Merger shows that contraction isn't going away

The hedge funds-of-funds industry is contracting yet again with a merger of two big institutional players, a move that has some industry observers scratching their heads about the compatibility of the parties and wondering which firm will be next on the auction block.

Pacific Alternative Asset Management Co. LLC, Newport Beach, Calif., and KKR Prisma, New York, will combine in the second quarter to form a new hedge fund-of-funds firm, PAAMCO Prisma Holdings, with $20 billion of discretionary assets under management and $14 billion under advisement.

The new firm will be majority-owned by its employees and will operate independently from KKR & Co., New York. KKR acquired 100% of Prisma Capital Partners LP in 2012. KKR will retain a 39.9% stake in the new company.

Jane Buchan, PAAMCO's chief executive officer and co-founder, and Girish Reddy, a member of KKR, co-founder of KKR Prisma and head of KKR's hedge fund business, will become co-CEOs and co-chairpersons of the new firm.

The question of whether the PAAMCO-Prisma combination will thrive when past acquisitions and mergers in the industry have not is unlikely to deter hedge funds-of-funds executives looking for a lifeline.

“At the highest level, scale is of critical importance to hedge funds-of-funds managers,” said Jeffrey Levi, a principal at money manager adviser Casey Quirk, a practice of Deloitte Consulting LLP, Darien, Conn.

“Mergers are a way for companies to gain and share operational infrastructure, distribution networks and costs,” Mr. Levi said, stressing that he expects to see “a pretty big phase of consolidation” among hedge funds-of-funds managers and traditional money managers in the very near future.

“I think you'll see straight hedge funds-of-funds consolidation or shifting of capabilities by these managers to add more multiasset class capability, liability-driven investment, hedge fund alternative beta and outsourcing-like products,” said Mr. Levi.

As for the effectiveness of the PAAMCO-Prisma working relationship, industry observers as well as the co-CEOs of the new company stressed that the two firms are very different in their approach to investment strategy.

“We're going to keep the brands separate,” Ms. Buchan said in a joint interview with Mr. Reddy. “While we share similar intellectual cultures, our investment processes are quite different,” she added.

Each firm will continue to manage investments in their offices on opposite coasts. “We will combine the alpha engines of each firm and redistribute it” in different ways, Mr. Reddy said, adding that the two investment teams will collaborate to develop new investment strategies such as alternative beta.

Multiple industry sources were not particularly optimistic about the new firm's prospects for success.

Mergers are “all about the narrative, why this collaboration will be additive to each firm. But this narrative doesn't make sense,'' said James C. McKee, senior vice president and director of hedge fund research, Callan Associates Inc., San Francisco, referring to the new firm's dual investment operations.

KKR's Scott Nuttall, global head of capital and asset management, stressed in an email that the deal is about gaining scale in the hedge funds-of-funds industry.

“This is about bringing together two strong players with complementary capabilities and products to become a top-five player in the liquid alternatives space. We are proud of the work done by our team at KKR Prisma and believe this is a transformative step that will benefit clients,” Mr. Nuttall said in an email.

“We have every confidence in our compatibility. It's what brought us together and provides the foundation of a great partnership,” Mr. Reddy said in an email.

If history is any indicator, odds are stacked against guaranteed success for merged and/or acquired hedge funds-of-funds managers.

The ranks of hedge funds-of-funds managers has been steadily shrinking since the financial crisis, according to analysis of Pensions & Investments' survey data collected from these firms in the eight years ended June 30, 2016.

AUM in hedge funds of funds as of June 30, 2016, declined 33.6% to $417.9 billion from $629.6 billion as of the same date in 2008, according to P&I survey data.

The number of hedge funds-of-funds firms that responded to P&I surveys dropped to 44 in 2016, with 29 firms reporting more than $1 billion in hedge funds-of-funds assets. In 2008, there were 71 firms, with 62 managing at least $1 billion.

Of those 62 firms reporting in the 2008 survey — conducted not long before financial turmoil struck global markets — only 29 also returned the 2016 questionnaire (P&I, Sept. 19).

Analysis of the 2016 data of the 29 $1 billion-plus firms that that responded to both P&I surveys:

• Four acquired or took ownership stakes in a total of 11 hedge funds-of-funds managers over the eight-year span;
  
• Six managers sold ownership stakes before 2008;
  
• Five firms remained independent;
  
• Ten firms, all units of large multiasset managers, stayed in the hedge funds-of-funds business without making acquisitions, although half experienced significant asset declines; and
  
• Fourteen firms had positive asset growth, and 15 firms experienced declines over the eight-year period. (Some of the 29 surviving firms are in multiple categories.)

Of the 10 hedge funds-of-funds managers with double- or triple-digit growth of assets under management between 2008 and 2016, four firms are independent or units of large money managers that grew organically while the remaining six firms sold ownership stakes to other companies at some point in their history.

Among the 15 companies with double-digit AUM losses, five firms were acquirers; two were acquired or had a backer; two were independent; and 11 were units of large money managers, four of which were acquirers. (Some firms with AUM losses are in multiple categories.)

A number of the hedge funds-of-funds managers near the bottom of P&I's AUM gain-and-loss chart have been active acquirers but had trouble holding on to the acquired assets.

Hedge funds-of-funds assets managed by BNY Mellon Investment Management, New York, for example, declined a precipitous 83.9% to $2.9 billion in 2016, from $18.2 billion in 2008.

BNY Mellon Investment Management acquired hedge funds-of-funds managers Ivy Asset Management, with $15 billion in AUM, in 2000, and EACM Associates Capital Markets in 2004, with $4.5 billion under management.

Ivy began to see high client redemptions in 2006 after losses from soured investments in Amaranth Advisors LLC and again after 2008 when its association with Bernard L. Madoff Investment Securities LLC became known. BNY Mellon shuttered Ivy in 2010 after assets declined to $2.5 billion (P&I, April 5, 2010).

Benjamin Tanner, a BNY Mellon Investment Management spokes-man, declined to comment.

London-based Man Group PLC also had a steep 80.4% decline in hedge funds-of-funds assets over the eight-year period, despite bolstering its AUM with the acquisition of FRM Holdings in 2012 and Pine Grove Asset Management LLC in 2014.

As of June 30, 2008, the combined AUM of Man Group ($45.3 billion), FRM ($15.6 billion) and Pine Grove ($1 billion) totaled $60.9 billion. Man Group hedge funds-of-funds AUM on June 30, 2016, was $11.9 billion.

A Man Group spokeswoman declined to comment.

Legg Mason Inc., Baltimore, has been one of the most active acquirers of hedge funds-of-funds firms, beginning in 2005 with Permal Group, which brought in $20.5 billion.

In 2013, the Fauchier Partners acquisition brought in $6 billion. In 2016, Legg Mason merged Permal with EnTrust Capital, which managed $12 billion at the time.

Assets of the three hedge funds-of-funds firms totaled $26.3 billion as of June 30, 2016, down 45.1% from $48 billion as of the same date in 2008.

Gregg S. Hymowitz, EnTrustPermal's chairman and CEO, said in an interview that while the firm's core commingled multistrategy hedge funds of funds have decreased since the financial crisis, its co-investment hedge funds of funds have attracted $6 billion during the eight-year period from institutional investors.

“When Legg Mason acquired Permal Group in 2005, it was primarily a firm with a European high-net worth investor base, which saw some nice growth until the financial crisis. After that, they did a nice job transitioning that business to an institutionally focused one,” added Joseph A. Sullivan, Legg Mason's CEO, in an email.