Texas Permanent's plan to change hedge fund portfolio hits a snag

Texas Permanent School Fund's slow journey toward direct investment in hedge funds hit a traffic jam, thanks to the state education agency's decision that the permanent fund must reconsider a proposal to terminate three of its five hedge funds-of-funds managers.

The Texas State Board of Education and its committee on finance/ Permanent School Fund, which oversee management of the $24.4 billion Austin-based educational endowment, have spent more than a year in heated debate over a recommendation to move to direct investment in hedge funds through strategic relationships with two existing hedge funds-of-funds managers. Implicit in the proposal was terminating three hedge funds of funds.

On April 20, the education board approved Blackstone Alternative Asset Management and Grosvenor Capital Management LP as strategic relationship managers. The finance committee recommended terminating GAM USA, K2 Advisors LLC and Mesirow Advanced Strategies Inc., but the full board was prevented from acting because proper notice had not been posted publicly in time for a vote, according to a webcast of the meeting.

But the proposed structural changes, especially the termination of existing hedge funds-of-funds managers, have been so controversial for some of the 15 elected members of Texas State Board of Education commissioners that they forced a slower pace on the restructuring between the state education board's April and July meetings.

On July 20, education commissioners directed Holland Timmins, Texas Permanent's chief investment officer and executive administrator, to renegotiate fees and terms with four current hedge fund-of-funds managers. Only K2 Advisors was terminated, effective immediately, at that meeting, the webcast showed.

Because the two strategic partnerships explicitly include portfolio construction details and knowledge transfer to staff as part of the deal, Mr. Timmins intends for the staff to eventually assume in-house management of a hedge fund portfolio of direct investments, according to meeting webcasts.

Mr. Timmins declined to be interviewed for this story.

To prepare for bringing the hedge fund portfolio in-house, the Permanent School Fund last year received a special appropriation of $18 million from the Texas Legislature to hire nine people for a hedge fund unit. The Board of Education will soon request an opinion from the state attorney general about the legality of internal management, according to a webcast of the board's July 20 meeting.

Mr. Timmins has spent the last year doggedly trying to reduce the number of hedge funds-of-funds managers to two from the five that have jointly managed the $2.5 billion hedge fund portfolio since its inception in March 2008, according to webcasts of the last six combined board and finance committee meetings.

As of May 31, Grosvenor managed $800 million; Blackstone, $667 million; GAM USA, $327 million; K2 Advisors, $392 million; and Mesirow, $330 million. Mr. Timmins' goal was to reduce fees because the underlying managers and the funds-of-funds managers both charge management and performance fees.

Hedge fund portfolio management fees totaled $72 million from inception through Dec. 31 and are projected to accrue an additional $115 million between 2012 and 2016. During a webcast of the July 18 finance committee meeting, Mr. Timmins projected cost savings of $6.4 million in the first year and a total of $34.6 million over five years by terminating three hedge fund-of-funds managers.

Mr. Timmins' projected cost savings were based on a scenario that would have Blackstone and Grosvenor continue to manage their existing hedge fund-of-funds portfolios and assume co-management of portfolios of the terminated managers at no extra cost in collaboration with permanent fund investment staff.

In order to implement those cost savings, Mr. Timmons came back to the finance committee at its July 18 meeting with three scenarios: Terminate the three remaining hedge funds-of-funds managers; terminate K2 and Mesirow and retain GAM; or terminate K2 and GAM and retain Mesirow, according to the webcast.

Mr. Timmins told commissioners the impact of fees on the gross cumulative 1.64% return of the hedge fund portfolio in the four years ended March 31 was 0.87%, which reduced the cumulative net return of the whole portfolio to 0.77%.

The return of the hedge fund portfolio is “pretty close to zero because so much of the return is being eaten up by fees,” Mr. Timmins said during the July 18 meeting.

“The entire proposal relates to the structural problem of the double layer of fees. The most effective way of addressing that is terminating all three managers and realizing the cost savings from the entire program,” Mr. Timmins said.

David Bradley, a commissioner and finance committee member, responded: “This is all a (revelation) about these unnecessary and excessive fees. ... Where were your concerns five years ago when the recommendations came for the full board to enter into manager-of-managers relationships and to select five managers ?”

Mr. Timmins said “any investment program evolves” in response to market conditions and for hedge funds, returns have fallen “significantly” in recent years. “When you pay very high fees, you need to get very high returns. We are in a world where fees are not effectively related to the returns you are realizing.”

During the July 18 finance committee meeting, Robert L. Craig, vice chair and a finance committee member, interjected a calming influence by presenting a fourth scenario: Terminate K2 Advisors and negotiate for lower fees, better terms and clarified responsibilities with the four remaining funds of funds.

Mr. Craig said in an interview that he had been talking to other education commissioners during the three months between meetings and got “the idea from them that this approach would be more palatable. It became apparent that terminating K2 was the correct thing to do, since both staff and the consultant NEPC recommended this. But we all asked why we were suddenly going from five firms to two.”

Mr. Craig said he was confident that Blackstone, Grosvenor, GAM and Mesirow all would respond with lower fee proposals “in order to keep our business.”

The finance committee approved Mr. Craig's motion to terminate K2 Advisors effective immediately, and divide its assets between Blackstone and Grosvenor, with the exact amounts to be determined by staff. The committee also approved a proposal to negotiate reduced fees and clarify contract terms and responsibilities with each of the four remaining hedge funds-of-funds managers and extend the contracts with Blackstone, Grosvenor and Mesirow past their Aug. 31 expiration date to allow sufficient time for negotiation.

Renee Soto, a K2 spokeswoman, declined to comment about the firm's termination.