Hedge Funds: Living large

In the early 1980s, McDonald’s Corp. and its poultry supplier hired fledgling firm Bridgewater Associates to help the fast-food company hedge the price of chicken after it launched Chicken McNuggets.

The problem: There was no futures contract available to hedge the price of chickens. Instead, Bridgewater officials turned to grain futures as a proxy for chicken prices.

While hedge funds were just a glimmer in founder Raymond T. Dalio’s eye at that time, Bridgewater has emerged as the largest institutional manager of hedge fund assets, with $36 billion under management as of Dec. 31.

The other top 10 hedge funds — each managing more than $20 billion apiece in hedge fund assets — also have become institutional powerhouses.

According to data compiled by Pensions & Investments, the other leading institutional managers of hedge fund assets are:

•D.E. Shaw group of companies, New York, with $29.7 billion in institutional assets;

•Paulson & Co. Inc., New York, $27.6 billion;

•Farallon Capital Management LLC, San Francisco, $25.2 billion;

•Och-Ziff Capital Management Group LLC, New York, $23.2 billion;

•Highbridge Capital Management LLC, New York, $21 billion;

•Barclays Global Investors, San Francisco, $20 billion;

•Renaissance Technologies Corp., New York, $19.2 billion; and

•Citadel Investment Group LLC, Chicago, $14 billion.

Not on the list is Goldman Sachs Asset Management, New York, which had $32.5 billion in total hedge fund assets as of Sept. 30. GSAM officials declined to break out the portion managed on behalf of institutions.

To compile its list, P&I gathered information from hedge fund companies and by scouring Securities and Exchange Commission filings and press reports and talking to industry sources.

Collectively, these managers run $299 billion in total hedge fund assets, of which at least three-quarters represent institutional portfolios.

Some of the firms started as traditional institutional managers, others as high-net-worth managers that went after institutional clients, and a third group broke into the institutional ranks “through sheer naked performance,” said executive recruiter Nick Lord, principal in the global hedge fund practice of Heidrick & Struggles Inc., New York. The members of this elite group have differing investment strategies, but they are united in their desire to manage large sums of institutional assets.

To do this, each firm had to build the infrastructure and risk-managed investment processes demanded by institutional investors.

“In some ways, these very large hedge firms are coalescing into powerful money management companies from their boutique beginnings, just as traditional asset management firms did years ago. It’s the same kind of evolution,” said Paul D. Schaeffer, managing director-strategy and innovation of SEI Corp.’s investment manager services unit in San Francisco.

For some firms, a nod from a well-placed investment consultant helped enormously to build an institutional following. In the case of Och-Ziff Capital Management, consultant Cambridge Associates LLC, Boston, was an early enthusiast and brought “heavyweight endowment clients,” said a former consultant who asked not to be identified. “It helped them to improve their institutional reach, although I have not really seen them do very aggressive client pitching.”

Sources said despite their differences, executives at all 10 firms understand the importance of building a corporate infrastructure robust enough to satisfy the most diligent institutional investors and their consultants.

“Institutional investors are looking to invest in a business and the large firms on this list have built solid businesses that deal with issues like operational risk, key-man risk, transparency, communication and investment process. In doing this, non-investment staffing has become much more important to these firms and, as a result, the back office has become part of the front office,” said Lynn Tidd, a partner and global head of the hedge fund practice of executive recruiter Russell Reynolds Associates Inc. Ms. Tidd is based in Boston.

The firms also are not afraid to poach from their peers. Och-Ziff beefed up client relations effort about five years ago when it hired in a big team from Goldman Sachs, the former consultant said. “2002 had been a tough year for them with the credit crunch, and they needed to step up their client communication. Before that, Daniel Och (chief executive officer) had done all of the client service.”

Here’s how some of the top managers have built their institutional hedge fund businesses, coming from different backgrounds:

High-performance manager

For Paulson & Co., it was spectacular returns — helped by a big, dead-on bet on subprime mortgages in 2007 — that ballooned total assets in the second half of the year by a whopping 132% to $29 billion, fueled largely by institutional investors.

James Wong, managing director and head of investor relations, said John Paulson, founder and president, started the firm with institutions in his sights but knew that “there’s a logical time when institutional investors can invest with you. They don’t want (their allocation) to be more than 10% of your portfolio, so hedge funds have to be of a certain size before institutions will look at you for a significant allocation.”

