Brevan Howard Asset Management occupies the summit of the European hedge fund industry by assets under management and is now among the top handful of managers globally. From day-one assets of $870 million on April 1st 2003, the firm founded by co-CEO and chief investment officer Alan Howard and five others has grown to manage around $24 billion today. Starting with about 50 employees it now employs around 310 in seven offices on three continents. Rising assets under management and a remarkably steady investment performance have seen operating profits of Brevan Howard balloon from £11 million in 2004 to £113 million for the year to June 2008 after operating allocations to corporate members.
Notwithstanding that unparalleled record of expansion and profitability, Brevan Howard today is very much focused on risk managing the existing business. Overseas offices have been shuttered, while forays into other portfolio strategies were either reversed or abandoned on the launch pad. Instead, renewed emphasis is being put on the firm’s core trading strategies and tightening the focus on limiting liabilities and conserving capital. To get a broader appreciation of Brevan Howard’s operations, trading culture and management The Hedge Fund Journal visited its voluminous Baker Street headquarters for an interview with founding partner and Co-CEO Nagi Kawkabani.
“Our intended scope of activities is much narrower than it was 12 months ago,” Kawkabani says. “We just want to concentrate on what we are doing. We have no plans to go into any new areas. We are just focussed on trading liquid capital markets – that is all we are interested in. The one area we would like to grow a little more aggressively is equities trading. Equities trading is a small part of our effort now, but falls within our core competence in terms of understanding liquid capital market risk. It adds capacity and enhances the return profile of our master fund. So we will be looking to potentially expand our equity activity, but without ever compromising our focus on rates, government bonds and FX.”
The narrower focus has meant cuts at Brevan Howard have been applied across the board from traders to support staff and include the closing of offices in Mumbai and Tokyo. A year ago the firm employed 400. But despite the smaller staff numbers Kawkabani says that the number of senior risk taking investment professionals hasn’t changed. What’s more, investment capacity is judged to have increased since the retained personnel now have a couple of more years of valuable portfolio management experience.
“They are better traders than they were, and we can allocate them more capital,” says Kawkabani. “We may have fewer traders in number than we had a year ago, but the number of effective risk-takers at the firm has not changed over the last year. Effective risk takers are those that are actually making money. We think our capacity to manage assets has in fact increased because people who ran, say, x amount can now run two or three times x because they have been making money.”
One area from which the firm withdrew is convertible arbitrage, a move it made well ahead of the worst period of the credit crisis. The strategy was judged too niche and didn’t fit in with the firm’s core focus on liquid capital markets. Even though convertible arbitrage funds are now performing well, their capacity constraints and gap risk remain problematic. Several funds that were in the planningpipeline last year were mothballed. The emphasis on consolidation also meant a planned India fund was shelved.
Credit spun out
Changes have also occurred in the US operation. In one move, the credit team was spun out to rationalise the business management structure. “In New York there is a separate asset management firm which only trades credit, and they do that exclusively for us,” says Kawkabani. “They run their own business in New York, so we don’t have to run a remote office. They are set up to address their own regulatory regimes and remuneration schemes.” Trading of the FX UCITS Fund, however, is to remain within the firm and the fund began accepting external capital in the middle of July. London remains the trading hub for areas other than credit, but trading desks in Hong Kong run by partner Kaspar Ernst focus on Asia while there is also a trading desk and research arm in Tel Aviv. In another move, the development of a quantitative strategies product was shelved. Kawkabani says: “We tried building our own systematic strategies, but we discontinued them. As a firm we are very qualitative driven, we are discretionary managers, not systematic managers.”
Stripping back the firm’s non-core activities magnifies the operational focus on the Brevan Howard Master Fund, the firm’s global macro flagship and the world’s biggest macro fund with assets under management (AUM) of close to $20 billion. Like a few other fund managers who managed to generate returns in 2008 – the BHMF was up 20.43% and is up about 13.8% to end-July 2009 – the fund still lost assets to investor redemptions. Handling those redemptions was facilitated by Alan Howard’s prescient move to put a majority of the fund’s assets into cash before the extent of the credit crisis emerged. However, the combination of strong performance and rising net inflows into the fund since May mean that it is likely to close again (it was closed from 2006 until early 2008), probably in 2010.
