Liongate Capital Management

Originally published in the September 2008 issue

Jack be nimble, Jack be quick, Jack jump over the candlestick.

One version of the origins of this traditional nursery rhyme is that 'jumping over a candlestick' was a way of foretelling the future. Funds of hedge fund managers are not blessed with perfect foresight, but an ability to recognise imminent trend changes and nimbly adapt to the new circumstances is a distinct advantage. The Hedge Fund Journal spoke with Randall Dillard, Partner and Chief Investment Officer of Liongate Capital Management about the company's investment strategy, which combines top-down analysis with active capital re-allocation.

Liongate was founded in 2003 and currently manages assets of approximately US$4 billion. The company runs two main funds that are open to investors, the Liongate Multi-Strategy Fund, which was launched in April 2004 and has approximately US$3 billion assets under management and the Liongate Select Fund, which was launched in November 2006 and has over US$500 million AUM. In February of this year, the Liongate Multi- Strategy Fund Enhanced (2X) Feeder was launched, which provides investors with 200% exposure to the flagship Multi-Strategy Fund, and currently has just over US$100 million AUM. Offering leverage for the first time in the current volatile market may appear to be a contrarian approach, but Dillard explains that the new product offering has been purely driven by client demand. The Enhanced Fund is an add-on at the request of existing clients that is provided as a service and the fund is not actively marketed.

With regard to the two main funds, Liongate's investment approach has been to keep the fund's capital flexible and liquid, across the portfolio strategies, sub-managers and their underlying assets. Consequently, Liongate's funds have managed to avoid illiquid strategies which are now declining in value, such as asset bank securities.

Looking further ahead, Liongate expects to grow its assets by offering new funds, in part to appeal to existing investors, who may want a different exposure or concentration of strategy groups. The Select Fund, for example, which is essentially a concentrated version of the Multi-Strategy Fund, was launched in response to client requests for a fund offering higher target returns, but with a higher standard deviation.

"It's efficient to fold sub-sets of the entire strategy universe that we cover with multi-strategy into more specialised fund of hedge fund sector exposures," says Dillard. As part of this growth process, in September 2008, Liongate is launching a commodity fund of hedge funds product. "A lot of investors feel they need commodity exposure but are worried about sharp downside volatility. Our investors want us to diversify, de-correlate, and collar downside volatility, rather than extract beta returns."

Capturing and holding market opportunities

Liongate's investment philosophy starts with top-down analysis to gain an understanding of the effect of macroeconomic changes on hedge fund strategies and to identify market signals that reveal where opportunities or risks have developed. From that starting point, strategies can then be selected that are best positioned to profit from the imminent economic conditions affecting the current market cycles.

Having arrived at a desired strategy exposure, Liongate will re-allocate capital actively to capture the market opportunity. The average monthly portfolio weight change is 3-5%, but if necessary, shifts can be more rapid. Current liquidity provisions with Liongate's managers, for example, allow for over 60% of the portfolio to be changed in three months. The largest shift in the fund's history was in 2004 when the portfolio was changed by 28% in one quarter after the Federal Reserve started to increase interest rates. "That event changed the risk/reward ratio of many strategies, albeit within a predictable market environment, so we shifted the portfolio towards areas which would be clearly rewarded in thenew interest rate environment," says Dillard. "For example, emerging markets were generating increasing risk-adjusted returns in 2004, while convertible bond arbitrage profits were declining simultaneously".

Liongate is proactive as well as reactive in its assessment of emerging macroeconomic trends. "We knew when the Federal Reserve started to raise interest rates in 2004, that eventually credit would be re-priced, as liquidity was drained" explains Dillard. "So we were able to carefully and slowly stage our withdrawal from long credit over 2006, until we had no exposure left."

In the case of its equity long/short exposure, Liongate was aware (because there was a strong bull market in progress in the fourth quarter of 2006), of the danger of withdrawing prematurely. "The art," says Dillard, "was to take advantage of that equity rally in the 4th quarter of 2006, and then reduce the portfolio weight in equity long/ short by February 2007, as interest rate resets of sub-prime mortgage securities were due to spike up. Volatility in credit markets often affects the equity capital markets too, and indeed this happened, so we continued to sharply reduce our portfolio's weighting in equity long/short strategies and positioned the portfolio defensively. When the credit markets tanked in July 2007, our exposure in long/short equity was only 2% of the multi-strategy portfolio which limited losses from the sell-off in the equity markets".

