Institutions gain the upper hand with hedge funds – at last

Hedge fund managers staged a stunning comeback in 2009 and the bonus for institutional investors is that they are firmly in the driver's seat moving into 2010 and beyond.

Collectively, hedge fund managers last year turned in their best performance in a decade, with a 17% return, according to a composite of diversified hedge fund indexes compiled by Bank of America Merrill Lynch Global Research's year-end Hedge Fund Monitor report.

But sources said it was an especially important year for institutional investors, because heavy redemptions from high-net-worth investors at the end of 2008 and in the first half of 2009 left hedge fund managers with a collective client list that for the first time is tipped toward institutional investors.

More specifically, about 72% of hedge fund assets came from institutional investors in 2009, according to data provider Preqin Ltd., London.

The bias toward pension fund investors has given them “the upper hand and they know that if they want certain attributes from the hedge fund managers, they have to demand them” and they have largely been successful in getting concessions on issues like transparency, liquidity and very deep operational due diligence, said Nadia Papagiannis, alternative investment strategist at Morningstar Inc., Chicago.

“Transparency, liquidity, capital preservation, integrity, independent administrator are not (just) buzzwords, but (became) the words of caution among institutional investors,” said Vidak Radonjic, managing partner at Beryl Consulting Group LLC, Jersey City, N.J.

The transparency achievement “was the single most important change in 2009 and going into 2010. These trends that institutional investors have started will define the industry and continue for years to come. It's not like anyone will go back now to accepting less transparency,” said Kenneth J. Heinz, president, Hedge Fund Research Inc., Chicago.

Mr. Heinz and Ms. Papagiannis agreed “transparency may end up being the private-market solution to perceived problems on the regulatory front,” as Mr. Heinz stated. “It will be interesting to see how that plays out in legislative approaches,” he said.

When it comes to regulation, Richard H. Baker, president and chief executive officer of the Managed Funds Association, Washington, the hedge fund industry's lobby group, said he expects financial reform legislation that might affect hedge funds to pass this summer.

“These issues are so important to the American public that no legislator is going to be willing to go home and start campaigning (for re-election) without having passed some kind of reform,” he said.

It's hard to predict the contents of a reform package, Mr. Baker said. “There are so many moving parts ... If it were only dealing with hedge funds, this process wouldn't be so hard, but it's likely that private equity, venture capital and other interests may try to get into the debate.”

The power institutional investors are beginning to wield — and any improvements in hedge fund governance possibly resulting from legislation — likely will become even more important as overall allocations to hedge funds increase in the next few years.

Consultant Stephen L. Nesbitt noted that pension funds, especially public plans, will begin moving more assets into hedge funds. “It's a done deal,” Mr. Nesbitt said. “The only question is how they will execute this, whether through hedge funds of funds or direct (investments).” Mr. Nesbitt is CEO of alternative investment consultant Cliffwater LLC, Marina del Rey, Calif.

Mr. Nesbitt predicted that direct hedge fund investment likely will begin to win out over funds of funds beginning this year, even for midsize pension funds. “Historically the proportion of pension fund assets invested in funds of funds was about 75%. That's going to flip-flop to about 75% into direct hedge funds very soon,” he said.

More specifically, consultants like Beryl's Mr. Radonjic are advising clients to “stay away from strong directional strategies and allocate more to non-directional (relative value) strategies benefiting from the better liquidity and improved investor confidence” such as long/short equity, which will be in the “sweet spot” this year because of “numerous opportunities for skilled managers on both the long and short side.”

Long/short equity managers are likely to attract the most institutional investment dollars in 2010, as many use them to replace all or part of their long-only equity allocations, said alternative investment consultant Aoifinn Devitt, principal with Clontarf Capital, London.

“If even a fraction of pension fund equity allocation moves into long/short equity strategies, it will be absolutely huge, a wall of money,” Ms. Devitt said.

But Ms. Devitt and other industry observers stressed that hedge fund managers still are remaking themselves into the kind of substantial money management companies institutional investors are accustomed to investing in on the long-only side of the business.

“The hedge fund industry at Dec. 31, 2009 (compared with a year earlier) revealed a huge improvement in performance and a fundamental change in the client base, (which) now is predominantly institutional. There's been great deal of stabilization, but there also was a substantial shakeout in the business, which has led to a true realization of the structural changes that most hedge fund managers have to make in their basic business models,” said Kevin P. Quirk, a partner at vendor consultant Casey Quirk & Associates LLC, Darien, Conn.

Ms. Devitt noted “the large institutional players, those with more than $5 billion under management, are really setting themselves up to build long-term relationships with pension funds. These relationships take a long time to develop, much longer than hedge fund managers are accustomed to with high-net-worth investors, but the investments ultimately will be stickier money.”

“Hedge funds are inching toward institutionalization, rather than leaping,” said Cliffwater's Mr. Nesbitt. He pointed to the introduction of institutional-only share classes that offer lower fees in exchange for longer lockups as a positive step, but noted hedge fund managers still are not offering “a discount for size” in fees for large mandates.

While Mr. Quirk and others said most companies were busy in 2009 buying or building capabilities to be more accommodating to institutional investors, hedge fund managers had to be willing to invest in 2009.

That was something that not every manager had the courage to do, said one hedge fund senior investment executive who asked not to be named.

“Your success was dependent on how ready and willing you were to bend over and pick up dollar bills that were on the floor after 2008,” the source said. “It was very detrimental to over-learn the lesson of 2008 and just sit there on your hands, too nervous to put the cash you'd stockpiled to work. Managers who waited too long in 2009 got whipsawed when they got back into the markets in midsummer and later,” the source added.

Edward A. Perlman, portfolio manager and managing partner of credit specialist Scottwood Capital Management LP, Greenwich, Conn., found plenty of opportunities for investment in 2009 after “the U.S. government, whom we lived in fear of in prior years, became very creditor-friendly, especially in March and April. This enabled us to keep investing in credit without fear.”

In fact, Mr. Perlman's confidence grew strong enough in 2009 that he ended a solid 2½ years of having more short exposure in the firm's $600 million in hedge funds to being net long.