The Waxing and Waning of Demand

How DE Shaw finally responded to institutional investor dominance

SIMON KERR
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Recently it emerged that DE Shaw & Company was cutting the fees on its multi-strategy Composite Fund from very high levels to high levels. When a hedge fund behemoth like DE Shaw changes the terms of business it is tempting to read across that the continual call for lower fees at hedge funds must be coming to fruition. It is also easy to infer that there has been a sudden change in the dynamics of the relationship between the providers and investorsof the capital. The reality is more complicated than that and more specific, and the thread of the tale, of which the easing of terms is just the twist at the end, goes back a long way.

DE Shaw, along with Renaissance Technologies, is the epitome of one sort of hedge fund firm. “Since its organization in 1988, the firm has earned an international reputation for financial innovation, technological leadership, and an extraordinarily distinguished staff,” is how DE Shaw describes itself. The firm is rational in its approach to management as well as its investment style.

Over time DE Shaw has passed some notable milestones, and earned some distinctions amongst its peers. It is well noted that historically DE Shaw traded as much as 5% of the daily volume on American stock markets (pre 1998) and even now DE Shaw sometimes accounts for 1–2% of the daily trading volume on the New York Stock Exchange.

Big recruiter of PhDs
It is one of the few hedge fund firms to have achieved a hand over of day-to-day management beyond the founder and guiding principal, David Shaw. The firm has been run by a six-person management committee since 2002. It ranked as the second largest hedge fund firm by assets under management globally in 2007 with $30 billion of capital, and assets peaked at $39 billion in 2008. It has had the second largest number of employees of any hedge fund firm – and only in recent years has Man Group surpassed it, among hedge fund peers, in employing more PhDs.

DE Shaw was named the Hedge Fund of the Year by Risk in 2007. As recently as April 2010, its was nominated as Institutional Hedge Fund Firm of the Year and Multi-strategy Hedge Fund of the Year by Institutional Investor – though the awards were won by Highbridge Capital Management and Hudson Bay Capital Management respectively.

The accumulation of so much capital under management did not come about just because of an excellent technological infrastructure and the employment of bright people – though DE Shaw and other successful asset management companies have those things. The initial attraction of capital in asset management is due to investment returns, and DE Shaw has produced very good returns over time.

High returns accelerate growth
In the early part of the last decade, when the firm had assets in the low single-digit billions of dollars, the returns of the flagship DE Shaw Composite Fund were way ahead of the peer group of multi-strategy hedge funds and the broader industry returns. From 2002 to 2004 the Composite Fund had annualised returns of 19.1% compared to an annualised return for the Dow Jones Credit Suisse Hedge Fund Index of 9.3% over the same period (see Table 1 for the annual returns).

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The outperformance of the funds caused a subsequent outperformance in asset accumulation. As the asset gathering of the hedge fund industry accelerated in 2004–05, DE Shaw outperformed on this measure. The rate of asset growth was an astonishing 50% for most of 2005, and towards the end of that year DE Shaw managed $17 billion of capital.

The rate of growth was fastest in 2005, but the absolute peak in assets under management came three years later. By mid-2008 the firm had $39 billion of capital to deploy in markets, and was in the very top tier of hedge fund firms by size. The period since that peak in assets has seen a reversal of fortune for the quant mavens – firm-wide hedge fund AUM was down to about $18 billion in late 2010, a figure less than what the flagship DE Shaw Composite Fund contained in 2008 before the financial crisis. The consequences of the growth in assets were a factor in the reversal that occurred, but it has not been the only factor.

Liquidity lesson and expansion
Going back to the market crisis of 1998, David Shaw himself was taught a major lesson about the importance of liquidity. Ever afterwards the cost of funding of positions (the price and security of the funding by prime brokers amongst other sources) received some priority from the DE Shaw management. There were also lessons about the sustainability of the scale of operation in markets, taking account of liquidity shrinkage in times of market turmoil. The consequence was that for some years afterwards the investment strategies were scaled to the capacity of the markets, and to a greater degree the addition of new investment strategies became a requirement for the firm’s growth.

