“Not an easy thing to do at all.”

Stuart Fieldhouse talks to Nick Browne, Director of Dexion Capital, about his firm's revolutionary approach to fund of funds investment

Stuart Fieldhouse
Originally published in the February/March 2006 issue

Stuart Fieldhouse talks to Nick Browne about the rise and rise of Dexion Capital

Dexion Capital was formed in the summer of 2000 by Robin Bowie following a career in the UK fixed income markets, with stints at Barclays, Goldman Sachs, and HSBC, amongst others. His aim when he founded Dexion was to introduce hedge funds to institutional investors, although he quickly discovered at that time that large scale hedge funds were most interested in fund of fund structures. Thus, he shifted the focus of the business to one of researching the hedge fund industry on the part of institutional clients. It was a decision that would take the firm into very profitable waters.

“We started gathering a database of the better fund of fund providers, both qualitative and quantitative information,” explains Nick Browne, who joined Dexion in January 2001 as a director, and has played a key role in its product development strategy. “It was apparent early on that institutions didn’t know the fund of hedge funds space at all in those times. They might have had one or two come round to present to them, but the fund of hedge fund community didn’t really market itself.”

Neither buyers nor the funds of funds themselves had a clear idea of who their competitors were, or how they measured up against them. This situation formed the platform for Dexion’s advisory business, which constructs bespoke fund of funds portfolios for institutional investors, and has garnered clients from the UK, Europe, the Middle East, and Asia. “Institutions will approach us because they do not have the skills to choose a fund of hedge fund for themselves,” says Browne. “It is a question of matching investors with the best fund of funds.”

Through discussions with UK institutions in 2002, Dexion discovered that the tax and regulatory problems surrounding hedge funds were impeding big investors from “dipping their toe in the water” so to speak. For example, the offshore non-distributor status of the funds and the fact that they were not regulated by the FSA affected many institutional clients which might otherwise have been enthusiastic: e.g. insurance companies were not allowed to hold funds of funds as investable assets on their balance sheets.

These challenges led to the creation of a closed-ended investment company by Dexion that would be listed on the London Stock Exchange, with shares traded on a daily basis. “That would both satisfy the capital gains tax requirements of UK resident individuals and also be an asset that institutions could have on their balance sheet with much more favourable regulatory treatment,” explains Browne.

The closed-ended funds business began with Dexion Absolute in December 2002, in the teeth of a bear market, and has gone on to form the backbone of Dexion’s business. “Wereinvented the product really – there were a few of these vehicles around, performance was poor, mainly because they hadn’t hedged the currency exposure, and they were largely unloved by the investing community, and were trading at significant discounts. The closed ended sector at the end of 2002 was in a bad way.”

Best of breed

Dexion selected a best of breed manager by conducting a beauty parade with a core of institutional clients using a short list of four firms with different risk/return profiles, and presenting a large amount of quantitative and qualitative due diligence in the process. From this, it narrowed the field down to US-based Harris Alternatives, partly thanks to the Chicago firm’s long track record and the consistency of its management. “Harris is a group that never thought about forming a closed-ended investment company,” says Browne. “They had no need to go out and chase assets – they were turning assets away. The offer then was a locked up pool of capital they could manage on a discretionary basis, and mirror their existing funds.”

Part of the appeal for the US manager was the quarterly redemptions, and the fact the capital was locked up for the duration of the company. Dexion Absolute now has £530m in assets under management, making it by far the largest exchange-listed fund of hedge funds globally, and on the verge of entering the FTSE 250 company. It has been a great success.

Off the back of Dexion Absolute, the firm has been able to roll out two more closed-ended products. Dexion Equity Alternative was launched in March 2004 (a ‘C’-class was issued last year) and now has £140m in assets. Its focus is more on equity long/short managers, which comprise about 65% of the portfolio, and the investment advisor is K2. In November 2004 the firm added Dexion Trading to its range, which provides exposure to directional trading, with FRM as the investment adviser. With just over a year under its belt, ‘Trading’ has garnered £85m.

The liquidity issue has been one of the key attractions for the funds: the average daily volume in Dexion Absolute is over 600,000 shares, making it an extremely liquid stock in comparison to the sector. “There are no liquidity issues for any small or medium-sized investor trading in it,” says Browne.

Dexion Absolute is seeing larger ticket investors like pension funds and insurance companies investing because of the fact that it offers funds of hedge funds exposure via a large-ticket (e.g. £5 million) trade on the London Stock Exchange. Earlier investments were of a much smaller scale. Browne reckons that decent liquidity can be achieved once a listed vehicle of this kind tops £85m, although the firm’s target for its funds is £200m and up. Dexion has successfully gone back to the market with conversion share issues on five occasions to raise additional money. Subject to demand and market conditions, it hopes to continue to do this, as the funds directly benefit from the critical mass: wider investor appetite and significantly higher turnover can be achieved this way.

