Even though total assets under management in funds of hedge funds bottomed out in the second quarter and are now growing, the rationale for funds of funds is still in the dock for many investors. In this market environment, one solution for funds of funds is consolidation.

Man Group has bundled its three former multi-manager units into one new structure called Man Investments, while F&C Investments gave up trying to build a presence and bought Thames River Capital. Smaller deals have occurred, but hundreds of smaller players remain.

One recent deal in this vein is the May merger of Saguenay Capital and Strathmore Capital. Saguenay Strathmore Capital (or SSC as the firm expects to be eventually rebranded) is a deal that builds out a platform, broadens the product set and delivers benefits of scale.

“We’ve seen in the last few years that the smaller firms are slipping to their demise,” says Stephen Harper, CEO of SSC and founder of Strathmore Capital. “By 2010, the need to extend beyond Europe became apparent but we wanted to avoid spreading ourselves too thin.”

What became the solution involved going back to the start of Harper’s career in the mid-1980s when he had worked closely with Saguenay founder Brian Walsh, who set up one of the first swaps desks in Canada. They had then moved together to get the balance sheet backing of Bankers Trust to build a leading derivatives business in Toronto during the late 1980s. Walsh’s three partners – Dave Dobell, John Murphy and Lucien Burnett – were also colleagues of Harper at Bankers Trust during that time.

When Walsh moved to London in 1990 to become Chairman of Bankers Trust International, Harper, followed him to run Bankers Trust’s equity derivatives business in Europe and eventually becoming COO of the Global Derivatives Business. Founding Strathmore occurred after a pension fund client that was also a hedge fund investor approached Harper to set up a European hedge fund portfolio to expand its focus beyond US managers.

Labour intensive due diligence
“It was flattering to be asked to run a portfolio, but I wondered if the world really needed another fund of funds,” Harper recalls. Despite harbouring misgivings that funds of funds were essentially an asset gathering model, he realised that scale was needed to handle the labour intensive nature of doing an institutional standard of due diligence. Strathmore began focusing on low beta strategies run from Europe in 2003 and has developed a universe of over 300 hedge funds.

The old access model that funds of funds ran has given way to investors allocating directly to the very biggest hedge funds. No one, it seems, ever gets fired for allocating to Brevan Howard or Bridgewater. Aside from whether funds of funds can add much value to this, Harper has one bigger concern.

“The issue I have is whether the big funds can be nimble enough to avoid more crowded positions,” he says. “Is there alpha residing in them? Are they alternative? We do see alternatives with smaller managers.”

From inception, Strathmore always worked on a managed account basis. It didn’t even run a commingled fund. “Clients wanted an element of control plus they were underwhelmed by the quality of due diligence so therefore wanted to benefit from higher standards,” says Harper.

Strathmore launched its first commingled product as a UCITS fund in February 2010. The JPM Mansart Strathmore Fund is managing $60 million through a multi-manager product set up on the J.P. Morgan UCITS platform. The fund’s careful approach to manager selection means that it doesn’t invest in funds that use total return swaps to replicate exposure to asset classes outside of the permitted UCITS asset classes.

Merger synergies
When Harper and Walsh began looking at combining their companies Saguenay needed to invest in more infrastructure, while Strathmore needed a US presence. Putting the firm’s different business units together also broadened the offering to clients.

As a specialist managed account investor, Strathmore was more positioned toward the advisory end of the spectrum. For its part, Saguenay had built up a business with several family offices and institutions, running both commingled funds and managed accounts.

Its flagship product is the Saguenay Offshore Fund which launched in February 2004 and has attracted $275 million. It is a multi-strategy offering, providing quarterly liquidity, taking a primarily fundamental approach with a bias to long/short equity strategies. Earlier this year BarclayHedge ranked the fund, which returned 7.27% annualised over the three years to 31st March 2011, the 6th best performer among funds of funds with assets above $250 million. Saguenay runs a second multi-manager fund(AUM of $50 million) offering a higher concentration on equity long/short managers.

“There is a strong common purpose inherent in our two businesses, making the strategic rationale straightforward,” says Walsh, who is chairman and CIO of SSC. “Ultimately, we share the same values, ambition and vision for the combined group in building a dynamic alternative investment manager focused on superior risk-adjusted returns for our clients.”

The familiarity that the partners had from working together made the merger a straightforward process. The obvious risk of cultural difference – the main risk in any merger – was minimal.

On the investment side, the enlarged group looks well balanced to grow now that combined assets are around $2 billion. Moreover, it also has the product range and geographical spread (with offices in London, New York and Toronto) to better service a wider variety of investors.

The fundamentally driven funds SSC favours tend to be sector-focused and market neutral. It is also invested in some higher frequency trading funds. Long-biased managers with high net exposure are out.

“We like to understand the extent of capital flows in a strategy,” says Harper. “We also like to know who the victim is and why the hedge fund manager will get the advantage again. Generally we like managers who have a good sense of the market they are trading. These managers tend to have a good understanding of the liquidity of their positions and what it will be like when everybody tries to get out.”