Sometimes the expansion of DE Shaw by investment strategy came about because of planning, but it also came about because of opportunity arising. The move into energy trading came about because the bankruptcy of Enron in 2001 left a lot of space for new capital to profitably enter the business. The direct lending business of DE Shaw was also started because of the rich opportunity set. As each new market was examined the firm was looking for three things – inefficiencies in the business to exploit, an analytical edge to apply to the market, and an appropriate way to resource the activity (hire or build organically).

In the last decade using this framework DE Shaw added macro trading capabilities, volatility trading, equity arbitrage, and investments in asset-backed securities as well as credit-related strategies. The thrust has been for the firm to operate in more and more markets and instruments. What’s more, the qualitative element to the investment processes became a larger component as the firm diversified away from the core systematic and quantitative approaches on which the firm was founded.

By 2006-07, like many large multi-strategy asset management firms, DE Shaw saw a big opportunity for returns in investment strategies with a long time horizon for investing and with limited liquidity. These private market type investments were lumpy, not readily realisable or easily marked to market, but were perceived as having high internal rates of return. In particular, the firm made a heavy new commitment to property-related investing in the middle of the decade. However, the more that the growth in AUM at the firm was in these private equity-like investments, and the higher the percentage of the whole these investments became, the greater the risk of mismatch between the terms of business of the firm’s funds and the liquidity of the investments.

DE Shaw runs a series of hedged and semi-hedged and indeed long-only funds. The two largest hedge funds are both multi-strategy. In addition to the DE Shaw Composite Fund there is the Oculus Fund. The changes made to the latter are indicative of events at the firm overall.

Illiquid strategies and illiquid funds
The shift to more illiquid strategies in 2006-07, though following a route to better return opportunities, also opened up the prospect of a higher probability of a mismatch between the terms of liquidity for the funds and the time horizon of the underlying investments in the funds. The solution to this for a firm which was in the winners’ circle of the hedge fund business, for whom investor demand had exceeded supply for over seven years, was to alter the redemption terms. It was entirely logical from their supply-side perspective to unilaterally change the terms of the funds for the investors. DE Shaw didn’t break new ground in making these changes. It was part of an industry-wide pattern that large hedge fund firms did not negotiate terms – they set them for investors.

It was announced in late 2006 that from January 2007 the gate on the macro-biased Oculus Fund would be lowered. The gate provisions in the prospectuses limit the proportion of a fund’s capital that can be withdrawn by investors at any one time. Under the old terms investors in the Oculus Fund could in aggregate withdraw up to 1/8th of the assets of the fund on a dealing day (with a suitably long notice having been lodged with the administrators). Under the new terms only 1/12th of the fund’s assets could be subject to redemption notice on a dealing day.

Be under no illusion, investors in hedge funds, including those run by DE Shaw, do not like having the terms of business changed in favour of the management company controlling the assets. The investors go along with it where they have to – where the hedge fund management company is in a strong position because of returns, and where changes to the continuity of relationships will be damaging. It is often the case that if an investor redeems from a range of hedge funds offered by a brand name manager the investor will not be allowed back in. In one extreme case an investor in the Quantum Fund in its pomp was warned by George Soros if they did as the investor had indicated and marginally trimmed the very large position they had in the fund, then the investor would have to redeem his whole holding. Hedge fund managers can be proprietorial about the capital they look after, even though only a minority of it may be theirs.

Quant shock
The quant shock of August 2007 proved an augury of later events. Many large managers using quantitative stock selection techniques had awful drawdowns – losing 10-20% in a single month. Those that held on to positions tended to bounce back in the following months. The portfolio managers running the funds at DE Shaw stuck to their disciplines. So after a loss of 18% in the equity volatility book (allocations to the strategy of the Valence Fund, at that point making up 30% of the Composite Fund) the flagship funds were still up at the end of 2007.

Some credit is due to the managers of the group’s hedge funds in the recovery of net asset values in the final quarter of 2007, but the reaction of some investors was telling. The monthly losses were too big for a small minority of investors in some of the funds and they withdrew capital. On balance more new capital was committed in the fourth quarter of 2007 than was withdrawn so AUM in the firm went up. But there was disquiet amongst some institutional investors about the quant shock and how DE Shaw handled communication. The cries about opacity would get louder later, but given the strong capital inflows into the industry, there were only murmurs about the level of disclosure on positions and the attribution of P&L by large hedge fund groups. This issue would, of course, return soon with a vengeance.

