Co-investing entering new arena: Hedge funds

Institutional investors increasingly are translating co-investment experience in private equity, real estate, infrastructure and energy funds to their hedge fund portfolios.

Co-investment with hedge fund managers is growing, if a bit slowly, especially with credit and activist equity managers as institutions become more comfortable with an even more direct type of hedge fund investing.

Appetite is growing: 52% overall of investors surveyed by J.P. Morgan Capital Introduction Group for its 2014 Institutional Investors Survey said they were willing to participate in hedge fund co-investments.

A breakdown of respondents showed 74% of endowments and foundations would co-invest with hedge funds, followed by 68% of consultants; pension funds, 60%; family offices, 59%; and insurance companies and hedge funds of funds, both 46%.

Despite this professed interest, the overall pace of pension funds, endowments, foundations and sovereign wealth funds in hedge fund co-investments has been a tad slow, sources said.

“This is a good investment space, but there are a significant percentage of institutional investors that are too boxy to be comfortable with co-investing,” said Stephen L. Nesbitt, CEO of alternative investment consultant Cliffwater LLC, Marina del Rey, Calif.

“You have to be flexible to take advantage of co-investing because it does fall into the cracks between asset classes,” Mr. Nesbitt added.

“The interest level in co-investments is about the same as a year ago, but the difference is that institutional investors had a desire to see co-investment ideas but not to invest,” said Richard d'Albert, principal, co-chief investment officer and portfolio manager at credit specialist hedge fund manager Seer Capital Management LP, New York.

“The credibility factor has risen and now the conversations are turning more often to investment,” Mr. d'Albert said.

Seer Capital has set up co-investment vehicles with a handful of larger clients, Mr. d'Albert said, noting the firm's hedge funds “get first dibs on any of our investment ideas, but sometimes we do run across an outsized opportunity that has great potential, but is too big to accommodate in our funds.”

Seer Capital managed $2.2 billion in structured credit hedge fund approaches as of June 30.

Hedge fund managers offering occasional one-off co-investment opportunities or permanent, dedicated co-investment funds are grouped within event-driven equity and fixed-income approaches, as well as specialists who invest in structured products, lending, mortgage- and asset-backed securities and more esoteric credit investments, such as Iceland bank debt.

In addition to Seer Capital, among those managers attracting institutional investor interest in their co-investment funds are JANA Partners LP, Pine River Capital Management LP, Solus Alternative Asset Management LP, Starboard Value LP and Taconic Capital Advisors LP.

One reason for the slow buildup in hedge fund co-investment is the relative newness of the niche. Institutions have been co-investing with private equity and real estate managers for more than two decades. But hedge fund managers, for the most part, only shifted to co-investment since the 2008 financial crisis.

Before the crisis, hedge fund managers routinely segregated less liquid assets in separate “side-pocket” funds they ran alongside their flagship commingled funds. The crisis made it extremely difficult to divest those illiquid investments and, rather than sell assets at fire sale prices, hedge fund managers shut redemption gates, locking up investor assets for years.

Mr. Nesbitt said hedge fund managers have begun to recapture the institutional market by repackaging their best, most concentrated investment ideas into vehicles with “much better terms,” including lower fees, lower carry, fees charged only on invested capital and “very attractive performance.”

“Performance comparison of the hedge fund co-investment niche is impossible,” said Jon Hansen, managing director-hedge funds for C/A Capital Management, Boston, the investment outsourcing money management subsidiary of consultant Cambridge Associates LLC.

“There's no way to give a range of returns for hedge fund co-investments because performance is so dependent on unique, individual underlying deals,” Mr. Hansen said.

But the returns of individual co-investments, rarely revealed publicly by hedge fund managers or their large investors, will propel more institutions to seek a place in the investment queue, sources predicted.

“Hedge fund co-investment will evolve from the minority sport that it is today into a defining feature of risk capital markets in the future,” wrote Simon Ruddick, CEO and managing director of alternative investment consultant Albourne Partners Ltd., London, in an e-mail.

“Hedge fund co-investments embody the nimbleness and flexibility required to give hedge fund managers, and their investors, an essential edge in the ever more competitive quest for alpha. We see hedge fund co-investment as a core component of a larger phenomenon: customized investments,” Mr. Ruddick wrote.

One early example of the type of customization institutional investors are doing with their hedge fund managers is the New Jersey Division of Investment's $300 million investment in February with credit hedge fund manager Solus Alternative Asset Management.

The investment division, based in Trenton, manages investments for the $78.6 billion New Jersey Pension Fund.

Solus' credit mandate specifies flexibility, allowing the firm to invest up to two-thirds of the allocation in its flagship opportunistic event-driven and special situations credit strategy and up to two-thirds in “recovery-like opportunities, including ... high-conviction co-investment opportunities,” according to a report from Christopher McDonough, director of investments, at the Feb. 3 State Investment Council meeting. The council advises the investment division on pension fund management.

Mr. McDonough was unavailable to comment about the division's rationale behind the Solus investment, said Christopher J. Santarelli, a spokesman for the New Jersey Treasury Department, which oversees the Division of Investment.

The Solus investment was not New Jersey's first to a hedge fund co-investment. In May 2013, JANA Partners was awarded $100 million for investment in its flagship Strategic Investments Fund, which invests about 30% of its assets in shareholder activist opportunities. New Jersey also committed $200 million to co-investing with JANA in activist shareholder deals.