Hedge funds took $18 billion in institutional money in first quarter

2011 is off to a roaring start for institutional investing in hedge funds, following a year of recovery for the hedge fund industry.

First-quarter institutional hedge fund activity, including net inflows and pending searches, totaled $18 billion — the highest since the intense investment pace of the first quarter of 2007, which saw $25 billion in activity, according to analysis by Pensions & Investments.

In fact, net hedge fund investment activity in the quarter ended March 31 was up 38% from the same quarter in 2010, when activity totaled $13 billion.

Observers are optimistic that 2011 will be a very big year for hedge funds, as many institutional investors worldwide have increased — or soon might do so — their hedge fund allocations.

“Institutional investment is back to pre-2008 levels,” said Stephen L. Nesbitt, CEO of alternatives consultant Cliffwater LLC, Marina del Rey, Calif.

“Even before September of 2008, when the financial crisis hit, institutional investors were nervous and started to hesitate to invest in hedge funds. Between September 2008 and even through 2010, there was definitely a "risk off' mentality. But now everyone is getting a grip. Institutions have dealt with their liquidity issues and are increasing their alternative investment allocation. Forget about real estate for now. The focus is especially strong going forward on hedge funds and private equity,” Mr. Nesbitt said.

P&I's estimate of net hedge fund activity likely is low, based on reported hedge fund increases, searches, hires, postponements and terminations. Amounts are not routinely given when searches are made public, and many searches and hires are never announced publicly.

Among those intending to significantly increase their hedge fund targets is the New Jersey State Investment Council, Trenton, which on March 24 approved new rules that would allow the state's pension system to place as much as 38% of assets in alternative investments, up from the current cap of 28%.

The new rules define four alternative investment categories and set caps for each: absolute-return/hedge funds, 15% of total assets; private equity, 12%; real estate, 9%; and real assets, 7%. The new authorization is subject to a 60-day public comment period and is scheduled to take effect in May.

After ratification, the New Jersey Division of Investment, which manages the state's $71.6 billion in public pension assets, could put as much as $10.7 billion in hedge funds if it moves to a full 15% allocation. That would make the New Jersey fund the second largest hedge fund investor among P&I's top 200 pension funds.

To do that, in current dollars, staff could invest an additional $7 billion into hedge funds, given that the fund's actual hedge fund investments totaled $3.7 billion, or 5.16% of plan assets, as of Feb. 28.

Another large pension fund looking to increase its hedge fund limit is the $108 billion Texas Teacher Retirement System, Austin.

A bill now in the Texas House of Representatives would raise Texas Teachers' hedge fund limit to 10% from 5%, an increase of $5.4 billion in current dollars. The current hedge fund allocation was set by the Legislature in 2007.

Another Lone Star State fund, the $18 billion Texas County & District Retirement System, Austin, in March increased its target allocation to hedge fund as part of a new asset mix, confirmed Paul J. Williams, investment officer.

The absolute-return target increased to 20% from 15%, resulting in an additional $900 million slated for investment in hedge funds.

Several big first-time hedge fund investors put money to work, while other institutional investors have received, or are seeking approval for significant increases in their hedge fund targets.

After two years of study, Connecticut Retirement Plans & Trust Funds, Hartford, finally moved its first $200 million into hedge funds, investing $100 million each in funds of funds with Prisma Capital Partners and Rock Creek Group.

M. Timothy Corbett, chief investment officer of the $24.5 billion Connecticut system, said in an interview that his staff is negotiating contracts for separate $100 million allocations to three other hedge fund-of-funds managers — Permal Group, Blackstone Group and K2 Advisors LLC.

Among large funds that are working to put billion dollar-plus allocations into direct investments in single and multistrategy managers:

• The State of Wisconsin Investment Board, Madison, which oversees $83.3 billion, last year began to search for single and multistrategy hedge fund managers to run a total of $1.4 billion, as part of the rollout of its new hedge fund allocation;

• AP1, Stockholm, with 218.8 billion Swedish kronor ($34.3 billion) in pension assets, last year began a search for three hedge fund managers to manage $1.5 billion within strategic partnerships;

• The $154.7 billion Florida State Board of Investment, Tallahassee, early last year invested $250 million each directly in three activist hedge funds, but did not create a dedicated hedge fund allocation with a 6% target until June. Investment staff is at work getting the first 2% or $2.2 billion invested directly in single and multistrategy funds.

Institutional investment activity so far this year has shown a burst of speed, with renewed interest in hedge funds and funds of funds that began in earnest early last year but slowed markedly toward the end of 2010.

Industry pundits were almost right about 2010. Their prediction that the year would be a banner one for hedge fund investment was realized as institutional investors around the world invested or launched searches for a total of $32 billion, but their forecast that net hedge fund activity in 2010 would hit $49 billion fell well short.

The first half of 2010 showed strong net investment activity of $25 billion, but activity dropped to $6.9 billion between July and September.

Sources said many pension plan investment committees had to take long, deep breaths before making more hedge fund investments.

In fact, Colorado Fire & Police Pension Association, Greenwood Village, took its absolute-return investments down to zero in 2009 from 5%, because the 5-year-old program had a “portable alpha structure that was inappropriate,” said Scott Simon, CIO of the $3.1 billion system.

The fund set a new 11% absolute-target and restructured the allocation to invest about 70% in hedge funds and 30% in commodities.

The hedge fund part of the new portfolio was completed through the hire of fund-of-funds managers Aetos Capital Management LLC in March and GAM USA in February, Mr. Simon said. Aetos will manage $130 million in a long-short equity hedge fund-of-funds mandate. GAM USA was rehired to run $100 million in a global macro portfolio. GAM USA had managed a different hedge fund-of-funds strategy for Colorado fund as part of the now dismantled portable alpha program, Mr. Simon confirmed.

Pending approval from the board of trustees, Mr. Simon said he expects to hire a yet-to-be-named commodities fund of funds in April to run about $100 million, which will bring the system close to its target, Mr. Simon said.

Funding will come from reducing the pension fund's allocation to equities and fixed income. In an asset allocation change, the target for global equities was reduced to 45% from 58%, and fixed income was reduced to 20% from 27%. He said the new asset allocation model is “a bit more aggressive” than the system's targets prior to 2009.

After nearly six years of study, three of the five pension fund systems within the $113.4 billion New York City Retirement Systems finally made large first-time hedge fund investments last month.

All three funds have invested in hedge funds of funds managed by Permal Group, under what one anonymous source described as the “master plan” of Larry Schloss, CIO of the New York City Retirement Systems.

The first was the $23.1 billion New York City Police Pension Fund, which committed $150 million to Permal.Next to invest $250 million with Permal was the $39.6 billion New York City Employees Retirement System.Most recently, the $7.6 billion New York City Fire Department Pension Fund's board of trustees committed $50 million.

All three investments are subject to successful contract negotiations.

Mr. Schloss said in a news release about the police pension fund's investment that more hedge fund investments can be expected from the Big Apple's retirement systems, while noting that the Permal investment is “consistent with the long-term objectives of providing reliable returns, reducing investment volatility, and capitalizing on the changing market landscape.”

Reporters Timothy Inklebarger and Robert Steyer contributed to this story.