Investors, particularly long-term institutional investors, will accept less favourable liquidity terms (redemption or notice) because they recognise that, in practice, it will only make a difference in extreme circumstances. Whilst it is business as usual the change will not have any impact. The quant shock of August 2007 was not quite business as usual, but the credit crunch of 2008-09 was most definitely not.

Post crisis: a game changer

Whilst long-term investors such as pension plans and endowments were not forced in the short term to liquidate assets during the credit crunch the same could not be said of other categories of investors. Many wealthy individuals and family offices have allocations to asset classes on the basis of staying wealthy rather than making high returns on the money. For these investors hedge funds are a “stay rich” home for their money. For those managing money with a capital preservation criterion, the fall in markets and across asset classes and investment strategies that was witnessed in 2008 put on a lot of pressure. Rich individuals and those that were conduits for their money into hedge funds, the private banks and the funds of funds, reacted to the unprecedentedly broad fall in net asset values of hedge funds in 2008 by putting in redemption notices where they had capital. That is, notices to all the hedge funds where they were invested.

No single hedge fund or hedge fund management company escaped the wave of redemption notices in the second half of 2008. The motivation was in some cases emotional and indiscriminate, but whatever the cause, merited or not, even the largest, best, and most well-known hedge funds received sizeable redemption notices.

Some hedge fund management companies stuck to their prospectus terms and gave monthly liquidity out as well as in – Gartmore for example – whilst others invoked force majeure clauses which allowed the investment advisors to the hedge funds to suspend redemptions for various reasons. Gates were a limitation, and queues developed to get capital through the exits. One reason commonly given for the suspension of ordinary redemption processes was that that the treatment of illiquid investments was an issue – the investors left in the funds might be inequitably treated if the less liquid investments were left in the hedge funds, whether in side pockets or not.

In the case of DE Shaw, investor-level gates were introduced. Investors in the two largest funds, Composite and Oculus, were allowed to withdraw up to 12.5% of the capital they had committed to the funds each quarter, meaning it would take two years to fully redeem. As it turned out, redemption notices were received for more than 8% of the assets of the Oculus Fund and 6% of the Composite Fund for the end of December 2008.

A new responsiveness
Over the decade up to the crash of 2008-09 capital inflows to hedge funds became increasingly dominated by institutional investors. The earliest investors were HNWIs, followed by endowments, and then more recently insurance companies and pension plans. With the crash, institutions became dominant and now provide a majority of the total capital to hedge funds. This dominance is still growing as institutions have accounted for most of the net inflows in recent years. Post credit crunch, DE Shaw knew that the hedge fund industry had undergone a sea change. As the industry (and most firms) went from growth to shrinkage, hedge funds became much more responsive to their clients’ requirements.

At DE Shaw, this new responsiveness first became manifest in June of 2009 when, having previously suspended redemptions, it allowed investors the one-time option of pulling 16% of their assets from the Composite and Oculus funds. However, this came with the condition that investors who acted on the limited offer had to forgo additional withdrawals in 2009.

The repayment process accelerated in January 2010 when investors in the Oculus Fund, who were on a staggered withdrawal scheme, were told that they could redeem their remaining capital at the next dealing day. The balances were some 37.5% of the original capital commitments, and would have taken place 15 months after the original dealing date expected by the investors when they put their redemption requests in. Some investors expressed annoyance at that point (early 2010) that DE Shaw had restricted withdrawals even though the funds were largely invested in liquid securities and had enough cash on hand at the end of 2008 to support most of the redemption requests. Investors in the Composite Fund would hardly have been pleased to wait until September 2010 to have the same staggered withdrawal restrictions removed.

Aiming to placate institutions
New thinking at DE Shaw turned into new commercial tactics specifically designed to placate the firm’s institutional client base. Over 2010 this become manifest in several ways. The first case of this was the launch of a new institution-friendly version of the Oculus Fund called the DE Shaw Heliant Fund. It employs all the liquid investment strategies of the Oculus Fund, but incorporates new elements reflecting the concerns of investors on fees, gates and transparency. The Heliant Fund is designed to be more liquid than Oculus. It offers monthly withdrawals (Oculus is quarterly) with no overall gate provision. However there is an investor-level gate allowing redemption of only 1/12th of their previous capital contribution in the new normal 30-day notice period.