“The target AUM may be $25 billion, but we will close the fund well before that level,” says Kawkabani. “We’d like to be at $25 billion within a year and so once we have seen redemptions stop we may close the fund well before $25 billion to allow for organic growth. For now the Master Fund is open by appointment. The aim is just to replace the net capital we have lost through redemptions, not to grow the fund. We are playing a defensive game.”
The same capacity limits apply to the listed BH Macro and BH Global funds. The former is a feeder for the global macro Master Fund and the latter allocates to all five Brevan Howard funds. “No further placements are planned to increase the amount of capital in them,” Kawkabani says. “They are semi-permanent capital and a valuable part of our capital base. They give us greater visibility in the market, for good or ill.”
The Master Fund’s strong performance shows how the current market conditions are suited to relative value and macro strategies. “There are massive opportunities across both strategies,” Kawkabani says. “The dislocations allow you to have nice juicy spreads to do relative value. The uncertainty that we currently have gives you great opportunities to trade. The opportunity set for what we do is very rich across both. For us anyway, the distinctions between the two can be blurred.”
UCITS III expansion
One product area where the firm is expanding is UCITS III. Such funds are onshore and have a broader range of portfolio management tools than a traditional long-only fund. Last year, Brevan Howard recruited the six man interest rates team from Aberdeen Asset Management where it had responsibility for rates and curve positions globally including the more constrained core and core plus sterling bond mandates. Headed by Philippe Lespinard, the UCITS team in February launched the Brevan Howard Absolute Return Bond Plus Fund, which is being marketed to institutions with an aim of delivering annual returns ofcash plus 4%.
“We generate quite a bit of alpha just from the basic directional views we have on markets,” says Kawkabani, discussing the rationale of the new fund. “We know that those views can be expressed in a simpler linear form than we typically use in the Master Fund. The Master Fund is quite a heavy user of derivatives, and so there are capacity issues because our ability to trade actively in derivatives is constrained. We have this alpha in simpler directional trading that you can implement using straight swaps. It means investors don’t get the leverage and complexity you get in the Master Fund, and you won’t see the same Sharpe ratio. But the absolute return, the residual alpha, is still attractive. So we can offer a toned-down version of the return profile of the Master Fund in the UCITS III format for those who may not invest in offshore funds.”
One reason for hiring the Aberdeen team was their best in class reputation. Another reason was that the existing hedge fund team wasn’t used to running a fund format constrained by UCITS regulations on, for example, leverage.
“We didn’t want to distract them from their main task of trading the Master Fund,” Kawkabani says. “Running two different sorts of mandates waters down effectiveness. Portfolio managers just want to trade. They don’t want to be distracted by juggling two mandates and booking trades differently. So we decided to bring in an experienced team that could leverage off the core Brevan Howard skill-set of trading rates, bonds, and FX. We put them on our platform and under our risk management disciplines. They share our low tolerance of loss, and our focus on trade and portfolio structuring. We believe that making money in the long term is a function of these disciplines. We are not going to bring someone in and ask them to trade differently here than they did before. That is not the way human beings behave. We had to make sure that the way they trade fits within our comfort zone. They have been trading paper and indeed real portfolios for more than a year now, and we have had no surprises. They think the way we think anyway.”
The rationale for the UCITS expansion is that there is an alpha or return stream that is outside of or spare to the Master Fund. Kawkabani likens it to a refinery flaring off gas in processing crude oil or in this case the UCITS fund returns being flared from the Master Fund’s performance. “It is a simple linear expression of our views. We can generate quite a bit of excess return (and) we can offer that in the UCITS form for a different investor base.” he says.