Paulson’s assets totaled just $600 million when Mr. Wong joined five years ago. Mr. Paulson was focused on “being ahead of the curve so we’ve been ready every time for the next phase of growth” — like in 2003 when Paulson became one of the first hedge fund firms to hire a chief compliance officer and in 2004 when it registered with the SEC as an investment adviser.

Mr. Wong said because Paulson does not have a huge investment team — just 20 people, which is in line with the philosophy of Mr. Paulson “to hire quality not quantity” — it’s crucial that investment professionals stay focused on managing money.

“The (investment team doesn’t) have a lot of time to spend with investors, so we have to have very sophisticated, capable investor relations people who straddle client service and marketing and are equipped to answer very complicated investment questions,” he said.

Paulson’s investor relations staff — which includes specialist teams focusing on endowments, foundations and pension fund executives — communicates constantly with clients. “We don’t want clients to be surprised by inevitable down cycles,” Mr. Wong said.

The institutional manager

Bridgewater Associates always focused on institutional investors, but has completely transformed in its 32 years, said Bob Prince, co-chief investment officer. In 1975, Mr. Dalio founded the firm to help companies manage global interest rate and currency risks deriving from international financing and operations.

“While the rest of the world was focused on managing assets, Bridgewater was focused on managing liabilities through the use of derivatives, Mr. Prince said. “A key step in this process was understanding the risk-neutral position in order to know how much risk a company was taking. Bridgewater later applied a similar framework to the separation of alpha and beta,” Mr. Prince said.

The firm launched a number of innovative investment strategies in the 1990s, including currency overlay, inflation-indexed bonds, super-long duration bonds for liability management, global bonds and emerging market debt.

What’s more, Bridgewater pioneered the separation of alpha and beta in the early 1990s and created the alpha overlay, “what Ray often referred to as the ‘holy grail of investing,’” Mr. Prince said. “It involved investing in 20 uncorrelated return streams that could be leveraged up or down to a risk or return target, then overlaid on cash or any other benchmark. When leveraged to 12% volatility and overlaid onto cash, it offered pension funds a higher return than stocks or bonds with a level of risk between the two.”

Acceptance was slow until rocky markets in the early part of the new century convinced pension fund executives to seek a combination of higher returns and lower volatility. With a 10-year track record as proof that portable alpha worked, institutional mandates poured in, with assets under management topping $169 billion in 2006 vs. $33 billion in 2000. The flood prompted Bridgewater to conserve investment capacity by accepting new business only in hedge funds and beta strategies and dropping many clients that insisted on clinging to traditional strategies. Total assets under management stood at $150 billion as of year-end 2007.

Private wealth manager

When Kenneth C. Griffin — then a fresh-faced 22-year-old right out of college — started Citadel Investment Group in 1990 primarily for high-net-worth investors, few institutions were investing in hedge funds, said Scott Rafferty, managing director who heads investor relations and marketing. But some pension funds made allocations very early. The $10 billion pension fund of Weyerhaeuser Co., Federal Way, Wash., is known to be a Citadel client, investing with the firm for about a dozen years.

Citadel has boomed in recent years. Total assets, just $1 billion in 1998, jumped to more than $12 billion by midyear 2006. An $8 billion spurt in the past 18 months ended 2007 at $20 billion. Mr. Rafferty said institutional investors were responsible for a large portion of the growth in the last five years. A dozen new institutional clients were added in the last quarter of 2007 and “another handful” will fund commitments in the first quarter of ’08.

Those new institutional clients are finding Citadel, which has not conducted a concerted marketing campaign, Mr. Rafferty said.

The quant

Like many hedge fund managers, most of the assets the D.E. Shaw group managed in its early days were from private clients. But Trey Beck, managing director, said many of the firm’s innovations throughout the years were made with institutional investors in mind. He pointed out that in 2006, the firm was among the first hedge fund managers to offer 130/30 strategies and, in 2000, to offer long-only versions of its strategies to institutions not quite ready for hedge funds. The firm also was a leader in adding private equity, real estate and venture capital capabilities to the company’s investment arsenal early in the decade, although Mr. Beck said the firm has invested in private equity since the early 1990s when the firm founded Juno Online Services Inc.

In fact, the small quantitatively focused hedge fund firm that David E. Shaw, chairman and CEO, founded in 1988 has evolved into such a fully fledged alternatives manager that Mr. Shaw now can focus most of his attention on D.E. Shaw Research LLC. “He’s not just there as a figure head; he’s the chief scientist,” said Mr. Beck. The interdisciplinary research group works in computational biochemistry. Mr. Shaw remains involved in decisions affecting the company.