The liquidity crunch post-2008, a tough asset raising climate and low levels of hedge fund performance means that no one can be surprised when two funds of funds merge. The operational and financial logic of consolidation means mergers or outright takeovers are high on the agenda of multi-manager firms big and small.
Man Group’s acquisition of Financial Risk Management for consideration that could rise to a total of $246 million paid over three years is among the most prominent funds of funds mergers so far. The slimming of Man’s multi-manager business post-Madoff is well documented. FRM, for its part, has operated outside the public company spotlight, but founder Blaine Tomlinson has a respected hedge fund investing track record spanning over two decades. Before founding FRM in 1991, Tomlinson set up AIG Financial Products in London and prior to that pioneered the set up of a derivatives trading desk for Nomura.
A full scale integration of the merged multi-manager business followed the closing of the deal on July 17. Yet the efforts involved in putting the transaction together began in October 2011 when Tomlinson approached Luke Ellis, a former senior partner of FRM, to leave his role as head of Man Multi Manager, and return to FRM. In response, Ellis proposed that Man acquire FRM.
“I approached Luke about coming back,” recalls Tomlinson. “The motivation was that at the age of 61 I was looking to succession planning and ensuring the business would be well run when I eventually retire. Luke said he was contractually tied up with Man, but asked whether I would be prepared to sell so we set-up a small working group at FRM to consider it. Most important was whether it would make sense for clients. There was also the matter of the strategic rationale and exploring the synergistic benefits. We agreed to talks with Man but knew we had to focus on these issues.”
As you would expect in a people business like hedge funds, the role of Luke Ellis in Man and FRM combining became pivotal. Ellis interned in 1985 with Tomlinson at Nomura and years later joined FRM where he stayed for a decade, eventually joining Man to head the rebuilding of the Multi Manager business following the credit crunch. Ellis thus knew the teams in both firms and their respective key clients. He had also adopted some of FRM’s systems and processes at Man. Crucially, Ellis provided a solution to the succession planning which had driven Tomlinson’s thinking from the outset.
Another essential factor in making the deal work was to retain the support of Sumitomo Mitsui Trust Bank. SMTB was a minority shareholder in FRM (and retains a similar economic interest). Its clients accounted for $4 billion of FRM’s $8 billion AUM, down from a peak of $13.8 billion at the end of 2007 before the financial crisis. “We presented a strategic plan to them,” Tomlinson says. “Not so much showing what the deal would look like but what the strategic benefits were. A large part of that was what the business would look like in terms of staffing, processes, services, products and who was going to run it.” SMTB were reassured that FRM’s Japanese office would remain intact and that client service would be maintained. “The other thing is we had a strategic relationship with them,” adds Tomlinson, “Key to this was that those terms were maintained and supported in spirit, not just in fact by Man. There were some very senior meetings between SMTB and Man where senior management of Man showed their long term commitment.”
The enlarged Man multi-manager business retains the FRM brand name with Tomlinson becoming non-executive chairman. Critics of the deal, particularly rival funds of funds executives speaking on the condition of anonymity, have questioned the synergy of combining the firms. Tomlinson, understandably, has a different view. He cites Man’s strong global distribution platform, which gives it significant reach with retail and high net worth investors. Complementary to this is FRM’s primary focus on institutional investors, its consequent robust research and investment processes and strong sense of fiduciary responsibility to clients. Man also had invested significantly since 2009 in developing a large scale proprietary managed account platform and position level analytics, areas which Tomlinson says have the potential to be transformative in the way portfolios are managed and direct investor services are offered. In addition FRM brings advanced portfolio construction and fund monitoring systems and was progressing towards offering these directly to large clients.
The combined investment team of Man-FRM numbers over 70 with AUM up to $19 billion. It returns Man to a slot it occupied before the 2008 crash. “If you think of the combined investment resources and infrastructure, including the managed account platform, the position level risk monitoring and the personnel, it is going to be among the best resourced in the industry,” says Tomlinson. “As you go forward, scale is an advantage. In this industry you are either niche, offering something specific or you need increased scale. What we bring together is a very compelling argument for clients.”
The actions of other funds of funds show that they share this view. Earlier this year Union Bancaire Privée bought Nexar Capital. And in May buyout firm Kohlberg Kravis Roberts acquired Prisma Capital Partners. Arki Busson, founder of EIM, recently went on the record about the benefits of his own $8 billion fund of funds possibly linking up with a merger partner. Meanwhile, industry heavy weights Blackrock and Blackstone have built the leading funds of funds franchises by AUM through combining deals with organic growth.
“I think it shows there are powerful pressures toward consolidation,” says Philip Middleton, analyst with Bank of America Merrill Lynch. “Man is obviously trying to position itself as one of the end game players in consolidation. You would expect to see more such deals as they are driven by industry logic.”