Capital allocation: a disciplined approach

This in-depth analysis of the capital market strategies deployed by Liongate's sub-managers is partly a function of Liongate's culture. "We are not focused on gathering assets, Liongate has an investment led culture," explains Dillard. "If you are willing to persist and travel a lot you can get access to the best investment minds in the world. If you synthesise what they say, it effectively tells you how to construct your portfolio. If you talk to the top 20 managers in a strategy, you may not agree with everything they say, but by the time you have spoken to all 20 you will find a lot of information about where to invest in their sector profitably," continues Dillard. "Portfolio construction is not about getting a momentary market edge, it's about obtaining clarity of information continually and the consistent application of investment simplicity."

Re-allocating capital proactively put Liongate in an enviable position when the credit crisis broke last year. "We did not know exactly when the event would happen, but had known for some time that credit would re-price," says Dillard. "In August 2007, the market realised that there was a looming solvency issue for banks. If you had a long credit strategy bias it was difficult to get out of that exposure, you more or less had to have the exit strategy in place and we had already done that." Funds of funds that had locked in capital with particular managers for six months or longer were also not in a position to shift their portfolios quickly, even if market liquidity had allowed it. "It's like watching the train come down the track and not being able to jump off. You know you need to get off, but you're just unable to."

The results of this timely reallocation can clearly be seen in the fund's performance, with the Multi- Strategy Fund posting gains of 17.7% in 2007, while the Select Fund's returns were 23.3%.

In 2008, there have been no dramatic shifts in Liongate's portfolio thus far, as Dillard believes that a clear direction of markets has yet to emerge from all of the turbulence. "At the moment, you want to preserve the wealth of your clients and earn a return that is higher than cash, while waiting for the markets to recover and capture the gains."

Dillard believes that Liongate is among the most rapid allocators of capital in the funds of fundsindustry, an investment approach that requires discipline in ensuring the correct redemption terms are obtained from portfolio managers. "You need to have a flexible portfolio. Over the last few years, up until last summer, there were so many asset categories that were rising in value, that a lot of people didn't put a premium on liquidity," says Dillard. "When the market lurches in a different direction you need that liquidity, so we preserve it as a discipline." This may mean that there are managers that Liongate would like to work with, but who cannot offer sufficient liquidity in their redemption terms. Dillard suggests, however, that with the explosion in size of the industry, it is not necessarily the case that managers with closed funds and long lock-ups always offer the best riskadjusted returns.

Liongate is not afraid to drop entire strategies from the portfolio. Convertible bond arbitrage, for example, which was a big component of the market in 2004, was removed from the portfolio completely for a time. "If you feel that you need to be the same percentage of any available strategy then you are going to be tracking the index, which is not what our clients want," says Dillard. Managers, too, can be dropped from the portfolio completely. One result of this active approach to capital re-allocation is that portfolio turnover has been between 43-47% in each of the last three years, which is higher than most of its industry peers. This helps reduce Liongate's correlation to fund of hedge fund indices and aids outperformance, but also necessitates a high level of communication with managers.

Managing the single manager relationship

"It is sometimes a criticism of funds of hedge funds that they move in and out of single manager funds unpredictably," says Dillard. "There are a number of single manager funds where we have withdrawn completely and then later moved back in when the strategy has been appropriate. The key to doing this without disrupting the relationship and the manager's business is good communication: tell them early about what you are doing in your portfolios, and most managers will work with you."

"If you take the example of equity long/short, we managed down the exposure over several months in 2007, but the discussions with those managers started in the fourth quarter of 2006. In none of our withdrawals was there any disruption for our managers. They are all top managers and there is no doubt in my mind that we will in the future return to a lot of them."

At least 35 managers are chosen for investment in the Multi-Strategy Fund, with a maximum portfolio weighting to any single manager of 5%. The Select Fund uses a smaller number of managers, at least 20, but has a single manager limit of 7%. There is also a degree of overlap between the two funds, with some managers appearing in both portfolios. At 45, the number of managers currently in the Multi-Strategy Fund is high relative to its historical levels, which reflects current market volatility (see Table 1).

"When markets are this fearful and emotional you can take a view that specific strategies are going to work and concentrate your portfolio with the better managers in those strategies. But the market is experiencing such turbulence that there isn't one strategy or group of strategies that is obviously going to provide stable risk-adjusted returns. So you want to expand the number of managers in these conditions to be less susceptible to the downside volatility."

When choosing managers, Liongate has six criteria: independence, creativity, knowledge, experience, transparency and integrity. The events of the last year have increased the importance of transparency for many investors, but Liongate is already ahead of the curve in analysing risk exposures. "After the peak of equity volatility in 2006, we reviewed the level of information that we were getting from single managers," explains Dillard. "We decided that we simply couldn't be as professional as we wanted to be in constructing a portfolio with the information we were receiving." Since then, Liongate has insisted that its managers fill out an exposure report on a monthly basis. This report does not require a manager to reveal the most market sensitive information, such as specific short positions, but it breaks exposures down into asset category sub-sets. Liongate can then construct a portfolio that spreads risk, and also tilts exposure towards the elements it believes will outperform.

