Hedge funds of funds are competing with consultants

Updated with correction

Hedge funds-of-funds managers are turning the tables on investment consulting firms that have been poaching their institutional clients.

As asset owners allocated fewer dollars to hedge funds of funds over the past few years, many consultants successfully convinced their clients to invest in the consulting firms' own commingled vehicles, instead of with external funds of funds.

Now, officials at the large institutionally oriented funds-of-funds managers increasingly are pushing back, offering free services — typically found in an investment consulting relationship — to their biggest clients. Those services include:

• performance measurement and monitoring;
• rebalancing customized performance and portfolio attribution analysis;
• initial and ongoing investment strategy/operational due diligence;
• manager sourcing; and
• fee, contract and terms negotiations with managers.

Key to providing the free services is the fund-of-funds manager retaining a substantial discretionary portfolio, generally $200 million or more, industry observers said.

But there are limits. Most funds-of-funds executives stressed they have no intention of offering pure investment consulting such as asset-liability studies, overall portfolio construction and asset allocation calculations.

Texas Permanent School Fund, Austin, established strategic partnerships with two of its three hedge funds-of-funds managers - Blackstone Alternative Asset Management and Grosvenor Capital Management LP - in November 2012, according to records of finance committee meetings of the Texas State Board of Education, which oversees investment of the $30.2 billion educational fund.

PSF's investment department uses many of the high-end consulting services BAAM and GCM make available to them, and the level of customization is at the more extreme end among institutional investors. In-house staffers manage direct hedge fund investment portfolios side-by-side with portfolio managers from each company.

The goal is to eventually move hedge fund portfolios in-house after a protracted period of education, training and knowledge transfer, Holland Timmins, PSF's executive administrator and chief investment officer, has told finance committee members.

Mr. Timmins was out of the office and unavailable for comment.

Such close collaboration is possible because of the size of the portfolios each firm manages or co-manages. As of June 30, BAAM had a total of $1.3 billion and GCM $1.4 billion from the Texas fund.

Hedge funds-of-funds executives say the driver behind sharing the internal expertise, infrastructure and investment culture they have built over the years is a natural evolution of the deepening relationships between managers and investors.

“I view this phenomenon as positive. Providing our investors with more services and support is part of building strategic, collaborative partnerships,” said J. Scott Perkins, executive managing director, Lighthouse Partners LLC, Palm Beach Gardens, Fla. Lighthouse Partners managed $8.2 billion in hedge funds-of-funds strategies as of Oct. 31.

“Now that hedge funds-of-funds (managers) are feeling competitive pressure from investment consultants, they are performing more and more of the duties of a consultant,” said Greg T. Fedorinchik, senior managing director and head of the global client relationship team at Mesirow Advanced Strategies, Chicago, which managed $13.8 billion as of Oct. 31 in hedge funds-of-funds strategies.

Consultants agreed with Mr. Fedorinchik, and view the motivation behind the expansion of hedge funds-of-funds services as business survival.

“I think these arrangements are a great example of how hedge funds-of-funds managers are doing everything they can to preserve their most-favored-nation status and their asset bases,” said James C. McKee, senior vice president and director of the hedge fund research group at consultant Callan Associates Inc., San Francisco.

“I do think it's all about competition,” agreed Susan N. McDermott, Chicago-based partner and CIO-institutional advisory at investment consultant Pavilion Advisory Group Inc. “Everyone is literally getting into each other's business by way of expansion.”

Industry heavyweights Blackstone, A&Q Hedge Fund Solutions and Grosvenor, each with long-established funds-of-funds businesses and hefty assets under management, dominate this high-touch niche, sources said.

Blackstone's hedge fund solutions business, launched in 2000, is far ahead of any value-added service of its competitors, said observers. BAAM had $65 billion under management as of Sept. 30 in a wide variety of discretionary investment strategies.

“We were an early adopter and it grew out of our focus on being strategic partners with our investors,” said Brian Gavin, senior managing director and BAAM's chief operating officer. “Solutions work is not a business for us; it's part of our strategy for discretionary investment clients as they move through the hedge fund investing life cycle.”

At the request of clients, BAAM will assist with every phase of that cycle, especially in the transitions between commingled fund and customized separate account management and between creating direct investment portfolios and setting up internal hedge fund investment teams, Mr. Gavin said.

“Whether you call it partnering, solutions or outsourcing, what we do is assist our discretionary investors in managing their hedge fund portfolios the way they want to,” said William Ferri, managing director and global head of A&Q, New York. A&Q, a subsidiary of UBS Global Asset Management, managed $22.6 billion in hedge funds-of-funds strategies as of Oct. 31.

Chief investment officers or hedge fund specialists working for sophisticated institutional investors often know how and what they want to invest in — “very specific needs, not cookie-cutter stuff” — but “don't have the global resources to comprehensively manage a hedge fund portfolio. We have those resources and our investors can tap into them,” Mr. Ferri said.

Chicago-based Grosvenor offers a suite of solutions for asset owners investing through the firm's discretionary hedge fund allocation strategies, often consolidating direct and fund-of-funds portfolios, regardless of what companies manage them, on the firm's investment platform.

“Clients' portfolios get a lot of lift from residing on Grosvenor's platform because of the risk management, due diligence, performance reporting and measurement systems. It's a high value-added benefit,” said Michael J. Sacks, chairman and CEO.

Grosvenor managed $27 billion in hedge fund allocations as of June 30.

“I don't look at hedge funds of funds any differently than I do other large money managers that are seeking to create strategic partnerships with their investors,” said an executive of an investment consulting firm who asked not to be identified. “Hedge funds-of-funds companies like Grosvenor, Blackstone and others do have the depth of experience to offer sophisticated institutional investment teams advice and additional services beyond money discretionary management,” the source said.

“These arrangements are the natural outgrowth of relationships between the manager and the investor, as the investor gains more experience and expertise with hedge fund investment.”

Other managers among the top cadre of institutional hedge funds-of-funds firms also offer value-added services to investors with customized fund-of-funds mandates, but that assistance tends to be clustered on the investment side, rather than on the broad portfolio assistance offered by the largest managers. Examples include portfolio and performance analysis, manager sourcing for direct hedge fund investment portfolios, scenario analysis and due diligence, observers said.

Besides Lighthouse Partners and Mesirow Advanced Strategies, other firms offering extended services to investors include Aetos Alternatives Management LLC, Aurora Investment Management LLC, Corbin Capital Partners LP, EnTrust Capital Management LP, Goldman Sachs Asset Management, Permal Group and The Rock Creek GroupRock Creek Group LP.

Mesirow made a “strategic decision” about 18 months ago “not to get into the consulting/advisory business,” Mr. Fedorinchik said, as well as to retain control of its analysis tool kit. “Internally, we offer a very specific set of investment and operational processes that we can and do make available to our clients, but that doesn't include advisory services,” he said.

And rather than “give clients access to our portfolio construction and analysis tools, we will perform custom analysis for them. These tools provide Mesirow with a huge competitive advantage, so we do stop short of letting them out of the house,” Mr. Fedorinchik said. n