Fund-of-funds firms continue spiral of asset declines

Updated with correction

Hedge funds-of-funds managers are, in the main, losing the battle to hold onto their assets, although a cadre of firms still is thriving.

The one-year asset declines amounted to an 8% drop in the aggregate assets — $405.7 billion as of June 30 — compared to the prior year for the 53 firms running at least $1 billion in hedge funds of funds that responded to Pensions & Investments' 2012 survey. Far worse, aggregate assets declined 42% — fully $294 billion — in the four years ended June 30 following the financial crisis of 2008-2009.

Blackstone Alternative Asset Management was the largest hedge funds-of-funds manager in P&I's 2012 ranking, with $41.4 billion as of June 30, followed by UBS Global Asset Management Alternative and Quantitative Investments, $25.6 billion, and Goldman Sachs Asset Management, $22.5 billion.

While Blackstone and Goldman Sachs showed gains of 11.3% and 10.3%, respectively, for the year, the three firms with the largest percentage asset increases were:

• Aetos Alternatives Management LLC, up 42.9% to $8.7 billion;
• Strategic Investment Group LP, up 30.7% to $3.9 billion; and
• Morgan Stanley Investment Management, up 29.9% to $11.9 billion.

The three biggest percentage declines for the year ended June 30 were suffered by:

• Man Group PLC, down 26.6% to $10.3 billion;
• Attalus Capital LP, down 49.9% to $1.1 billion; and
• Neuberger Berman Asset Management LLC, down 29.9% to $2.8 billion.

UBS Global Asset Management A&Q suffered a 17.1% loss, but retained its second place ranking in 2012.

Overall, 64% of the 53 hedge funds-of-funds managers in P&I's universe had asset declines for the 12 months ended June 30. Over the four-year period, 55% of the universe experienced asset drops but individual company losses were far more severe than in the one-year time frame.

The biggest declines in assets since the 2008 financial crisis were:

• Man Group, with a 77.3% drop;
• GAM, down 75% to $6.2 billion; and
• PineBridge Investments, down 68.8% to $3.1 billion.

Among that small group that thrived while their brethren suffered over the past four years were:

• EnTrust, up 79%, up to $7.5 billion;
• Prisma Capital Partners LP, up 55.7% to $7.8 billion; and
• The Rock Creek Group LLC, up 50% to $7.5 billion.

The massive asset declines in funds of funds following the 2008 financial meltdown were the result of a redemption double-whammy: high-net-worth clients, bank private clients and other retail investors pulling assets very soon after the crash followed by institutional investors that moved their assets into single or multistrategy hedge funds, according to P&I analysis and industry sources (P&I, Sept. 19, 2011).

Performance of many hedge funds of funds has not met expectations, observers said, eroded to a great extent by the extra layer of management and performance fees charged by hedge funds-of-funds managers on top of those levied by the underlying hedge funds in the portfolio. The impact of fees on returns convinced many institutions to look to direct hedge fund investment.

The $48.8 billion Massachusetts Pension Reserves Investment Management Board, Boston, for example, began dismantling its $3.5 billion hedge funds-of-funds portfolio last October and in April, accelerated the process by upping the target for direct investments in hedge funds to $4.2 billion from $1.5 billion and lowering the allocation to funds-of-funds firms to $750 million. Four of five hedge funds-of-funds managers will be terminated by July 2013 and direct investments in new hedge funds continue apace.

Holland Timmins, chief investment officer and executive administrator of the $24.4 billion Texas Permanent School Fund, Austin, is trying to move to strategic partnerships for hedge fund management from funds of funds to reduce fees and improve performance of the fund's $2.5 billion hedge fund allocation. The plan is for staff to learn from hedge funds-of-funds managers how to build internal portfolios of direct investments in hedge funds (P&I, Aug. 6).

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 portfolio to 0.77%, Mr. Timmins told the finance committee of the school fund at a July 18 meeting.

Over time, Mr. Timmins projected cost savings of $6.4 million in the first year and a total of $34.6 million over five years by eliminating the second layer of hedge funds-of-funds' fees.

In fact, the two existing hedge funds-of-funds managers that Mr. Timmins originally hoped to retain as strategic partners — Grosvenor Capital Management LP and Blackstone Alternative Asset Management - are among the very institutionally oriented firms that are offering institutional investors highly customized fund management through separate accounts.

“The new business being won in the institutional arena by hedge funds of funds is in separate accounts, not commingled funds,” said Jim McKee, director of hedge fund research, Callan Associates Inc., San Francisco.

Mr. McKee said the move to separate accounts was “not surprising after what happened in 2008 when co-investor risk became a huge issue.” Many institutional investors, by being slower after the crash to request redemptions than other, more trigger-happy investors, ended up stuck in a fund of funds that stopped giving investors their money back because some securities in their funds had become so illiquid.

