Gold Dust Around the Edges

Crisis means opportunity for competent funds of funds

Originally published in the November 2008 issue

Where to now for funds of hedge funds? The situation looks bleak for a sub-sector of the alternative investment industry which was already being considered over-crowded before the credit crunch reared its ugly head (an estimated 2000 funds of funds globally going into 2008, according to one informed estimate). To continue to survive in a rapidly contracting market, some funds of funds are having to come up with more imaginative ways of doing business, whether it be focusing on emerging managers, or developing regional or single-strategy products. Those firms that are still optimistic about the prospects for the hedge funds industry going forward are wedding themselves to more aggressive, imaginative strategies while keeping an open ear to what the investor community is asking for.

PAAMCO, one of the larger and more respected funds of hedge fund managers on the block, relies on its expertise in building bespoke portfolios and the high levels of transparency it receives from managers, a differentiating factor in these times of trial. Stephen Oxley, Managing Director at PAAMCO in London, says the managers PAAMCO invests in are generally sticking to their liquidity terms although he has seen managers suspend redemptions, impose gates and restructure portfolios to protect existing investors in response to other investors selling out, particularly from the private banking and high net worth sector.

There is limited demand for strategy specific funds of funds at the moment, but investors are still asking for products with more of a regional bias. “Apart from long/short equity, we don’t see much call for this sort of thing,” he observes. “Institutional investors want a more diversified approach. The other area you may see demand going forward is in credit – we and our institutional clients see huge opportunity because of recent market action.”

Oxley says one of the keys to success in the funds of funds business will be making informed decisions about emerging opportunities and strategies. PAAMCO is keeping a close eye on these, with a view to moving quickly to invest with the leading names once a given area of new investment gains sufficient traction. “We regularly publish internal papers on these subjects,” he says. “If there’s one thing we are convinced of is that a good fund of funds needs to be flexible.”

Some funds of funds managers are seeing the current crisis within hedge funds as an opportunity, either to expand their own businesses, or gain access to managers they could not have hoped to buy into a year ago. Some hedge fund managers are positioning themselves to take advantage of the anticipated TARP asset sale next year.

Distressed investor opportunities
Fund of funds specialist Permal has launched a new fund which will seek distressed investor opportunities in the hedge fund market, looking for investors interested in selling their holdings in closed or illiquid hedge funds. Now that millions of dollars are heading in the opposite direction, Permal reckons a unique opportunity has arrived for investors to buy top performing managers at a discount.

The new Permal fund, called Hedge Fund Opportunities, is being structured as a closed-ended vehicle with a limited lifespan. It is seeking to raise at least US$250 million between now and the end of January in three tranches, prior to closing to new investment. As Omar Kodmani, senior executive officer at Permal explains, “this is not an evergreen fund, it is exploring a specific window of opportunity. It is seeking outsize returns from a window that may not be there a year from now.”

Because of the fact that the fund is seeking to acquire hedge fund investments at a discount which will be recognised immediately in the P&L, it has to take on a quasi-private equity structure in order that shareholders are fairly treated to the accretions to NAV over the fund’s lifespan.

The fund has generated interest from serious institutional investors, including pension funds that usually don’t speak to the funds of funds market, as well as some of the leading family offices. “This has global appeal,” says Kodmani. “We have been approached by private banks with ultra-high net worth clients who are very interested in this concept.”

Permal aims to build a diversified portfolio of managers, relying on industry sources for its deals. Like other fund of funds managers, it is currently steering clear of event driven and convertible arbitrage, and illiquid strategies that have traditionally relied on leverage for their returns. “It is not that different from conventional fund of funds investing,” says Kodmani. “There’s no point buying at a discount for its own sake.”

A wide network of active investors is required to make such a strategy work, although Kodmani also admits that since news of the fund has spread, many investors have been contacting him out of the blue.

The essence of the strategy relies on a discounted transfer and/or the NAV. The opportunity is being driven by the panic selling currently gripping the market, as investors seek to free up cash or move assets into more liquid investments. There is no real formal market as yet for dealing in illiquid hedge fund investments, although firms like Hedgebay have done well in entrenching themselves as aviable option for investors seeking to buy and sell in the secondary markets. “So many hedge fund investors are having liquidity issues,” says Kodmani. “They need to get out of positions quickly, and are becoming forced sellers.” He has seen a lot of turnover already this year from seasoned investors, but now new sellers are coming to the market. “We’re getting major approaches, and it looks like we’ll not be short of manager ideas,” Kodmani adds. “We will still need to work through 100 managers to find the 10 or 20 we want to invest in, however.”

