participant in global growth, but this phase of world growth has been Asian led, and we want our investors to benefit from that. Plus we think we can add more value by applying our research-led approach to companies outside the United States. Right now if I'm looking for real estate exposure I think I'd prefer Brazilian exposure to the risk/reward here. The roll out of mobile telephony in developing countries has a much bigger impact there than here, and we understand those transformations." The stick is partly the difficulty of applying capital to very efficient markets domestically. "In the last three years the percentage of the (US) stock market that has been shorted has gone up a lot," explains Samberg. "It seems that everybody is short now." The relative efficiency of the US markets has led to Pequot shifting portfolio exposures to outside the US, so that the Core Fund is approximately 50% non-US now.

Internationalisation at Pequot extends to the firm as well as the products. In January of this year Pequot Capital Management (UK) Ltd was authorised by the UK's regulator the FSA. From the London office Dr Faraz Naqvi runs the Healthcare Fund and Emerging Markets Healthcare Fund with (New York -based) Co-Portfolio Manager Navroze Alphonse. It would be unsurprising if Pequot based more researchers from other teams in London in future, or indeed opened a research office in the Asian time-zone. Pequot also has some client-facing functions operating out of London.

Risk Management at Pequot

All first-tier hedge fund management companies have high-end risk measurement/risk management capabilities. Even modern era macro managers, the last bastion where a presiding investment genius may operate with a subjective approach, nearly always have structured risk information with which to operate. Even more so, then, that a rational fundamentally-based hedge fund shop like Pequot Capital should have looked to enhance its' risk infrastructure and methodology. Two years ago Jeff Hurwitz arrived at Pequot as Chief Risk Officer after three years at Steve Cohen's SAC. The five-person Risk Management Group that Hurwitz heads is responsible for all firm-wide risk methodology, measurement and management. His initial remit reflected the direction the group is heading. "I was brought in to take the existing risk processes and expand on them," says Hurwitz. "If you will, to take risk measurement and risk management at the firm to the next level." The strategic direction of the firm has been built on the research processes, and the intention has been to bring in more talent, and create more funds off the back of the research and risk management platform. "Within Risk Management we had to be in a position to build ourselves out so that the firm could do the same in a controlled, informed way," he says.

According to the CRO, Pequot understands that no single risk measure provides the answer, and so uses a mosaic of analytics to support the risk management process. "Risk is not black and white – it is various shades of grey. Although we go into granular detail about risk measurement in the portfolios and across the firm, we still recognise that risk management is more of an art than a science," allows the earnest Hurwitz. "My role is divided into two parts. I wear a risk oversight hat, and I am also looking to add value to the portfolio managers' investment process."

Numerous risk analysis methods are utilised to measure exposure at various levels, from the individual position to the firm in aggregate: VaR, stress testing; scenario analysis; sensitivity analysis; implied correlation; implied volatility; exposure bucketing and liquidity analysis.

When Jeff Hurwitz arrived at the firm he spent some time with each portfolio manager discussing their investment styles and how they approached the task of constructing and managing portfolios. This enabled the CRO to establish agreements with the PMs on the expected range of exposures for running their particular products, taking into account each PMs' idiosyncratic style as well as the broader strategy requirements. So the risk monitoring, the oversight part of the Risk Management function, has two components: there is the quasi-compliance oversight to ensure prospectus limits are observed, and there is oversight on behalf of Pequot management so that managers stay withintheir agreed style box.

"Risk measurement is the quantitative input to the risk management process, but we don't accept it as sufficient to look just at a 99% confidence interval VaR and leave it there," says Hurwitz. "We know that VaR is some estimate of loss in 'normal market conditions', and that 'normal market conditions' are defined by the look-back period used in the analysis. We also acknowledge that the use of past history in most risk measurement techniques is a big assumption, but, by taking a comprehensive view of risk in many different dimensions and measures, we can really understand what is going on. That comprehensive view includes spending a lot of time looking at the tails of the distribution of potential returns in order to estimate how portfolios might behave in extremely adverse environments."

"For example, we use a look-back period of 500 days in calculating several of our risk measures, such as VaR and simulated volatility. However, the last two years have seen record tight credit spreads and record low equity volatility. These have been amongst the tamest markets ever seen! Just relying on the last two years of data could result in an underestimation of risk in some portfolios if the results are not interpreted with a bit of a qualitative overlay," warns the 12-year risk management veteran.