By moving to separate accounts, Mr. McKee said, institutional investors went from “renting to buying at the same price” because they now are invested directly in the same hedge funds as they were through a fund of funds but with much more control over the liquidity terms and investment approach without an increase in fees.

However, Mr. McKee said it isn't easy to get hedge funds-of-funds managers to lower their fees — not just keep them static — even for large, new separate or commingled fund allocations. That's because funds-of-funds managers tend to rigidly honor “most-favored-nation” guarantees made to earlier clients. Funds-of-funds managers maintain that all clients have to pay the same fees for the same strategy, in essence, Mr. McKee said, noting “there's a bid-ask spread problem in the hedge funds-of-funds industry. Institutional investors are unwilling to pay the offer price and hedge funds-of-funds managers are unwilling to meet the bid.”

He added the impasse is ”very frustrating for me as a consultant.”

On the other hand, J. Tomilson Hill, New York-based Blackstone Alternative Asset Management's CEO and president, is not frustrated by his firm's growth overall and in particular, in establishing new strategic partnerships with larger institutional investors.

“You can't retain or win new assets without generating absolute and relative returns, but there is a great deal more we can do to help a large institutional investor figure out what they want and what they need. Once we assist with that process, we find a way to deliver those services in a cost-effective way,” Mr. Hill said.

With over 200 employees and a disciplined approach to delivering client service, Blackstone's customized solution might include running narrower sleeves of an existing investment strategy; providingintense client education; using the firm's size to persuade hedge fund managers to create investment strategies to capitalize on unique investment opportunities; or providing top-down macroeconomic views to assist investors with managing their overall portfolios.

Prisma Capital Partners , New York, has offered customized hedge funds of funds and separate accounts since it opened in 2004, said Girish V. Reddy, co-founder and CEO. “Customized portfolios have become `normal' but they always have been normal for Prisma,” Mr. Reddy said, noting 65% of the firm's assets under management are in these kinds of arrangements.

Other factors that Mr. Reddy said have helped Prisma grow its institutional client base include investment in “smaller, specialist hedge fund managers instead of larger managers that most of our clients could invest in directly.”

Rock Creek Group, Washington, also has managed customized hedge funds-of-funds portfolios for institutional investors since its launch in 2003, with 70% of assets now invested in special arrangement vehicles, said Afsaneh Beschloss, CEO and chief investment officer.

Ms. Beschloss and a number of her staff started managing hedge fund portfolios for the World Bank's investment pools, including the $14.9 billion defined benefit plan, in the 1980s and “that long history of investment has proven attractive to many new clients, especially since we use the same centralized process we did at the World Bank.”

Outside the small faction of hedge funds-of-funds companies that have maintained growth over time, the “big institutional mandates, $50 million or $100 million or larger that might once have been invested in some of the former `brand name, premium label' funds-of-funds firms, now are being directed to those managers willing to offer separate accounts and other custom services,” Callan's Mr. McKee said.

Mr. Hill said Blackstone Alternatives Asset Management intended to attract institutional investors from inception, but observed that many other hedge funds-of-funds companies “started as high-net-worth shops that catered to friends and family but gradually began to target institutions. This worked for a time, but a lot of these firms' executive teams got very complacent. They had AUM, their business was a cash cow (and) was not predicated on innovation, so they didn't build up their investment teams, add infrastructure or adapt to new conditions.”

Firms in this situation are among those that already have gone out of business or are looking for a buyer, sources said. In the year ended June 30, PerTrac, a specialist hedge fund software provider, found that 3.81% fewer hedge funds of funds reported their performance and assets to various industry databases than the previous year, a sign of the ill health of the industry.

EIM Group, which managed $13 billion as of June 30, 2008, and $5 billion as of June 30 this year reportedly has sought a buyer for more than a year without any luck. EIM had significant exposure to the Madoff Ponzi scheme, which sources said caused many clients to redeem investments.

Union Bancaire Privee Asset Management LLC experienced decimating asset declines after its investments in Madoff funds were revealed. UBP was the largest manager in P&I's annual ranking for the year ended June 30, 2008, with $57 billion under management in hedge funds of funds. As of June 30, 2012, UBP-Nexar, as it now is known after acquiring Nexar Capital LLC earlier this year, managed $12.2 billion, which includes about $3 billion of Nexar hedge funds of funds.

In 2009, quite soon after the financial crisis, Crestline Capital LLC, for example, acquired $2.2 billion of hedge funds-of-funds assets from Northwater Capital Management Inc. As of June 30, 2008, Northwater's assets totaled $4.5 billion.

In March of this year, Crestline also acquired investment contacts totaling $300 million from Lyster Watson & Co. (P&I, March 26). Neither Northwater nor Lyster Watson remained in the hedge funds-of-funds business.