Finding an appropriate fund is only half the battle: a transfer of ownership still needs the approval of the manager of the underlying hedge fund, and a recognition that the fund’s historical high water mark is accepted in terms of performance fees. Permal has not found either to be a major obstacle so far: its standing in the market means managers are happy to have it on board as an investor, and replacing an investor who wants to get out with one who wants in can’t be a major problem for a manager in this climate. “If a manager is closed, we tend to be contrarian, and tend to sell that manager at a premium,” says Kodmani. “Conversely, if a manager has had a bad year, we’re happy to acquire more shares at a discount. Our new fund is really a creature of this extreme market environment – we’re seeking a juicy discount, and want to match that with good managers. So many firms are launching distressed funds right now, but this fund really focuses on distressed investors.”

It all boils down to how skilfully the manager can tap the herd-like panic that has set in with much of the hedge fund investing community in recent months. Many investors are starting to reveal how short termist they really are, while others clearly demonstrate how they have been wedded to a strategy of performance chasing.

The long tail gets shortened
Beyond the chance to pick up holdings in a ‘gold dust’ manager, there is also now a possibility to acquire funds of funds businesses and whole portfolios wholesale. SilverStreet Capital announced this month that it is looking to take advantage of expected consolidation in the hedge fund market to acquire funds of hedge funds’ businesses as part of its growth objective. CEO of SilverStreet Capital, Gary Vaughan-Smith, says he sees the need for some funds of funds to downsize in response to redemptions. “With our flagship fund holding up relative to the peer group, we are in a strong position to act as a consolidator and further develop our business,” he explains. He anticipates fall out in the fund of funds sector from the global credit crisis somewhere in the order of 30%, and of the current universe of funds of funds globally, 20% already manage 80% of the capital. “There is a long tail that is running not very much money,” he says.

SilverStreet is expecting to see many funds with under US$300 million being forced to close or merge. In what Vaughan-Smith calls an “interesting opportunity,” some 300 management firms could be left standing in this space when the dust finally settles. His firm is speaking to “a number of people” at the moment, but Vaughan-Smith says there are no deals on the table just yet.

“We could also see some family offices divesting themselves of their funds of funds operations,” he adds. “It will really depend on how successful they have been in getting third party money into their funds.”
Vaughan-Smith is upbeat: he sees the current crisis as an opportunity for Silver Street to expand rapidly in a way which would simply have been too expensive to adopt as a corporate strategy a year ago. The firm has an 18 month track record and US$600 million under management, but recently took on Alan Miller, the former CIO and co-founder of New Star with John Duffield, as it gears up for further growth.

Acquisitions aside, Vaughan-Smith recognizes that there is an opportunity to acquire holdings with top drawer managers with discounts of as much as 20%. A great deal depends on the sentiment surrounding the manager concerned, what his performance has been like recently, and what sort of lock-ups are in place.

For less liquid strategies with gates in place, SilverStreet is expecting discounts of somewhere in the region of 10-15%. For the aggressive fund of fund with the money and investor support to do it, this is a buyer’s bonanza.

PAAMCO’s Oxley stresses that of the new institutional money he has been seeing coming into hedge funds recently, much of it is from major players like pension funds, and is being invested for diversification purposes. “Despite the recent turmoil and redemptions by private clients and others, most institutional investors are maintaining, and in some cases increasing, their allocation to hedge funds.”

This matches up with the interest that Permal has been seeing in its new fund. Investors who view hedge funds from the perspective of longer term allocations (i.e. those with liabilities measured in decades rather than years) will see the current climate as a buying opportunity. And those with existing hedge fund allocations will be looking to those robust funds of funds businesses that can ride out the storm to present them with portfolio options that can suit their circumstances, as well as providing them with a means to either diversify their risk in the hedge fund market, or offer them the opportunity to exploit the value opportunities that currently exist.