Other features of the Heliant Fund also reflect institutional imperatives. These are focused on the areas of administration arrangements and transparency. There has been a long standing practice for some of the larger US-based brand name hedge funds to be self- administered. This made sense when the firms long ago set up this capability, and in some cases offered it to outside funds. But post-Madoff, the presence of a high-quality third party administrator is now a must for all hedge funds expecting to sell to investing institutions. In the case of the Heliant Fund this is substantially addressed by Citco Fund Services providing monthly verification of the fund’s positions and their pricing, the cash and counterparty balances, and the investors’ capital.

On the subject of increasing fund transparency for institutional investors – long a bugbear for some investors in DE Shaw funds – the Heliant Fund’s launch set a couple of precedents. Firstly, Credit Suisse Asset Management creates a month-end analytics report for investors, based on daily position information provided to it by DE Shaw. The second precedent is that on a quarterly basis DE Shaw provides investors with an operational update that includes a breakdown of assets according to the FAS 157 fair value accounting rule.

Lower fees
The final point to note about the Heliant Fund, and again it set a precedent, is that the fee structure is different to the Oculus Fund. It was very telling that the Heliant Fund launched with industry standard fees of 2% and 20% in contrast to the premium fees of 2.5% and 25% Oculus charges.

A recent low point in the waxing and waning of demand for DE Shaw hedge fund products came in the autumn of 2010. As $3 billion worth of redemption notices for the Composite Fund became effective at the end of September, again the firm showed its commercial nous by offering a new share class in the fund to new and existing investors. Returning to the theme of liquidity management, the new share class excludes exposure to the less liquid side pockets of the Composite Fund, which were between 8% and 13% of the fund assets depending on the domicile of the fund. However, it could be that such initiatives were too little and too late.

Layoffs, returns and AUM shrinkage
The attrition of assets under management at DE Shaw, which had taken two years to come to full fruition because of the gating, finally had its full impact. Total assets fell by more than 60% from the peak in 2008. Management responded by laying off 150 staff members. The layoffs were equivalent to about 10% of the workforce. To put this in perspective, the whole staff of DE Shaw numbers 1,300 compared with 220 at the start of 2002.

Hedge fund layoffs, of course, are a function of a fall in fee income. The fee base shrank significantly in 2010, as the firm’s ranking by asset size fell from fifth amongst American hedge funds at the start of the year to around 20th at the end. The large redemptions in September 2010 were a function of two circumstances – the attitude towards clients as reflected in the terms of business for the funds (high fees, difficult redemption terms, and a perception of low transparency over many years), and a new, commercially dangerous development in uncompetitive returns. Indeed, 2010 marked the first year in five that the returns of the Composite Fund trailed the Dow Jones Credit Suisse Hedge Fund Index. Table 2 shows that the Composite Fund also significantly lagged the benchmark index for multi-strategy hedge funds.

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The mindset of the management of DE Shaw & Company is that that they are in the business of producing an absolute return for their clients. So the 2010 returns for the Composite Fund were very much outside the management self-conception.

In February 2011, the firm announced that the fees charged on the Composite Fund would be cut with the management fee reduced to 2.5% (from 3%) and the performance fee cut to 25% (from 30%). Still, the fee scale is at a significant premium to the industry and at a higher level than other funds run by DE Shaw.

The fee reduction is not a one-off change. In the relationship between this specific manager of capital and the providers of that capital, the clients, the upper hand had largely been held by DE Shaw since the founding of the firm. The financial crisis changed that. The re-positioning of the firm’s products in recent years may have been a rational response from management, but it wasn’t enough to keep some clients invested.

Changes in the terms of business can be important but will not be the most important factor in the mix. The tone of the relationship between an investment manager and its clients is reflected in the degree of openness and the transparency on offer, but the substance of that relationship is in the returns on the funds and the AUM. They are linked, and that substance has been substantially diminished on both counts in the case of DE Shaw and Company.