Kempen Fund of Funds

Long-term approach pays off

Originally published in the November 2013 issue

New York was once called New Amsterdam, and Amsterdam-based Kempen finds around 70% of its hedge funds in the New York area including Greenwich (with most of the rest in London and Hong Kong). Although merchant bank and €30 billion asset manager Kempen’s Dutch roots date back to 1903, the fund of funds, which started in 2005, has never historically been directly invested in hedge funds based in the Netherlands. The geographic breakdown of the client base is almost the polar opposite of where Kempen invest: there are no US investors, with most investors still being Dutch institutions and high-net-worth individuals, including Kempen and its employees – for whom the flagship Kempen Orange Investment Partnership (KOIP) is the only Kempen fund their deferred bonuses can be invested in; Kempen’s $900 million of fund of funds assets contains €35 million of proprietary and employee money. Kempen’s top-tier post-crisis performance is starting to attract inflows not only from local private banks in the Netherlands but also from investors, including family offices, in the UK, Spain and Switzerland.

Since January 2009 KOIP has annualised at around 9.9% and is up 7.1% this year to September. This places it well inside the top 5% of multi-strategy funds of funds in the European-dominated Morningstar database. Kempen admits that their ranking is not as high though still top quartile against databases that include more US funds of funds, although some of these have more equity beta. KOIP’s net equity exposure has averaged 20% since 2008, and its net credit exposure has also been moderate – around 10% for corporate credit, with some additional structured credit. KOIP’s sister fund of funds, Kempen Non-Directional Partnership (KNDP), has even lower equity exposure, between 0% and 10%.

Asset allocation, strategy weightings and managerselection have all contributed positively but the last of these has made the biggest contribution, matching Kempen’s mainly bottom-up, fundamental investment philosophy. The best asset allocation decisions have been ramping up credit and distressed, including structured credit, in 2009 – and then tactically topping up structured credit in late 2011 after intelligence alerted Kempen to a fund liquidation fire-sale cheapening the asset class. The best strategy selection move lately has been avoiding managed futures. Although Kempen admits that CTAs would have been helpful in 2008, since then Kempen thought that traditional CTA strategies would struggle in a market that alternated between inflationary and deflationary fears without a clear macro direction.

Manager selection has added value in all strategies, and Kempen think that performance dispersion places a premium on picking the right managers: the gap between best and worst managers in strategy groups has never been less than 11% in recent years, and was in 2009 as high as 38%. So, for instance since 2009 Kempen’s macro managers – including quant macro using fundamental inputs – have annualised at over 10%, well ahead of the average. Their credit and distressed bucket has made the biggest absolute contribution, annualising at 18% over the past five years, and Kempen has also been adept at picking winners (and avoiding losers) in all of the other strategy categories – “there have been no bleeders,” says senior portfolio manager, Michiel Meeuwissen.

Longer-term view
The impacts of Kempen’s late 2011 tactical top-up of structured credit – and its late 2012 addition to equity strategies as tail risks receded – should not be exaggerated, since even a 3-6% change in strategy weights is quite a big move by Kempen standards. The manager tends to rebalance allocations only incrementally, and mainly relies on managers to take tactical views. So Kempen’s average holding period of six or seven years is far longer than that of many funds of funds. “If we need to redeem after two or three years, it means we made a mistake somewhere,” says senior portfolio manager, Remko van der Erf, who explains that Kempen internally describes its allocations as “partnerships” not because they are legally structured in that way but because they are intended to be long-term.

At a time when many allocators are obsessed with daily liquidity – or even intraday liquidity via exchange-traded funds – Kempen has no desire to shorten the minimum quarterly liquidity profile that has always applied to its funds of funds from day one. Investors accepting a one or three-year lock-up get a discount on the 0.75% management fee, and from 2014 the performance fee that had applied above a 8% hurdle rate will be removed. Kempen have identified that funds with lock-ups have outperformed those without them by a large margin – more than 3% per year between 1996 and 2009 – citing Professor Sadka’s research published in the Journal of Investment Management in April 2011.

Cautious on liquidity and leverage
Clearly this longer-term perspective does not mean that Kempen is running maturity mismatches. They monitor closely how liquidity of their investor base compares with that of their allocations. They are also wary of liquidity mismatches in underlying funds, and of illiquid assets in general. Today only 1.5% of KOIP assets are side pockets, with KDNP’s side pocket tally at just 0.3%. Kempen are perhaps comfortable with quarterly or annual liquidity because Kempen itself did not run into liquidity problems in 2008. The manager did not gate, kept its currency hedges intact, and met redemptions in full.

