Small hedge funds gaining bigger slice of institutional money

More pension fund chief investment officers are taking a close look at small hedge fund managers in an ever-widening search for diversified alpha sources.

Only a few large pension funds — the $230.1 billion California Public Employees' Retirement System and the $72.6 billion New Jersey Division of Investment among them — have made significant investments in small hedge funds in the last few years, and sources say the bulk of U.S. corporate and public pension funds have yet to make the move.

But given the performance potential of hedge funds of funds that invest in — and even seed — emerging managers long on talent but short on assets and track records, observers expect many larger, sophisticated pension funds to move into the space.

Sources also expect pension funds already investing in emerging hedge funds strategies to increase their allocations, as is the case with the New Jersey fund.

“We are seeing broad and significant interest in making increased allocations to emerging managers. Actual activity (i.e. funding) has been light, but we believe we are in the early innings,” Richard Quigley, global head of portfolio advisory at alternative investment consultant Albourne Partners Ltd., said in an e-mail. He is based in the firm's Rowayton, Conn., office.

One large Silicon Valley-based corporate pension fund went past the talking stage in mid-April with industry newcomer Busara Advisors LLC, New York. The pension fund put $150 million in a customized fund of funds investing exclusively in emerging minority- and woman-owned hedge fund companies. Busara opened in September 2010, and Joseph Schlater, Busara CEO, said the mandate is the company's first. He declined to name the client, citing a confidentiality agreement.

The big draw for executives of return-hungry defined benefit plans is the superior performance of smaller hedge fund managers. Hedge funds managing less than $50 million returned an aggregate 13.1% on an annualized basis in the 15 years ended Dec. 31, according to Hedge Fund Research Inc., Chicago.

Those smaller funds outperformed the 11.62% aggregate annualized return of hedge funds with more than $1 billion, as well as the 10.23% annualized return of the HFRI Fund Weighted Composite index for the same period, HFR data showed.

Revenue-sharing arrangements can amplify the strong performance, said Donald A. Steinbrugge, managing partner at third-party marketing firm Agecroft Partners LLC, Richmond, Va. By taking an equity stake in the young hedge fund company and sharing in the profits as it grows, “you get two shots on goal: the investment outperformance of the hedge fund itself and then your share of the profits.”

“Investors like emerging hedge fund managers because of their performance, but they also like the seeding funds-of-funds format because the alpha generated from the revenue share with the underlying managers can help offset fees,” said Deepak Gurnani, managing director, CIO and head of hedge funds at Investcorp International Inc., New York.

Because seeding funds tend to use a hybrid private equity format that relies on small hedge fund managers growing over time, most have two- to three-year lockups and therefore “tend to work for larger, more sophisticated pension funds because they are longer-term investors,” Mr. Gurnani said.

Investcorp managed $5 billion as of March 31, which includes $1.6 billion in commingled and customized seeding funds of funds.

The interest in smaller hedge funds also is part of a backlash by pension fund CIOs against large hedge fund managers.

About 90% of industry inflows went to large hedge funds in 2010 despite evidence that over the long term, small hedge funds significantly outperform, said Mr. Gurnani.

Added Albourne's Mr. Quigley: “Investors are becoming increasingly concerned that many well-established managers are becoming too big, particularly as industry flows have been so highly concentrated, and that increased size both reduces performance incentives and (the) ability to navigate very difficult markets.”

Howard B. Eisen, managing director at consultant and third-party hedge fund marketer FletcherBennett Group LLC, New York, said the large hedge funds are getting picky again after recovering from the precipitous losses of the past few years.

“After losing so much in the financial crisis and from client redemptions in 2010, all the big guys were looking to rebuild their assets. They all were open and you could get into any fund you wanted to,” he said. But 2011 is a different story. “They're all getting their swagger back in 2011 and are starting to limit capacity and closing their funds.”

The potential for outperformance is the driver behind the Trenton-based New Jersey fund's $200 million commitment to Reservoir Strategic Partners Fund LP, a seeding fund of funds managed by Reservoir Capital Group LLC.

The Reservoir investment is pending successful contract negotiations, Timothy M. Walsh, New Jersey director, said in an e-mail. Reservoir's earlier seeding funds returned an annualized 14.96% in the 11 years ended Dec. 31 with volatility of 9.88% and a Sharpe ratio of 1.15, according to documents from the New Jersey fund's March 24 investment advisory council meeting.

The HFRI FOF Composite index returned an annualized 4.14% over the 11-year period ended Dec. 31. The HFRI Fund Weighted Composite index returned an annualized 6.75% over that same time period.

The Reservoir fund will invest in eight to 10 small hedge fund managers and is structured as a drawdown fund, similar to private equity, with a three-year lockup. By investing early, New Jersey pays reduced management fees on both committed and invested money.

The Reservoir commitment puts the New Jersey fund's investment in emerging hedge fund managers around $350 million or 9.2% of the $3.6 billion hedge fund portfolio. The New Jersey plan made its first investment in emerging hedge funds with a $50 million investment in Rock Creek Group's Rock Creek Partners I in 2006, which is in the process of being wound down, Mr. Walsh said in his e-mail. The second commitment was made in 2007, with $150 million in two emerging manager funds of funds managed by Protege Partners LLC.

Reservoir Capital is well on its way to meeting its $1.5 billion target for its Reservoir Strategic Partners seeding fund, having already raised $750 million to $1 billion prior to its first close May 1, said industry sources who asked not to be named. One source who requested anonymity said most investors in the new fund are U.S. public pension plans. This marks a change for Reservoir, whose investors in previous funds were predominantly endowments and foundations including the $27.6 billion Harvard University endowment, Cambridge, Mass., and the $14.1 billion University of Texas System endowment, Austin.

“Pension fund investors, with their long-term investment horizons, seem to really like and `get' Reservoir's private equity structure. Because of their familiarity with that structure and the drawdown as Reservoir finds new managers to seed, the ticket sizes for this new fund are pretty chunky, like New Jersey's,” said the source.

Craig A. Huff, co-CEO of Reservoir, declined to comment because the fund is still open.

Other specialist emerging hedge fund and seeding funds of funds popular with institutional investors — including those funds managed by Protege Partners, Blackstone Alternative Asset Management and Larch Lane Advisors LLC — also have succeeded in raising new assets.

Sources said Blackstone's first seeding fund, Strategic Alliance Fund I, closed at $1 billion in 2007, while SAF II closed with $2.4 billion in 2010. Larch Lane, which manages a total of $1.5 billion, is close to hitting its investment target for the second close of one of its three seeding funds. Protege Partners manages $3 billion in several hybrid emerging manager/seeding funds.

Most of the assets in each company's funds come from institutional investors, sources said.