"I really think this is the way that all fund of hedge funds will ultimately work," says Dillard warming to his theme. "The reason is that you can call yourself an event-driven manager, an equity long/short manager or an equity market neutral manager, yet all of these strategies and managers might invest in the same or similar assets. The fact that managers call themselves something different by strategy name doesn't give you enough information to properly de-correlate your portfolio, and protect the down-side"

Last year, for example, while Liongate was withdrawing from equity long/short strategies, its risk management analysis showed an ongoing sensitivity to long credit. "We couldn't figure it out, because we had no long credit strategy exposure," explains Dillard. "From further quantitative analysis we found that there was a correlation between credit and mid-capitalised US companies in equity long/short. So we moved to lower that exposure faster than others. If we hadn't known at the aggregate level how many of our managers were holding mid-cap companies in the US we would have been exposed to a drop in returns when credit sold off."

Reconciling the ability to re-allocate capital swiftly with a rigorous approval process for new managers, which on average takes six months, requires both a healthy pipeline of potential managers and careful planning. Dillard, for example, visits about 250 managers each year personally, and in terms of forward planning he explains, "It's almost like a football game. We have a playbook for what happens in different market scenarios."

Prior to launching the Multi-Strategy Fund, Liongate spent a year constructing systems of alternative market and portfolio plays. "You really have to do your homework beforehand," says Dillard. "Wherever the market moves we know what the economic impact should be on a strategy, whether it is likely to be rewarded or create risk, and within the strategy, who have been the best 20 managers. That doesn't mean that we will know which strategy mix will be best every month, and you cannot invest from looking in the rear-view mirror, but it cuts the lead time in shifting the portfolio weights to stay current with the market."

Opportunities for the here and now

Dillard believes that in the current market environment the best place to invest is in funds of hedge funds. Funds of hedge funds have the advantage over long only mutual fund investment because, as Liongate's experience has shown, a diversified portfolio can be constructed, which is capable of performing in the most turbulent market conditions. "I'm not just saying that because I'm a fund of funds manager," laughs Dillard. "In 2005/06 I had the opposite opinion. There was a raging bull market in equities, which was an ideal long only environment."

But not all hedge funds are equal. The last year has flushed out those funds whose returns could be more accurately described as alternative beta rather than true alpha, and have consequently suffered because of their correlation to market indices. "If you can demonstrate in this market that your returns are positive, that you have preserved your clients' capital and reduced risk in some of the most fearful market conditions I have ever seen, then investors will appreciate your work on their behalf," says Dillard. "Our funds are positioned to make profit for our investors from these extreme market dislocations."

An uncertain market environment, in Dillard's opinion, also favours a rapid capital allocation model. "It was clear that global growth was slowing this year, but it has been less clear which strategies would be rewarded by that shift, and what the time-frame would be. So you need to be a rapid allocator of capital, making small tactical portfolio shifts, which is what we have done in 2008. The market environment doesn't currently allow you to take a long-range view of what portfolio mix will profit most in 2009"

Within this more fluid market environment, Dillard does have some clear views on particular areas that will perform, and conversely, selected areas to avoid. "Global macro can outperform because it's a strategy that trades across different asset classes. Macro is doing well, not necessarily because managers are in the right asset categories all the time, but because they are rapid tactical allocators of capital across different asset classes."

"Equity market neutral last year did not contemplate a contraction in liquidity and deleveraging in the construction of their strategies," continues Dillard. "But having worked that out, the strategy is now probably better positioned in the current environment to make money than traditional equity long/short strategies. We are not moving into equity market neutral yet, but are more likely to do so than move back into higher weightings of equity long/short."

Distressed debt, however, while attracting considerable interest from investors and funds this year is, in Dillard's opinion, still bottoming. "The distressed cycle is coming next year" he says. "We are already seeing a huge dislocation in financial assets, but haven't seen a corresponding dislocation yet in corporate credit. However, the corporate default rate is rising."

Overall though, Dillard is in no doubt that beyond the short-term uncertainty the investment outlook is very promising. "Once people get beyond the fear, the markets will present the best opportunities for some time. If you can preserve capital and keep your powder dry, there will be tremendous opportunities as some assets recover and others go lower.

Randall Dillard is a Partner at Liongate Capital Management LLP, which he co-founded in 2003, and CIO of Liongate Capital Management (Cayman) Limited. Dillard was previously at Nomura International from 1989-2001 as Head of Merchant Banking, as well as Managing Director within investment banking. Prior to Nomura, he worked in investment banking at Merrill Lynch, joining the company from the law firm Clifford Chance. He is a graduate of law from Pembroke College, Cambridge University.