Kempen almost always seeks managers that are less leveraged than their average peer group. Kempen is mindful that some assets, including some mortgage derivatives or junior structured credit tranches, can entail a lot of structural, embedded or implicit leverage even if they are not balance-sheet leveraged. So while Kempen admits that its credit managers lost money in 2008, they survived and had enough dry powder to make more after the crisis than they lost in it – with some funds’ 2009 profits more than double their 2008 losses. Kempen is particularly sensitive to leverage in combination with portfolio concentration or illiquidity.

Although Kempen thinks investors are well rewarded for owning less liquid assets, there are plenty of illiquidity premia that are not appropriate for a quarterly liquidity fund, even one with some one and three-year money. Dedicated direct lending strategies, and private investments in public equity (PIPES) are two areas Kempen avoids, as multi-year loans are too long dated. Liquidity in general is measured from Bloomberg or exchange data for some markets. In OTC markets Kempen uses their network to cross-check, and sometimes finds that managers overstate the liquidity that prevailed in crises such as 2008.

Apart from illiquid or excessively leveraged strategies, Kempen also treads carefully, if at all, elsewhere. For instance Kempen takes credit risk in the mortgage space, but has never believed it had a competitive edge in something as specialised as assessing prepayment risk. Additionally, Kempen’s long memories recall occasions when some mortgage strategies proved vulnerable to rate rises, so the manager has largely side-stepped this year’s sell-offs seen in some mortgage strategies. At either end of the directional spectrum, dedicated short bias is completely avoided while long-only managers are used only very sparingly. Strategies that carry substantial regulatory risks are also likely to be avoided, and this may include some regulatory capital instruments.

All seniors team
The team contains five full-time, senior professionals and five supervisors or advisers, which all tap into a wide range of networks. The head of the hedge fund team is KCM multi-management director Theo Nijssen who formerly founded the fund of funds business for Mees Pierson Fortis, and has sat on the boards of some Rothschild Capital Holding funds. Michiel Meeuwissen joined Kempen in 2000 and has worked on the launch of the Kempen product since 2004, while Remko van der Erf worked at Robeco Sage previously. Kempen has recently added two seasoned professionals from London’s fund of funds community: Igor Pujlic was previously deputy CIO and PM of a multi-strategy product for the Key Asset Management fund of funds that was acquired by Swedish bank SEB in 2007, while Marjoleine van der Peet spent seven years working as a portfolio manager under fund of funds doyen David Smith at GAM and was also at Watson Wyatt in Amsterdam.

All five due diligence professionals sit on the investment committee, which contains two internal supervisory members and three external advisers. IC chairman Paul Gerla previously spent 25 years at Shell, including at its pension fund, and is CEO of KCM. Lars Dijkstra, formerly of the Philips pension fund, is group CIO of Kempen. Each of the three external advisers specialises in different areas. The credit and distressed specialist, Adam Phillips, was CIO and partner of Marathon in Europe, having previously been a proprietary trader at Lehman. The fixed income macro advisory specialist Jonas Rinne co-founded quant macro shop IPM, was head of sales and trading at JP Bank and also advises Brevan Howard. Equity and event trading specialist Gordon Lawson headed European equity prop trading at Salomon before founding his own fund, Pendragon, from which he retired in 2004. The advisory investment committee members may be technically non-executive but in practice they can play a much more hands-on role, and may attend meetings alongside the full-time team. “The advisers are not just ceremonial – all of them have traded for their prior employers,” stresses Meeuwissen.

Junior analysts are conspicuous by their absence and this is deliberate. Kempen thinks that the end decision makers should get actively involved in all aspects of the due diligence process. Kempen also finds that funds appreciate that even the first contact is with the eventual decision-makers, sidestepping the need to leapfrog over “amuse geules” meetings with juniors before getting to the real deal. “The seniors do all face to face with managers, before coming to a conclusion,” says van der Erf.

Constant qualitative cross-checking
Kempen does carry out quantitative analysis to try and disentangle traditional beta, alternative beta and true alpha – and aims to obtain the bulk of returns from alternative beta and alpha. Internal risk aggregation exercises, up-streaming funds’ position-level data, can be customised to a high degree of granularity to satisfy client curiosities, which may include equity exposures in particular countries. In response to other client requests Kempen is about to add third-party risk aggregation to its suite of investor reports, which already disclose all funds owned.