To understand the qualities that Brevan Howard brings to risk management, a few remarks from hedge fund manager Lee Robinson of Trafalgar Asset Managers may be illuminating. In a late 2007 speech he argued that fund managers overused the word unprecedented, and that market crises happen with a greater frequency than is generally perceived. “We are prepared for the worst,” he said, while summing up the various scenarios – mark-to-market difficulties, drawdowns, shifts in volatility and redemptions – that might unfold en route to the planned exit points from a trade. He added that the aim wasn’t just to avoid losing money, but to avoid the forced liquidation of positions. Robinson wasn’t referring to his firm’s event driven strategies, but was generalising for all hedge fund managers and strategies.
Robinson’s key point is that great managers are prepared. They know what the impact of adverse changes will be on their portfolio. An old style macro manager could achieve these mental rehearsals fairly readily through discussion, which is what Jim Rogers and George Soros did. But that old approach is much more readily done with a few risk takers and a few large concentrated bets. Modern risk measurement departments in hedge funds conceptually carry out the same processes as Soros across many traders and strategies using standardised software that is almost always augmented by in-house systems. So it is at Brevan Howard, where the risk oversight team of 17 people under Aron Landy, the chief risk officer, prepare historic simulations and hypothetical stress tests for individual traders and at the aggregated fund level.
The simulations test current portfolios against the impact of extreme shifts that have moved markets. So, for example, the Master Fund and each trader’s book will be re-priced as if the LTCM crisis of 1998 was going to happen tomorrow. The changes in volatility, market price, credit spread, yield curve and correlation that occurred then will be imposed on current positions to see what the impact would be on the P&L. Similarly, the one and five day price changes imputed for a period like the Russian default in 1998 are calculated, with the same being done for the surprise Fed policy change in February 1994, the ERM sterling crisis and the 1987 market crash, among others.
Hypothetical stress tests run simulations of market conditions that haven’t occurred and might indeed be considered quite unlikely, but which are judged as remotely possible. Currently the kind of simulated stress tests carried out might focus on the expulsion of a country from the European Currency Union, or what would happen if Hungary re-negotiated EU membership, or China re-valued its currency or the effect of an inflation shock.
In the fixed income asset class particularly, but in other asset classes too, Brevan Howard trades are often constructed using options. The optionality gives a good upside/downside ratio per strategy, and usually gives a known downside risk (typically the loss of net option premium expended). Options are also used as hedges of directional trades – a well-out-of-the-money option position would be a typical hedge of a linear trade, or on one leg of a spread/relative value trade. This is consistent with a key Brevan Howard investment principal, which is to hedge whenever it is possible, not just when it is needed. Such hedging is a function of the availability of suitable instruments and their liquidity in terms of trading volume.
“Sometimes it is not possible to buy a hedge,” says Kawkabani. “Sometimes you just have to take a view and that’s your view. But if it is possible to buy an out-of-the-money option to hedge the tail then that is what you should do,” he says. “Sometimes there is no appropriate hedge or the cost is prohibitive. So you just size differently. There’s no secret formula so to speak.”
The use of options goes beyond being a useful tool at Brevan Howard. The firm’s investment culture expresses a strong preference for trading strategies with a defined time horizon and with pre-determined loss tolerances, with which option strategies comply. Further, part of the collective belief system is that risk and return are defined largely by a trader’s skill in constructing trades (and by extension whole portfolios) as cheap options rather than outcomes being a function of a mythical ability to forecast markets. In effect, this means that probabilistically Brevan Howard is capable of delivering the desired return stream of a macro manager – it is by design not default or happy accident.
The extensive use of options raises the bar in terms of risk measurement practice. It can be a challenge to comprehend the risk profile assumed at the level of the individual trader where options are used. Brevan Howard does stress testing of 50 traders and of entire funds to assess shifts in volatility and across over 150 other factors (up from 90 a year ago). Stress tests are also conducted at the level of the asset class (FX, equity, interest rates and commodities) overseen by different Brevan Howard partners. New stress tests are conceived as the risk managers become more creative in dreaming up scenarios.
Stress tests are intended to tell traders, their line managers (typically the designated portfolio manager of the fund), senior management and the risk department professionals what tail risk the portfolios are running. The risk hot spots exposed by stress testing and by actual P&L changes have to be turned from risk information into a risk management tool. This is monitored and implemented in several different ways.
