Pension fund officials who think they're avoiding the potential conflicts of interests in the capital introduction game by investing in a hedge fund of funds should think again.
At Morgan Stanley Dean Witter & Co., New York, one of the biggest players in the prime brokerage world, a majority of the manager introductions made by the capital introductions group arm of the brokerage unit are made to hedge funds of funds, said David J. Barrett, managing director. Mr. Barrett is widely credited as the man who made capital introduction into a business important enough to spin off from prime brokers.
At Deutsche Bank Securities Inc., New York, hedge funds of funds represent the largest single block of manager-investor introductions performed by the capital introductions group, said John D. Dyment, who heads the capital introduction group there. Several years ago, Mr. Dyment helped build the capital introduction arm of New York-based Goldman Sachs Group Inc.'s prime brokerage.
In fact, as hedge fund managers proliferate and more money flows into the industry, capital introduction teams at the major prime brokerages are growing more sophisticated and playing an increasingly important - and dominant - role in linking investors with hedge fund managers.
Capital introduction used to be basically the process of a third party making introductions between investors and managers. It has evolved from that middleman function to encompassing an entire process that includes introductions, investor education and advising and assisting managers with preparing materials for potential investors.
Not everyone considers that a good thing. Hedge fund-of-funds managers say capital introduction has abundant potential conflicts, not the least of which is that investors meet only hedge fund managers that do business with the parent prime broker, thus limiting the universe of managers. Furthermore, capital introduction teams are not likely to speak ill of the prime broker's hedge fund clients for fear of losing the business.
"The capital introducers are in a bind. They are, generally speaking, cheerleaders for anyone who is prime brokering with them," said Ezra P. Mager, a partner at The Torrey Funds, New York, a $400 million hedge fund of funds. "Since they act as cheerleaders for all the hedge funds for which they serve as prime broker, they find it hard to discriminate and say `this one (manager) is good' and `this one is not so good.' We don't look to them for judgment in advance."
More than introductions
Mr. Barrett said Morgan Stanley makes it clear up front that the capital introduction group only introduces hedge fund managers who have prime brokerage business with Morgan Stanley. "Since we have no relationship with managers who don't prime broker with us, making those introductions would be confusing to investors, unfair to our current clients and not directly beneficial to our business," Mr. Barrett said.
But potential conflicts have not kept investors - including funds of funds, large pension funds, foundations and endowments - from seeking out hedge fund managers through capital introduction.
And some investors and managers are asking for more than just introductions, Mr. Dyment said.
"The role of the capital introduction person is changing dramatically," Mr. Dyment said. "We're now working with managers to help their business, but also helping investors meet their goals and objectives."
Mr. Dyment said the help is not meant to replace advice investors get from their consultants, only to augment it. But it's no secret that prime brokers - on their own and through their capital introduction teams - are moving toward promoting themselves as one-stop shopping centers for the hedge fund industry.
Capital introduction teams at large prime brokers already have altered the landscape by wresting business from third-party hedge fund marketers. Marketers charge managers a fee, generally some percentage of the fee fund managers collect on returns (typically around 20%), to introduce hedge fund managers to potential investors.
Capital introduction teams do the same work, but rarely charge for it. Instead, they get their money from the prime brokerage unit, which charges hedge funds fees for using the brokerage services. Capital introduction teams earn their keep by lining up new investors for hedge funds. That, in turn, increases the hedge funds' trading activity and their use of other prime brokerage services, which then increases the amount of money the prime brokers collect from the hedge fund managers by way of fees.
Capital introduction groups have had "a devastating economic effect (on third-party marketers)," The Torrey Funds' Mr. Mager said. "If the prime brokers will do it (marketing) for what appears to be nothing, why should they (the hedge funds) go out and get a third-party marketer to market just them and give up some of that 20%?"
Mr. Mager said as more independent marketers fold because they can't compete, the capital introduction units of the prime brokerage firms will gain even more market share.
Eventually, hedge fund investors who lack the resources to do their own research may be forced to use capital introduction either directly or through a fund of funds. For now, however, there are some choices.
The Torrey Funds, for example, relies on the capital introduction teams at several prime brokers - including Morgan Stanley; Goldman Sachs; Bear Stearns Cos. Inc., New York; and Bank of America Corp., Charlotte, N.C. - for information about hedge fund managers. But capital introduction is only one of myriad sources The Torrey Funds uses, Mr. Mager said. The firm also conducts its own manager research, attends conferences and takes cold calls.
Bob Rafos, managing director for client services and marketing at fund of funds Northwater Capital Management Inc., Toronto, said his firm is in regular contact with "three or four" of the prime brokerage capital introduction teams.
J.P. Morgan Alternative Asset Management Inc., the division within J.P. Morgan Chase & Co., New York, that offers hedge funds, also uses capital introduction teams at the various prime brokers as one - but not the only - source of information about hedge fund managers, said Joel Katzman, president and chief executive officer of J.P. Morgan Alternative Asset Management.
Teams of research analysts each day look for news about hedge fund managers, Mr. Katzman said. Those same analysts also talk regularly with the 60-odd hedge fund managers in which the alternative asset management unit is invested. Those managers are often a good source of information about new talent, Mr. Katzman said. Other sources include accounting firms, e-mail distribution lists, conferences, competitors and clients.
"In this environment, you need a comprehensive system for finding managers," Mr. Katzman said. "The cap-intro units of the various prime brokers are a good source."
Quick and convenient
One reason is that capital introduction teams often will set up meetings between investors and a dozen or so hedge fund managers. Investors quickly and conveniently get introduced to a crop of new managers.
Mr. Katzman said J.P. Morgan Alternative Investment Management invests nearly $4 billion through funds of funds and by investing in individual managers. Roughly 15% of those assets belong to pension funds, including $200 million from "one very prominent pension fund." Mr. Katzman declined to name any of the funds.
The biggest prime brokers are careful about not endorsing particular managers, Mr. Rafos said. "They won't necessarily say you should invest with these people, just that you should talk to them," Mr. Rafos said.
"It's difficult to measure the success rate," Mr. Barrett said. "You may make some introductions on a road show or at a dinner and six months later the investor is still doing due diligence. Twelve months later they may make an investment. By that time, they've forgotten where and how they met. It's not like investors or managers are calling me saying `Thanks for the introduction.' Some managers and investors apprise us, others do not. It's simply the reality of this aspect of the business."