“We try to be as transparent as we can,” says Browne. “We issue a weekly net asset value; we also publish a monthly newsletter which gives a description of what’s going on, and performance by strategy. We also hold a large number of investor meetings across the course of the year.”

Trading at a premium

Another surprise has been that Dexion Absolute has been trading at a premium to NAV almost since launch, currently 4%, but at times between 6-8%. “The level of premium can sometimes be a problem,” Browne admits. “Sometimes it can get too big.”

Dexion spent a lot of time in 2002, when it was designing Dexion Absolute, considering the problems that can arise if an investment trust trades at a discount to NAV. Luckily, thanks to demand for the stock from many of the bigger regular investors in funds of hedge funds, like UK private banks, it has never been presented with that scenario. There is simply too much enthusiasm from the institutional investment community in London for hedge funds as an asset class, couched in a listed vehicle. It is hard not to see it as a marriage made in heaven.

Since Dexion Absolute has launched, the expansion of the London-listed fund of hedge funds sector has been radical, and it now exceeds £2.5bn in size, of which Dexion alone covers 48%. In June last year it broadened its potential market base for Dexion Absolute by issuing dollar and euro share classes, which are now available for sale in 12 different jurisdictions in Europe and Asia. It was a big step for the firm, which previously had capitalised on tax concerns regarding funds of hedge funds. Appetite for the concept is certainly picking up abroad, although Browne admits that its appeal is not mirrored in every jurisdiction. Still, in December 2005 Dexion Absolute went out with a second capital raise, and now has over €100m and $90m in the respective share classes.

Liquidity has been one of the major selling points of the Dexion range, but it could also emerge as a major future challenge for the fund of funds industry generally: the trend of single managers migrating into illiquid underlying investments, like areas of specialist credit, and the tighter terms they place on their investors, are having an impact on funds of funds. The introduction of restrictions on redemptions, of one, two, or even three year lock-ins, has creased brows at some firms. “Fund of fund managers cannot give their investors monthly liquidity and invest in funds with lock-ups,” Browne argues.

However, the success of the closed-ended formula at present remains its liquidity profile: construction of the underlying portfolios by the funds’ advisors is currently not limited by liquidity issues: “The advisor has unfettered ability to pick the best managers,” Browne says.

Dexion’s success cannot simply be attributed to a ‘fire and forget’ mentality that capitalises on enthusiasm for hedge funds coupled with a highly liquid, well-regulated structure. It requires hard work to be able to raise new capital in £40m increments, as the firm has been doing. It still invests heavily in marketing to new investors, and remains highly proactive in dealing with its existing clients. It employs market makers with an interest in the sector, like ABN Amro as well as an internal sales team, some based in the new markets it is targeting, but it also makes sure existing clients are kept up to date on what the fund advisors are up to. Better communication translates into more assets when a new share is issued, as existing investors can provide much of the new subscription capital as well. This has enabled Dexion to confidently issue more shares in April, June, and December 2005, and to be planning three more issues this year.

Knowledge base

“We have built our knowledge base over the last four years, and we have distilled out of that groups we think are the best providers in different strategies, what we would consider the top fund of funds operations,” says Browne. “All have over a billion in assets under management – we don’t believe in recommending small funds of funds, there is a minimum amount of infrastructure required, we need to see a multi-billion asset base.”

At the end of last year, Dexion went looking for another advisor for a new product, one that could find alpha in the hedge funds universe for its planned Dexion Alpha Strategies launch. The underlying portfolio would combine a diverse range of strategies, either those that are not currently fully-developed, or require a skill-based approach that can extract rich amounts of alpha. It chose RMF as its partner.

The new fund will follow the tried-and-tested formula of a closed-ended listing with ABN Amro acting as its market-maker. “There is six billion already invested in these types of strategies,” Browne explains. “It is not going to be a static portfolio, it is going to be dynamic.”

Cap intro

The third leg of Dexion’s business has been capital raising for individual hedge fund managers, an activity that can nestle comfortably with its other areas of specialisation without raising any conflict of interest issues. This has been facilitated via a strategic partnership with Julius Baer which is helping to bring scale to the operation.

“We like to work with managers who have the prospect of reasonable scale,” says Browne. “They have to be robust enough, large enough to be comfortable with institutional managers. We don’t necessarily require exclusive relationships, but we don’t work with the prime brokers. We prefer to work with managers based in London, and we’re trying to be a one-stop shop for those managers.”

Dexion’s formula has been a simple one, a business that in one sense is quite diverse, combining an advisory business with cap intro and a product development shop that has been extremely successful, while drawing on the established knowledge base within the initial advisory function. It is the range of listed products, and their success, which has really made headlines for Dexion, and it has been a process that has literally transformed the sector in which it operates. However, it is not as easy a game to be involved in as it looks. Says Browne: “We expect to see more people coming to the market to replicate what we’ve done. But it’s not an easy thing to do at all. You have to work hard at maintaining and growing your investor base – the success of our products has been based on continuously growing our market base, in keeping the interest up in the buyers. If you don’t interact with and educate your investor base, you will lose them.”