Traders at Brevan Howard have written mandates, just like prop traders at investment banks have capital budgets and risk limits. The mandates are defined by strategy, capital allocation, risk limits and stop-loss limits. The independent risk team monitors the adherence to mandates. The firm states that increased risk weightings are given to traders with positive performance and decreased to traders with negative performance. Thus risk is clearly defined as loss of capital, not volatility of returns. The dialogue between the risk management team and an individual trader occurs on an ad hoc basis. “When discussions occur between the risk team and an individual trader is determined on a case by case basis,” Kawkabani says. “Traders just do their own thing. As long as they stay within their limits that’s fine. If whatever they are doing starts to cause concern, there is a dialogue with the risk team. There isn’t a pre-defined process of when the interaction between the risk team and traders takes place per se.”
Stable senior team
As co-CEO, Kawkabani has a very close relationship with Howard and he is straightforward about the dynamics of the relationship. “Alan is clearly the senior partner and the driving force behind the firm,” Kawkabani says. “My role is to support Alan. That’s the way it breaks down. His primary function is to manage the portfolio and to manage the market risks of the firm and to ensure performance. To the extent there are other issues to deal with in running Brevan Howard then I help him to do that.” Since chief operating officer James Vernon runs the firm day-to-day and oversees the back office, Kawkabani says his focus is on the front office. “It’s more to do with the direction of the firm and the risks the firm runs,” he says.
The capital allocation committee on which Howard, Kawkabani and others sit meets quarterly. Capital allocation tends to only change at the margin. More than 70% of the Master Fund’s risk capital is allocated to the trading books of 10 senior trading partners. Other traders have far smaller risk allocations to trade the remainder of the capital. “We don’t change allocations for the sake of it,” Kawkabani says. “Allocations tend to be fairly stable. If people are doing well there is no need to fluff around. We don’t try to micro-manage.” In recent months, the Master Fund’s risk assumption has been fairly consistent. “There haven’t been massive swings in risk appetite,” he says.
Oversight meetings fall in a number of time frames but more frequently than the quarterly capital allocation deliberations. There is a weekly formal partners meeting. The risk oversight committee, which looks at the market-related consolidated risk across the funds, also meets weekly. The liquidity oversight committee, which reviews the liquidity of funds, their position in the market and counterparty analysis, meets monthly. Quantitative risk monitoring at trader and Master Fund level occurs daily, while the risk team operates automated liquidity monitoring for each instrument and for the portfolios as a whole. The risk management processes also involve the qualitative interpretation of risks at both the trader and Master Fund levels. This involves a daily qualitative analysis of key risks, and there is also the weekly formal risk review process, which includes an assessment of what is termed ‘blow-up’ risk.
The formal weekly review looks for gross shifts in the risk regime of markets. This is something for which the firm, and particularly Alan Howard, has a well-attuned feel. Management’s twitchiness over markets started with the blow-ups of the Bear Stearns mortgage backed securities funds in 2007. Alan Howard together with the Risk Oversight Committee took that as a signal to reduce counterparty risk and secure liquidity. On several occasions, both before and since, Howard prepared the firm’s funds for market dislocations by raising cash, cutting leverage and reducing harder to trade exposures. It certainly paid off in 2008. But at times the reduction in risk appetite has cost potential returns, though management are likely to feel vindicated that it is a price worth paying. The most recent Annual Investment Manager Review for the Master Fund noted the firm’s tactics at such points: “We limit the rights of prime brokers to rehypothecate our securities. We move our cash balances away from our prime brokers to segregated custody accounts at third parties.” Not surprisingly, Brevan Howard used a multiple prime broker model from a relatively early stage of its development and ahead of most other hedge funds.
A second aspect of hedge fund manager Robinson’s speech focused on portfolio management and underscores another characteristic of how Brevan Howard invests. Robinson observed that it was easy to have investment ideas, but difficult to mesh together those ideas into a coherent portfolio, and even harder to make that portfolio robust to varying market conditions. He cautioned investors to look closely at funds that exhibit high weekly and monthly correlations, and to beware of funds that had high risk concentrations. Robinson said all portfolios are essentially short liquidity and at risk to mark-to-market movements, but added that all great portfolio managers have tools to combat these problems. He concluded that: “The best managers are not the ones with defined upside and a wide range of possible downside outcomes. They are the ones with defined downside and a wide range of upside.”
