Big firms could find little room for institutional investors by end of year

Updated with correction Aug. 18, 2010

Institutional investors could face capacity constraints by year's end, thanks to their predilection for investing in big hedge funds.

The hedge fund industry as a whole has plenty of capacity to absorb the amount of institutional investment coming its way, but the major sources of new inflows - institutional investors — are mostly targeting the biggest hedge fund managers, and some of those funds are starting to limit new inflows to protect performance.

The issue could become acute, sources said, because of the sheer volume of institutional money slated to be invested in single-strategy and multistrategy hedge funds over the next 12 months by corporate and public pension funds, sovereign wealth funds and a few endowments and foundations.

Hedge fund consultants predict that the rush of money likely will cause some hedge funds to put on the brakes when it comes to accepting new assets.

The global pot of institutional money destined to be invested directly in single and multistrategy hedge funds, rather than in funds of funds, totals at least $16.8 billion, based on a conservative estimate by Pensions & Investments using reported search activity. The actual total likely will be higher, because many institutions don't disclose their hiring plans.

Among the largest direct investment searches announced this year are the first-time hedge fund allocations of $6.6 billion from the $109.5 billion Florida Retirement System, Tallahassee, and $1.4 billion from the $80 billion State of Wisconsin Investment Board, Madison.

Funds that are switching to direct investments from funds of funds include the €87 billion ($114 billion) Dutch pension fund Zorg en Welzijn, for its $1.6 billion hedge fund portfolio, and the $25 billion South Carolina Retirement System, Columbia, for its $5 billion portfolio.

“We have a situation where hedge fund (industry) assets are near their all-time peak and many of the largest hedge funds have more demand than they can handle, while a vast majority of hedge funds have seen very little inflows and are significantly below their peak assets,” Donald A. Steinbrugge, managing partner of hedge fund consultant and third-party marketer Agecroft Partners LLC, Richmond, Va., wrote in an e-mail response to questions.

Much of the new capital the big hedge fund shops attracted in the 12 months ended June 30 came from institutional chief investment officers who still are playing it safe after the financial crisis by concentrating their direct investments in large, name-brand hedge fund managers, said Howard B. Eisen, managing director of hedge fund consultant and third-party marketing firm FletcherBennett Capital LLC, New York.

“After the Madoff fraud in 2008 and liquidity problems in 2008 and 2009, you can understand why institutional investors wouldn't want to take the risk of investing with a smaller manager that lacks a brand name and strong infrastructure,” said Vidak Radonjic, managing partner of alternatives consultant The Beryl Consulting Group LLC, Jersey City, N.J.

Added Mr. Eisen: “Nobody is getting paid to take career risk. If your hedge fund investments wildly outperform, no one is going to say anything. But if your hedge fund investments wildly underperform or there's a blowup, you may lose your job.”

Data from Hedge Fund Research Inc., Chicago, show that 93% of the $9.5 billion of net inflows into hedge funds in the second quarter was invested with companies managing more than $5 billion. That cadre of large hedge funds collectively managed about 60% of total industry assets of $1.6 trillion as of June 30.

Further analysis showed that the 342 hedge funds managing more than $1 billion in HFR's database represented just 4.9% of the total number of hedge funds, but managed a whopping 76.1% of total industry assets, said Kenneth J. Heinz, HFR's president.

The idea behind investing in the 50 or 60 largest hedge fund shops is that they will have sufficient infrastructure and resources to withstand performance and market woes, FletcherBennett's Mr. Eisen said. But he noted that the sheer volume of institutional money has caused a number of these leading hedge funds to control inflows by closing their funds or limiting access only to institutional investors that approach them directly or through investment consultants.

Among the prominent hedge fund managers sources say have “hard-closed” some of their funds to all investors, “soft-closed” them to all but new or existing institutional investors, or are considering some kind of capacity control are BlueCrest Capital Management Ltd., Brevan Howard Asset Management LLP, Paulson & Co. Inc., Baupost Group LLC, King Street Capital Management LP, Graham Capital Management LP, Lone Pine Capital LLC, Greenlight Capital Management Inc. and Woodbine Capital Management LLC.

“Capacity is a real issue these days. It was gone for a long time, but it's definitely back,” said Daniel Celeghin, a partner at Casey, Quirk & Associates LLC, Darien, Conn., a consultant to money managers.

In fact, Mr. Celeghin predicted that “capacity will become the No. 1 issue for hedge funds over the next year or two, especially as pension funds begin to "unbucket' their portfolios ... include equity and fixed-income long/short hedge funds, rather than segregate hedge funds.”

Consultant Stephen L. Nesbitt said access to the most desirable hedge funds likely will tighten. Mr. Nesbitt is CEO of alternative investment consultant Cliffwater LLC, Marina del Rey, Calif.

Mr. Nesbitt said he “never advises clients to rush into investment decisions, but this year, I am advising those clients who intend to invest in hedge funds to prioritize their investment goals and to get moving or perhaps be disappointed.”

Mr. Nesbitt predicts about one-quarter of the single-strategy and multistrategy hedge funds Cliffwater recommends to clients likely will close to new investors before the end of the year. Mr. Nesbitt declined to identify the hedge funds his firm recommends.

“Contingent institutional interest massively exceeds credible alpha supply. This means capacity is bound to be an issue sooner or later” for hedge fund managers, agreed Simon Ruddick, CEO of alternatives consultant Albourne Partners Ltd., London, in an e-mail.

But Mr. Ruddick and other specialist hedge fund consultants stress that institutional investors and their consultants will continue to get some degree of preferential access from hedge fund firms that are “working hard to switch their investor base to (include more) high-quality assets such as pensions,” Aoifinn Devitt, principal, Clontarf Capital, London, said in an e-mail response to questions.

Mr. Ruddick said in his e-mail that “the strongest hedge funds are totally focused on achieving the most direct route to accessing secure capital. Selective opening, via a specialist consultant, is a relatively efficient way of achieving this.”

J. Alan Lenahan, managing principal and director of hedged strategies at Fund Evaluation Group LLC, Cincinnati, said the firm hasn't experienced difficulty in allocating client assets to the hedge funds they've selected. But he said that over the past six to nine months, a number of hedge fund managers have “limited capacity and controlled growth and we like that” because such a move protects the interests of existing investors. “Many (hedge funds) are limiting growth in certain channels, for instance from hedge funds of funds,” Mr. Lenahan said.

Hedge fund managers have developed a language all their own for describing the capacity controls they have imposed, Mr. Ruddick said.

“An "urban myth' is that the Eskimos have 50 words for "snow.' The hedge fund industry must have nearly that for "closed.' (The) truth is that capacity is an issue and that the provenance of the end-investor does matter,” Mr. Ruddick wrote in his e-mail.