Another layer of potential risk inherent in the portfolios is shown through the stress-testing of two types, historical and deterministic. Portfolios at Pequot are subject to historical stress tests of periods of extreme market duress. A 5-day data window is used for a couple of reasons – market turmoils such as the Russian crisis of 1998 unfold over multiple days. According to Hurwitz the second reason is that "beyond 5 days the portfolio manager can likely act, so the testing becomes unrealistic even for times of low liquidity." The second stress-testing of portfolios is of the deterministic type. These are time-agnostic tests of potential extreme moves in markets. One test simulates a 20% fall in equities, a 125% increase in volatility and a 75 basis point widening in credit spreads.

"We store all the outputs generated from our daily processes," states the Chief Risk Officer. "So risk assessment is not just where you are on any one day. Rather, it is also very important to look at the time-series of the metrics developed. So a large part of our reporting effort is focused on trend analysis. We believe fundamentals will prevail in the long-term, but it's not a path-independent process.

The second part of how Jeff Hurwitz views his role at Pequot is for him to add value to the investment processes of the portfolio managers. At first-rate investment management firms the Risk Management function is an integral part of the investment process: an understanding of risk is embedded in the investment culture, not merely acting as a passive observation or compliance capability. So it is at Pequot. "My approach is to ingrain risk information into the investment process of the PMs," says Hurwitz. "You have to listen first; to digest what each manager's process is. My ideal portfolio manager is in-their-own-right a good risk manager. In those instances, my role becomes risk optimisation. For example, we have a process that volatility adjusts positions. Higher volatility positions are scaled up and lower volatility positions are scaled down. Expressing position sizes this way in addition to the traditional way helps differentiate the risks between two similarly-sized positions that have different volatility profiles and can be used as an additional input into the position sizing process."

The interaction with the PMs varies by strategy. For some there are just the weekly meetings. For others there are scheduled meetings plus ad hoc meetings. "Some managers get to the point of what I call pro-active risk management – where they call me or come into my office, rather than the other way around. Say a manager wants to add a new position, we might run a simulation beforehand so he can volatility-adjust the initial position size. Right now I get a lot of unsolicited visits, and when I see our risk reports strewn all over a portfolio manager's desk I know we have some traction with that PM."

Clearly Hurwitz has achieved at least in part some of his major objectives at Pequot: a more robust risk measurement framework, and risk management embedded as part of the investment process. There remains more to do. "We want to provide more added value to the PMs," he says. "You can always get more precise in risk measurement," he concludes.

Diversification by strategy

Pequot Capital was an early mover in the creation of sector specific hedge funds. The Healthcare Fund was a carve-out from the Core Fund back in January 1998. Since then the TMT and Market Neutral Financial Funds have each expanded the roster of sector funds from the firm, but again, like the Scout Fund (small/mid-cap) all within the equity long/short category. An early move into another strategy category was the launch of the Credit Opportunities Fund in May 2003, a long/short fund managed by Steve Zamsky. The same manager also has responsibility for the Pequot Short Credit Fund that launched in July of 2005. "Steve's Short Credit fund is getting a lot of interest from investors," says Samberg, "and I can understand why. It can be great diversifier for investors. We don't know when we will get a significant widening of credit spreads, but this is an interesting play for when that occurs." Pequot has also launched and closed down an Asian distressed debt fund in recent years. "To grow a tree correctly it has to be pruned judiciously," according to Samberg.

Another move away from the core long/short equity competency came with the hiring of three managers that worked together at Citadel Investment Group in late 2005 which further broadened Pequot's product offerings. Carson Levit runs the recently launched Strategic Equity Fund that can invest globally and focuses on companies that are experiencing major change with clear catalysts. Steve Pigott is the PM for the Pequot Event Driven Fund, and co-manager with Levit and TMT Fund manager Peter Labon for the Dynamic Strategies Fund . The latter incorporates the highest conviction ideas of the Event Driven, TMT and Strategic Equity Funds in a concentrated portfolio.

The Dynamic Strategies Fund is an example of a growth area at Pequot, that of co-mingling strategies. Pequot has also followed European managers RAB Capital, Brummer and more recently Henderson in creating a fund of in-house funds. The Pequot Diversified Fund offers investors access to several of Pequot's established strategies using a dynamic, multi-manager, multi-strategy approach. Strategy allocation for the Diversified Fund is carried out by an Investment Committee led by Art Samberg. An overview of the firm's activities is reflected in the wheel in Figures 5 and 6.