Deals may help funds of funds business viability in the short term. But they probably can’t, at least on their own, revitalise a sector that since 2008 has lost around 40% of its assets, which currently stand at around $620 billion, according to Hedge Fund Research. For funds of funds to grow again it will be necessary for them to offer superior service, flexible product lines and improved investment performance. Tomlinson notes several ways FRM has got creative in partnering with clients, saying they can have specific needs in what they want to achieve in their portfolios of hedge funds. Some clients will specify a risk level around which FRM can create an investment solution. Others might specify a return benchmark, such as cash plus or an equity benchmark, and try to maximise risk adjusted returns. While others might use FRM to construct a finishing portfolio where hedge funds perform a specific function within a long only portfolio. Tomlinson sees partnering with clients in constructing investment solutions as an important way forward.
“The biggest difference among clients wanting customised portfolios is how they think about risk,” says Tomlinson. “The logic of the transaction is that the best resources for investing in hedge funds reside in funds of funds. That resource can be used to the benefit of individual clients in building customised portfolios. Some investors are capable of direct investing in hedge funds and for those we offer direct access and infrastructure services. But many investors want us to assume fiduciary responsibility for the performance of the portfolio. Not all consultants do that.”
It is broadly true that funds of funds have the broadest experience in hedge fund investing. But the value of that knowledge got undermined by what happened post-Lehman. Clearly, Tomlinson is right to emphasise that different institutional investors require different services. However, just as funds of funds are becoming more flexible, so too are consultants, some of whom, like Mercer, are moving into fiduciary roles.
In recent years it is no exaggeration to say that performance has been tough to come by, particularly for funds of funds. What’s more, risk aversion has supplanted desire for outsized returns with the majority of investors. Little change is expected in the near future. “Since 2008, it has been extraordinarily difficult to make money unless you were prepared to take specific bets,” Tomlinson says. “With clients, concern about risk is the top priority. A lot of clients have return expectations that are subsidiary to their risk expectations. Traditionally clients would want 4-6% over Libor but in this environment they want a diversified portfolio that won’t be subject to systemic risk. Diversification is thus maintained at the expense of taking less risk. Clients are taking less risk, managers are taking less risk and funds of funds are responding to that. Risk defined in terms of losing money is something clients are sensitive to. They prefer a lower return target and to minimise the risk they are exposed to.”
Tomlinson, who is an active hedge fund investor privately, thinks the key for hedge funds to be more successful in getting investor allocations is to focus on preserving capital. The exposure of the high risk embedded in equities markets in 2008 and subsequent periodic ‘risk off’ plunges can be a key selling point for the volatility control that the best hedge funds are able to offer investors. “This ‘risk on, risk off’ world could be around for quite a while,” Tomlinson says. “Something has to be done with the level of debt in the world and it is not easy to grow out of it. There are opportunities out there and we try to take advantage. But it is a tough market. Low bond yields and range bound equity markets are products of quantitative easing. The downside is minimised by QE; the upside is minimised by systemic risk.”
Adapting for survival
If it is a truism that businesses continually need to adapt to survive, it is likely doubly so for funds of funds. Profitability has been hit hard by drawdowns enduring and many funds of funds remain below their high water marks. In FRM’s case, Goldman Sachs estimated in May that FRM’s assets were about 10% below their high water mark, crimping performance fee income for now. This underlines the importance of increasing economies of scale to boost profitability by joining with Man’s multi-manager business.
“We believe that the acquisition has strategic merit for Man Group,” said Chris Turner an analyst with Goldman Sachs in a note following the deal. “Execution risk appears low and this deal would increase (multi-manager assets in Man) by 73%, adding size in a part of the industry where scale is increasingly a competitive advantage.” Scale can give advantage, but needs to be married with adaptability. This applies to performance and management fees, but also extends well beyond them.
“As long as funds of funds are adaptable to client needs there is an important role for them,”Tomlinson says. “It is important for us to be adaptable to client needs. The sensitivities for different clients are quite different. Some are service oriented, some are information oriented and others are focused most on risk. The key is adding value for fees, but that has a different meaning for each client. This is why adaptability is so important. It is why, for example, having access to a managed account platform gives you access to a range of valuable information that puts you in a different competitive place from someone without one.”
Muted debate on fees
If debate about funds of funds fees is muted it may be because the institutions have largely prevailed. Anecdotal evidence suggests that management fees are generally below 100 basis points for the institutional mandates that are driving change in the industry. For a fund of funds, scale gives an ability to write a bigger ticket and bring more influence to bear on reducing fees charged by a single manager. Scale also gives a fund of funds more clout in negotiating terms on governance, amending investment documents and doing more comprehensive due diligence to assess the business risk a single manager may face.
Like any hedge fund manager, Tomlinson wants to emphasize quality and service rather than fee levels. And it is obvious that for many investors, from HNW to family offices and small pension funds, a high quality fund of funds is a valuable ally to find, vet and structure an allocation to the return profile that hedge funds can deliver.
“I don’t think there is a generic view or set of priorities on fees,” says Tomlinson. “For many clients, the quality of service they get on the portfolio and the information is more important. This is not to say that fees aren’t important, but a part of the fees we are charging are recovered through reductions from the managers.” Asked how he will define when the merger is succeeding, Tomlinson pauses. “Delivering better client solutions and service is important,” he says. “Also improving the quality of the investment process. And I would say this merger is definitely doing that. The goal of all of this is to improve investment performance and how that performance is delivered to clients.”