At Brevan Howard, the traders often define the downside characteristics of their trades using options. The Master Fund was structurally long short-dated rates in 2008. Portfolios are stress tested to find out if they are robust in varied market conditions and are diversified rather than concentrated. The acid test of the process is outcomes and here the record of the Master Fund is impressive since its returns are not correlated to markets. What’s more, by making money last year Brevan Howard put itself in a minority of hedge funds. That it made good money for investors last year and continues to do so this year puts it in an exclusive club. Using Lee Robinson’s criteria, Brevan Howard is both a great hedge fund manager and a great portfolio manager.
In recent months, the regulatory profile of the hedge fund industry has risen. The European Commission’s ill-judged Alternative Investment Fund Managers Directive caught the UK government napping. Ironically, it was Gordon Brown, then Chancellor of the Exchequer, who established the Financial Services Authority. And it is the FSA that has had critical success in registering and supervising hedge funds, but doing so in a fashion that has let a vibrant industry develop and grow.
Hedge fund managers generally are guarded in discussing regulation. Kawkabani is no different, observing that whatever Brevan Howard does will of course depend on what legislation eventually emerges. Like other managers, he believes the FSA regime has worked.
“We think the FSA does a terrific job regulating hedge funds, as shown by the fact that hedge funds didn’t contribute at all as far as anyone can figure out to the financial crisis,” Kawkabani says. “So clearly the FSA is doing a decent job. There has been no UK based fraud as far as I’m aware of any meaningful size. I would say that the UK industry is regulated very well – it has gone through the worst period any one has ever seen for markets and there have been no issues. We will wait to see what the EU directive brings but as long as it’sreasonable regulation then it’s business as usual for us. But we will have to wait and see what the final form is.”
Like other hedge fund firms, Brevan Howard is concerned about the Directive’s approach to regulating leverage. Indeed, the Directive is imprecise on how this might apply to hedge funds where the use of leverage is obviously different than in private equity.
“Yes of course that’s a very big concern,” Kawkabani says discussing the leverage issue. “Because if you naively define leverage as notional exposure and then you try to limit it, you are by definition making it impossible for certain funds to manage their business. It would be like telling a bank you can’t lend money. You take away risk but the bank goes out of business; it just can’t operate. For certain strategies it is similar. You simply cannot define leverage in notional terms and expect a fund like ours to operate. We trade in three-month money, options and FX. How do you define leverage in those instruments? If you define our leverage as the notional exposure of our options positions it is impossible to trade.”
Brevan Howard is taking a constructive approach to the Directive. Kawkabani expresses optimism that the final framework will be improved and that there is no intent in Brussels to shackle the hedge fund industry. “We are not worried about regulation per se,” Kawkabani says. “We have been regulated since the start and we have no problem with it. We are just worried about naïve regulation that has unintended consequences. The unintended consequence is that it is just impossible for us to do our business. We’re hopeful that that is not going to happen and that after consultation the regulation will be quite sensible. We just have to make sure that everyone involved in the industry understands that it is important to get involved in forming the regulation. I really don’t think there is any intent to damage (hedge funds), it is just that they need industry input to make sure the Directive is drafted correctly.”
As Europe’s biggest hedge fund operator the firm is realistic about its responsibilities. These are now seen to go beyond its legion of investors. It was a founding member of the Hedge Fund Standards Board. The partners recognise that its sheer size will attract attention and it has embraced a comprehensive disclosure regime attendant with the requirements of its two stock exchange listed hedge funds.
“We obviously believe we have responsibility,” says Kawkabani. “Alan is the only European manager that the New York Fed has invited to be on its expert panel to advise them about the asset management business. We understand our responsibility as one of the larger players in the European field. But we prefer direct contact with stakeholders. Any investor has full access to us, any regulator has full access to us and any counterparty has full access to us.”