Building for the future

A new and potentially significant development at Pequot Capital is the Emerging Manager program. "The Emerging Manager program expresses how we believe that the hedge fund business is developing," says the forward-looking Samberg. "The hedge fund business is maturing, partly because of increasing institutional involvement. There was an opportunity for entrepreneurial managers to set up their own hedge fund management businesses – but that door is quickly closing. You need more resources than ever to be credible; returns have been scrunched down, and it just gets harder to differentiate yourself as a fund. I think it forces people to stay where they are. We have a route out for talented investors that see the attractions of working underthe Pequot umbrella." The support offering is reflected in the outer rim of Figure 6 (a version of this used by Pequot is known as "The Samberg Star", but Samberg himself, revealingly, snorts at the label. The firm is named after the location of the first office in Pequot Street rather than after the urbane CEO himself).

The Emerging Manager Program is one pool of capital spread across twelve strategies run by thirteen managers (only one team of two). The program is run by Brian Igoe, who came to Pequot from Cambridge Associates. "I joined a program that was up and running: the quality of talent already assembled was good," says Igoe. "We try to keep it that way by screening hundreds and hundreds of candidates. It is not just the support features that a large firm can provide that managers coming in here appreciate. We have a friendly collaborative culture here. The (nascent) managers get access to visiting company management like everyone else at Pequot. They are able to bounce ideas off the analysts and PMs of other teams, and they do. We also have an internal resource for mentoring, and that is rare in the hedge fund business. When you take account of all that, and the dialogue they enjoy with our risk manager we reckon that a manager running a hedge fund strategy here for a year is equivalent to 2 1/2 years experience elsewhere." The period cited is important. "The managers that thrive have to have a disciplined process that is shown to work over a year," states Igoe. "This is a true meritocracy: if they have done well, managers can graduate to their own fund in which the strategy is run side-by-side with their portion of the Emerging Manager Strategy. That way investors in the EM Strategy (which includes Merrill Lynch) still get the early manager performance effect."

The CIO of EMF continues, "The way I break things down is into three headings, namely research, portfolio construction and trading. Research is about the manager's idea generation; portfolio construction is all about risk management; and trading we recognise as an art. Trading is all about feel for the market. I look for some key attributes during the interview process. I want to see intelligence and integrity. I'm looking for a love of the business, and I want to meet someone that says that they hate losing," he laughs. In addition, the EMF under Igoe hasn't hired a candidate unless they have had short-side experience. On top of that Igoe is looking for someone that can work in the collaborative culture of Pequot, and can handle the stresses. "The business is tough enough without shouting," explains the Pequot Managing Director.

For their part, managers in the EMF program appreciate what they get at Pequot. One of them, Scott Craven, says that "the Risk Management Team at Pequot is better than any of the places I've worked at before." He continues, "You get access to a lot of people working at Pequot that think out-of-the-box. In sum I'd say that Pequot gives you all the tools you need to succeed in this business." Another EMF PM, Marc Lewis elaborates on the culture as he has experienced it. "The collaborative culture starts from the top down. It has been great to be surrounded by nice people, and it's been a fun place to work. I'd say that it's not a macho culture here that you can get at some investment houses. Here it's about doing the right thing and being professional."

The EMF program is well regarded at Pequot. "Brian Igoe has done a very good job", confirms Samberg. For his part, the firm's CEO feels some personal benefit of the Emerging Manager program: "These guys could be the future of the firm, and I like being around them. It's stimulating being around young people," he discloses.

Getting more out of what they have

For the firm as a whole, Samberg is not looking to add to the headcount. "We may be doing some product extensions, but we will not adding to capabilities. We intend to get more out of what we have. But we have to stay true to our fundamental research approach."

The fundamental bottom-up approach at Pequot ultimately turns into thematic investing within portfolios. Funds with thematic portfolio construction often turn in a return history with streaks of hot performance, as the big bets get rewarded. By Samberg's own admission 2006 was a "disappointing" year for returns across the group. The investment process at Pequot requires that the fundamental validity of the drivers of themes are checked to be still effective. So the pay off for investors in return for those themes that disappointed in 2006 may come in 2007. So one of the ways that Pequot could get more out of what they have is in the funds themselves.

Pequot Capital has deeply resourced the investment platform of the firm. Additional investment talent has been both brought in from outside and developed in-house. The Risk Management capability has been strengthened. The Group has now got to the position where product extensions of existing strategies and brand new strategies can and will be added to broaden and deepen the product range. This will give long serving staffers the chance to develop into portfolio managers. Having made the products international in scope, the whole firm is becoming more international in the various functions.

Samberg gives his macro view: "I absolutely can't believe that world economic growth is going to slow down a lot. This global growth phase can last five to seven years yet, and in the short term I can see two, three or four quarters of good growth this year. Sure you could bail out for a hiccough in the market, but you'd have to be really smart to fine tune it." As goes Art Samberg's take on world economic and market prospects, so goes our take on his firm's prospects on a medium-term view.