Strategic partnership is New Jersey Division of Investment's newest move

In two years, Timothy M. Walsh has taken the New Jersey Division of Investment to the third phase of its hedge fund investment evolution: a true strategic partnership with one of its first hedge fund managers.

Only a few institutional investors have similar, collaborative relationships with hedge fund managers. New Jersey goes one step further, allowing a look earlier this month into the nature of the relationship and the attractive terms struck with Och-Ziff Capital Management Group LLC.

Mr. Walsh, who is director of the division and chief investment officer of the $69.9 billion New Jersey state pension system, which the Trenton-based division oversees, has brokered a new relationship with Och-Ziff that extends the range of investment possibilities well beyond the division's original multistrategy hedge fund investment into the realm of specialized, customized strategies.

Sources say a strategic partnership with a trusted manager is a natural step for an investment department that oversees a 6-year-old hedge fund portfolio that totals about $6.2 billion, making it one of the largest institutional pools worldwide.

Unlike other large public pension plans, New Jersey began investing in hedge funds 6½ years ago, with $300 million in direct investments divided among four managers, including an initial $50 million in Och-Ziff's flagship multistrategy fund. But for a number of years, the division invested significant amounts through hedge funds of funds in what industry observers characterized as the first step on the evolutionary track of hedge fund investing by institutional investors.

During Mr. Walsh's two-year tenure, hedge fund assets have nearly doubled to about 8.9% of plan assets, up from a 5.1% allocation of $3.4 billion as of June 30, 2010.

Along the way, the New Jersey hedge fund portfolio has been steadily expanded with the addition of 13 new direct investments in single and multistrategy hedge funds during the second step of the typical hedge fund investing path.

As of May 31, the most recent data available, direct investments in single and multistrategy hedge funds constituted 67% of the portfolio, up from 58% as of June 2010.

The 2012 portfolio now is invested in 34 single and multistrategy funds, with the balance invested in five hedge funds of funds. In June 2010, the portfolio was invested in 21 separate hedge funds and five hedge funds of funds. New Jersey's upper limit on hedge fund investment is 15%, although the current target allocation is 12.5%.

A big part Mr. Walsh's motivation in this third stage of hedge fund investment is a quest for lower costs.

“In a zero percent cash-return environment, without a preferred return (performance hurdle), it's hard to justify fees of 2% (management fee) and 20% (performance fee) ... We've had some success negotiating lower fees but not as much as we would like,” Mr. Walsh said in an interview.

The hedge fund portfolio is outperforming its benchmark. For the fiscal year ended June 30, 2010, the return was 9.8%; the benchmark — the HFRI Fund of Funds Composite index — returned 4.68%.

For the year ended June 30, 2011, the portfolio returned 10.68%; the index, 6.68%. And for the fiscal year through May 31, the portfolio returned 5.42% vs. -4.07% for the index.

Sources said Mr. Walsh's efforts to tap new, more opportunistic and diverse hedge fund and funds-of-funds strategies have been game-changing, but more time is needed before a difference will be seen in terms of returns and risk control.

Mr. Walsh and his investment team have been careful to explain every new investment they intend to make with external managers to members of the New Jersey State Investment Council, which advises the division on investment policy. The council receives reports at every meeting that provide a glimpse into the inner workings of an increasingly sophisticated state pension investment department, sources say.

At the most recent meeting on Aug. 2, the division informed council members that $850 million had been committed to hedge funds. The least complicated investments described at the meeting were commitments of up to $150 million in MKP Opportunity Partners LP, a global macro fund managed by MKP Capital Management LLC, and up to $200 million to Dyal Capital Partners Fund, which buys minority stakes in established hedge fund managers.

Additional commitments of $250 million each were made to existing hedge funds-of-funds managers Arden Asset Management LLC, which now manages a total of $500 million, and Rock Creek Group, which now manages $750 million.

But these new Arden and Rock Creek commitments will be invested differently than a typical hedge fund-of-funds strategy. They will “allow the division to take advantage of unique investment opportunities. For example, the division had a first look at a portfolio of investments that Arden and Rock Creek are liquidating for a large state plan. The additional capital would allow the division to "cherry pick' the highest quality managers from the group,” according to Mr. Walsh's memo for the Aug. 2 meeting.

The Och-Ziff strategic partnership that Mr. Walsh presented to the council in August represents an expansion beyond the company's flagship hedge fund strategy, OZ Domestic Partners II Ltd. (See Mr. Walsh's memo to trustees.) (New Jersey's investment in that fund is being reduced by $100 million to $113 million to partially finance the new strategies.)

In 2010, the division expanded Och-Ziff's investment duties to include a customized long-only structured credit separate account. The new strategic partnership committed an additional $200 million to that separate account, bringing its total to $825 million. And $200 million to $500 million was committed to a second bank loan fund separate account with Och-Ziff.

What's new for Och-Ziff is a $600 million commitment to three new long-only strategies: credit with a commitment of up to $400 million; real estate, up to $200 million; and real assets, up to $150 million.

Mr. Walsh noted in his council memo that the new investments will “continue to foster the close working relationship and increase the information sharing with the manager, thus enhancing staff's ability to make informed investment decisions when implementing the overall allocation plan.”

In the interview, Mr. Walsh said, “We really like managers to have a lot of skin in the game” through side-by-side investments in the same funds.

Och-Ziff and its general partners committed to invest up to $100 million in the new and existing long-only funds.

Further enhancing the alignment of terms for investing $1.2 billion in long-only separate accounts, Och-Ziff will charge the division a flat 75 basis points on invested capital and will not charge a fee for committed capital. A performance hurdle of 6% net of fees per year for each strategy means the pension system will not have to pay the fee unless the manager returns at least that much over the five-year investment period.

Further, the “netting of all investment returns across the separate accounts and payment of carried interest at the end of the investment terms should significantly reduce the likelihood of paying performance fees unless the overall separate account relationship is profitable,” Mr. Walsh wrote in his memo to the investment council.