The Swiss Re stake
Swiss Re, one of world’s leading and most diversified reinsurers, bought a 15% stake in Brevan Howard Asset Management in 2007 when the firm was the fifth largest hedge fund manager in Europe with AUM of $15 billion. Swiss Re was seeking to expand its hedge fund exposure and looked at the top performing hedge fund management companies in several strategies. Obviously there had to be a strong financial basis in terms of return on capital for the investment as well as the right return profile for allocating to the underlying funds. On both counts, Brevan Howard appealed to the Swiss insurer.
Typically, a deal of this nature has to work on a couple of other levels, too. The potential acquirer has to be comfortable dealing with the principals of the target company, and Swiss Re liked what their experience in this regard told them about the partners of Brevan Howard. The Swiss viewed Alan Howard as a man with his finger on the pulse of the bond market and they liked his general approach to risk management. A related benefit is that Swiss Re hears what Brevan Howard is seeing in markets and gets insight into its thought processes. Swiss Re also liked the fact that the macro shop is not a one-man show and that Brevan Howard is a team operation. In particular, the men from Zurich saw an operational quality that reflected their own way of doing things.
From Swiss Re’s perspective, it is clear why a deal with Brevan Howard was attractive at the time. It is even easier to see with the benefit of hindsight as the asset growth of the Baker Street behemoth has outstripped the industry and the asset management company’s profitability has grown. But why did Brevan Howard cut a deal? October of 2007 is not even two years ago, yet in the world of finance it is a different era.
“At the time,” Kawkabani recalls, “when we sold a stake in the business to Swiss Re there were deals being done with hedge fund groups by Merrill Lynch, Morgan Stanley and Goldman, among others, and people were selling out to Lehman Brothers. We thought it would put us in a position to attract talent, that it would be a competitive advantage to us in doing it. Doing this deal would enable us to use a bit of equity to buy out a trader’s equity in their current employer’s business – so we could give equity for equity.” There were also other motivations. “It was a form of crystallising some value,” he says. “It was also a pretty good retention tool. Our traders don’t get all their bonus money up front – there is a vesting period. So it was another incentive for people to stick around. At that time there was a lot of pressure on retaining talent. By selling a small part to a sophisticated investor like Swiss Re we could show our investment talent that if we grant you a capital stake in the partnership it is worth something.”
Both parties are pleased with the outcome. “We’re delighted with our relationship with Swiss Re,” says Kawkabani. “It has worked out well for us. They are a great partner for everything we want to do, and we’ve been pleased with the transaction.” The Swiss reinsurer has retained its capital commitments to the Brevan Howard funds, signalling their approval.
In the meantime the stake has to be valued on the balance sheet of Swiss Re, which is a minor challenge as the yo-yoing share prices of quoted asset management groups testify. The insurer assesses the valuation frequently using standard valuation methods such as multiple of earnings and multiple of cash flow. Each month peer group comparisons are made on these metrics with premium quality quoted asset management groups. Overall multiples have come down since Swiss Re took its stake, but they have started expanding again in recent months. The prevailing market multiples are then applied to the Brevan Howard business taking account of the recent capital flows out of the business (last year) and into the business (in the last few months). On this basis the value of Brevan Howard to Swiss Re has been appreciating during 2009.
The trajectory of that growth in value could continue to run for many years. None of the founding partners are looking to retire anytime soon – they are mainly in their mid-forties. Asked if Brevan Howard can continue without the founding partners, Kawkabani says: “I certainly believe it can, but that’s many years off. It’s not something we need to consider now.” He adds: “I think the business model is going to remain exactly as it is within our planning horizon.”
For a firm to survive beyond the founding partners is a largely untested proposition in the hedge fund industry. Private equity firms have perhaps had more experience with the issue but there the results have been mixed. Going the public company route is one possibility but Kawkabani rules that out anytime soon. There is also the matter of what gives a partners-based business the ingredients to endure the partners’ eventual departure.
“What gives Goldman Sachs longevity beyond its founding partners?” asks Kawkabani. “Hopefully you create enough critical mass of talent that it becomes self sustaining. I believe we have done this so far. But hopefully we won’t have to put it to a test for many years to come.”