The same pattern, of complementing internal processes with an external provider, has already happened with operational due diligence. As with the risk aggregation, Kempen feels perfectly happy with the quality of their own process; witness that frauds and Madoff were always avoided, and Kempen had virtually no Lehman exposure, because their managers were on the case in monitoring counterparties. However, as Kempen are always striving to improve processes, they have retained Aksia as a second opinion on operational due diligence, after researching a number of providers. Kempen also uses Backtrack First Advantage for background checks, which on one occasion revealed information leading Kempen to discontinue their due diligence process on a manager. Background checks are intended to identify “whether people are honest in general – about their qualifications, sporting awards – have a clean criminal record, and treat people well,” says Meeuwissen.

But most of the team’s time is devoted to qualitative, forward-looking assessments that cannot be replicated with backward-looking models or references. Site visits are essential, with existing managers seen at least twice a year. Kempen made 16 trips, mostly to London and New York, over the first nine months of 2013. Kempen not only get more transparency in managers’ offices, they also feel the emotional pressures facing managers. Post-meeting desk research involves cross-checking facts on Bloomberg and with other managers to verify and benchmark what was heard on site. The portfolio managers also dig into individual portfolio holdings to test if the investment thesis sounds sensible. All of this extensive cross-referencing speaks to a cliché about the Dutch: that they and their politicians love to seek consensus. Kempen want to get comfort that multiple parties internally and externally share their convictions, through both formal and informal references, before proceeding with an investment. High conviction lays the foundations for relatively concentrated portfolios of 20 or 30 funds.

Kempen reckon that, via the networks of their 10-person investment committee, they cover 90% of the universe of “institutional size” funds, which they define as being assets of at least $250 million to $300 million, and track records of two or three years, although monitoring begins earlier. Like the Scottish, the Dutch have a reputation for being value-conscious – and some Dutch allocators dogmatically refuse to pay normal hedge fund fees. Kempen’s attitude to fees displays another archetypal Dutch character trait – pragmatism. Whilst fee discounts are sometimes obtained, history also shows that Kempen’s most expensive managers have performed best, echoing Prequin’s research. Kempen are also pragmatic in selectively using long-only managers, which naturally charge lower fees, to access some asset classes including CLO debt.

Given Kempen’s requirement for managers to be disciplined on capacity, the team feel it is healthy that so many of their funds are closed. Around five funds have already hard closed, and most of the rest are soft closed – allowing existing investors to top up. Yet even with hard-closed funds, a longer-term holder like Kempen might find opportunities to replace redemptions. Writing typical tickets of $30 million, combined with its loyalty, makes Kempen a nice investor to have for many managers, and some famous managers (Dan Och of Och-Ziff, Greg Lippmann of LibreMax, and Bruce Richards of Marathon) have spoken at Kempen’s annual symposiums, which can attract as many as 100 Dutch institutional investors.

Specialist managers
Although Kempen owns a few multi-strategy funds, they tend to go for specialists that focus on just one strategy, citing research such as Melvyn Teo’s 2011 paper that shows that managers with only one fund averaged returns above 7% while those with multiple funds made much less. Historically this search for focus has led Kempen into Asian small caps, Middle East and Africa equities, US mid caps, US REITs, mid-market distressed, and insurance-linked securities specialists.

Although Kempen does expect to continue increasing its allocation to equity-related strategies, right now the one strategy that excites them most is distressed debt in Europe. With much of the Dutch banking sector surviving on a raft of state support, and Utrecht-based SNS the latest casualty to be nationalised, Kempen are all too familiar with the problems of European banks. That the full extent of SNS problems has only become apparent five years after the credit crisis shows how long it can take for some banks to work through balance sheet issues. And bank balance sheets in Europe are more than three times GDP, while in the US it is only 0.9 times GDP. Even without new Basel rules forcing banks to bolster capital ratios, Europe’s banks would be forced to sell some portfolios of loans and would not be able to refinance others. Although many market participants have been disappointed by the amount of interesting paper that has materialised so far, as always Kempen are taking a longer-term view. Kempen has identified managers with a European presence and expertise in the continent’s many and various legal and insolvency systems, and now Kempen is quite content to patiently wait a few years for this story to play out.