Hedge funds-of-funds managers turn to customized investments

Updated with correction.

Top-tier hedge funds-of-funds managers are expanding their relationships with underlying hedge fund managers, morphing into active investors of institutional investor assets from mere allocators of those assets.

To improve returns and their relevance to asset owners, the largest, most institutional hedge funds-of-funds firms have ramped up their efforts to develop proprietary, customized investment vehicles in addition to investing in flagship hedge fund strategies.

That's a recent change for most of these firms, sparked primarily by significant institutional interest in high-performing opportunistic investments that don't fit easily into the traditional, fairly liquid flagship hedge fund template. In order to capitalize on less liquid investment opportunities, hedge funds-of-funds providers had to custom-build suitable vehicles.

“We call it active management. We're using hedge fund strategies in a different way to capture the desired outcome. We ask the underlying manager to manage our investment idea or one that they bring to us outside of their flagship fund vehicles,” said Von Hughes, managing director, Pacific Alternative Asset Management LLC, Irvine, Calif. PAAMCO managed $9.5 billion in hedge funds-of-funds strategies as of April 1.

Other hedge funds-of-funds firms that are pressing their underlying hedge fund managers into running custom strategies for them include A&Q, a subsidiary of UBS Asset Management; Aurora Investment Management LLC; Blackstone Alternative Asset Management; Corbin Capital Partners LP; Grosvenor Capital Management LP; KKR Prisma; Mesirow Advanced Strategies Inc.; Morgan Stanley Alternative Investment Partners; and Permal Group.

The investment strategies that hedge fund firms are running for these funds-of-funds managers are extremely diverse, including co-investment opportunities, single-security investments, highly concentrated portfolios, thematic strategies and portfolios of illiquid securities that often feature a lockup period more typical of private equity funds than hedge funds.

Managers said they use these proprietary investments in their own flagship hedge funds of funds, in portfolios of hedge fund managers customized to meet clients' specific needs and sometimes as stand-alone, single-strategy investment funds.

Adding customization at the investment strategy level, in addition to the portfolio level, has been made much easier in the past few years by the wide-scale move by hedge fund managers to offer strategies in a separate account format in addition to commingled funds.

“Ten years ago, customization would have been a big deal, very complicated since most hedge funds only were available as pooled funds,” said PAAMCO's Mr. Hughes. “But with separate accounts becoming so ubiquitous, it's much easier for hedge fund managers to offer just a sliver of their multistrategy approach in a customized fund for larger investments,” he added.

“In general, firms can no longer be a mere allocator to hedge funds. You must be creative and active investors to drive the value proposition for clients,” said Jon R. Levin, managing director, Grosvenor Capital Management, Chicago.

Grosvenor has dramatically increased the percentage of assets it invests in a customized manner with underlying managers to approximately 75% of the $27 billion the firm managed as of March 31, from less than 10% in 2008, Mr. Levin said.

The largest hedge fund solutions provider is Blackstone Alternative Asset Management, New York, which began customizing underlying hedge fund investments 10 years ago, said J. Tomilson Hill, vice chairman of The Blackstone Group and CEO of Blackstone Alternative Asset Management, both in New York.

“We decided ... that we could not be just an allocator to hedge funds. We had to create our own capacity by working with our existing managers to create new investment strategies,” Mr. Hill said.

One such strategy, launched in 2011, aggregates special opportunity investments into a single sleeve. It has attracted about $7 billion from institutional investors.

About 66% of the $65.8 billion BAAM managed in hedge funds of funds as of March 31 was managed in customized approaches.

“The practice of offering commingled hedge funds of funds featuring name-brand hedge fund managers is dead and buried. You're not coming to us to invest in huge hedge funds that you can access yourself a dozen different ways,” said Shane Clifford, Permal Group's New York-based executive vice president and head of global business development.

Permal Group managed $22 billion in hedge funds-of-funds strategies as of March 31.

Hedge funds-of-funds executives acknowledged they had to change their investment model to stay relevant to asset owners. But they also said they did so to exploit the excellent — and often less liquid, more esoteric — investment opportunities that continue to roll out after the financial maelstrom.

“The best investment opportunities are liquidity-driven and they are found between the seams between traditional investments (including hedge funds) and private equity,” said Jarrod Quigley, managing director and a portfolio manager in the hedge funds-of-funds unit of Morgan Stanley Alternative Investment Partners, New York.

Morgan Stanley AIP had $21 billion invested or under advisement in hedge funds-of-funds strategies as of March 31.

“There is significant institutional interest in opportunistic strategies, but most require longer-dated vehicles to come to fruition. So hybrid structures that combine hedge fund management with the longer lockup characteristics of private equity funds are needed to capitalize on the investment,” said Tom Macina, CEO of Mesirow Advanced Strategies.

Chicago-based MAS managed $14.1 billion in hedge funds-of-funds strategies as of March 31, about 60% of which was in customized funds.

Corbin Capital Partners, New York, set up a dedicated, diversified credit strategy in 2008 to take advantage of “on-the-run opportunities” such as corporate credit, residential mortgage-backed securities, collateralized loan obligations and European recovery trades, said John H. Cocke, partner and director of special investments.

Recently, Corbin Capital has been “getting into areas that had been dominated by banks” prior to regulatory-required deleveraging, such as real estate acquisition financing, Mr. Cocke said.

“In this market with its low future yield projections, we have to work very hard to find return sources for our clients,” Mr. Cocke said. “A big advantage for us is having experienced capital markets professionals reviewing these deals. That's the real differentiator between an investor and an allocator.”

Corbin managed $5 billion in hedge funds-of-funds strategies as of March 31.

New York-based KKR Prisma started customizing hedge fund strategies about 18 months ago as its internal portfolio managers began to pursue “idiosyncratic opportunities,” said Girish Reddy, co-founder.

Internal portfolio managers found their underlying managers to be amenable to the idea of customization because “hedge fund managers feel like they aren't using all of their intellectual capital and taking action on their best ideas because they are constrained by the investment guidelines of their flagship strategies,” Mr. Reddy said.

Among the eight customized strategies KKR Prisma has created is a basket of strategies with a tilt toward interest-only subprime mortgage securities; a focused portfolio of private student loans; a thematic portfolio focused on Argentinean debt; and a play on the dislocated Chinese convertible bond market.