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After more than five years of deliberation, the $115 billion New York City Retirement Systems finally took the plunge and began the process of investing in hedge funds. For its first step, in March 2011, three of the funds that make up the municipal system invested a combined $450 million in a separate account managed by New York–based fund-of-funds manager ­Permal Group.

The second step? Investing directly into single-­manager hedge funds with the assistance of the system’s hedge fund consultant, New York–based Aksia. Seema Hingorani, head of public equities and hedge funds at New York City’s Bureau of Asset ­Management who herself worked at hedge funds for several years and even ran her own fund, sees value in the two-­pronged approach. “Entering funds of funds first would get us invested in a critical mass of high-­quality hedge funds both quickly and efficiently, to start diversifying our overall portfolio while we built more of the back-­office internal infrastructure for our eventual direct program,” she says. At the same time, while the system’s investment professionals are confident they can make their own hedge fund investments, they wanted to access smaller, lesser-­known hedge funds, which Permal could help them find. Partnering with the fund-of-funds firm also is giving the pension system a leg up in terms of knowledge, expertise and intelligence on the sector.

So far the plan is working. Last year the Permal fund-of-funds portfolio lost 2.98 percent, net of fees — relative to the 4.26 percent decline in the InvestHedge composite index, that was not a bad result, especially given the tough market ­conditions.

Permal, which oversees $20 billion, stands at No. 6 in Institutional Investor’s annual Fund of Funds 50 ranking of the world’s largest funds-of-funds managers as ranked by assets under management as of January 3 (complete results can be found on ­institutionalinvestor.com). In total, the largest 50 funds-of-funds firms started the year with $503 billion under management, down from the $525 billion combined total of the top 50 at the beginning of 2011.

Permal’s unique partnership with New York’s retirement system is but one example of the way funds of funds have had to reinvent themselves since the financial crisis of 2008, when clients desperate for ­liquidity fled these firms in droves. ­Industry assets have shrunk by 42.6 percent since June 2008, when the top 50 funds-of-funds firms managed a combined $877 billion. A February 2012 Deutsche Bank study of the hedge fund industry found funds of funds experienced $7.2 billion in net outflows in 2011 alone.

To survive, firms have had to become more than just purveyors of one-size-fits-all, co-­mingled funds. These days the biggest funds of funds are focusing on institutional mandates, partnering with clients that want to go direct but still want an experienced fund-of-funds manager to guide their portfolio ­allocations.

If you want to succeed as a manager of managers in this environment, “you have got to be different,” says Robert ­Kaplan, CIO of Permal Group. “The days of being a passive hedge fund allocator are long gone. You have to offer insight, and you have to offer ­judgment.”

No. 1 on this year’s list, Blackstone ­Alternative Asset Management, is the New York–based hedge fund division of publicly traded alternative investment firm Blackstone Group. Just how important the funds-of-funds business has become to ­Blackstone Group’s bottom line is evident from the alternative investment firm’s 2011 annual report. ­Blackstone, which went public in 2007, noted that its hedge fund solutions business made $318 million in management fees and $12.2 million in performance fees in 2011.

Founded in 1990 originally to manage Blackstone partners’ own money, the asset management business started taking institutional investor money three years later. Having been an almost entirely ­institutional fund manager for most of its lifetime, ­Blackstone ­Alternative Asset ­Management is well situated to the new business climate. But even it has had to adapt.

“Thinking back to the conversations we were having with clients ten years ago,” recalls Gideon Berger, senior managing director and head of risk management for Blackstone’s hedge funds group, “investors would come to us and say, ‘Our consultant has recommended that we put our money in hedge funds; can you give us something really conservative, and while you’re at it, what is a hedge fund?’” Now, Berger says, most clients are much more sophisticated, and they often want something tailored to their needs — for example, a long-­only commodities strategy that will not be impacted negatively when commodities contracts roll over.

With $39 billion in assets under management, Blackstone is easily the largest allocator to hedge funds in the world. And the firm uses its size to its advantage, particularly when it comes to negotiating fees. Blackstone only rarely pays the customary full 2 percent management fee and 20 percent performance fee to any of its underlying hedge fund managers.

Peter Rigg, global head of the alternative investment group at HSBC in Geneva, agrees that the largest funds of funds are in a position to negotiate more-­attractive fee terms — a benefit that London-­based HSBC ­Alternative Investments, No. 2 in this year’s ranking, passes on to its clients. But Rigg also observes that his group will not pass up investing in a top manager if it cannot obtain a reduced fee. Top hedge fund managers still can hold the line on fees.

Another seismic shift in the industry since 2008 has been the change in geographic concentration of the power­houses. European firms once dominated the fund-of-funds industry for a simple reason: That is where the money was. The major investors in funds of funds were wealthy individuals, who often are based in ­Europe or invested through Swiss banks. In June 2008, HSBC was one of six European and U.K.-based funds-of-funds managers among the ten largest firms. Today it is the only top ten such firm with its main investment operation based outside the U.S.

A trend away from wealthy investors’ mandates has hit European and U.K. funds-of-funds firms particularly hard. Some of the best-known ­European and U.K.-based funds-of-funds managers — Union ­Bancaire Privée and Man Investments — were also investors with Bernard Madoff, the former Nasdaq chairman who, in December 2008, was found to have been running a massive Ponzi scheme.

Alternative and ­Quantitative Investments, No. 3 on this year’s list, is owned by a Swiss parent — in this case, UBS — and stands to benefit from the bank’s distribution. But like ­Blackstone, the UBS funds-of-funds business (which in fact operates out of New York) has always been primarily an institutional business, having originally been part of the Chicago-­based O’Connor platform.

Although European institutions are becoming a less dominant part of the fund-of-funds landscape, U.S. bank-­backed multimanager firms are on the rise, even as some U.S. banks have distanced themselves from some traditional hedge fund businesses, owing to regulatory issues and other concerns. Both Goldman Sachs and ­Morgan Stanley exited traditional hedge fund businesses in 2011 — ­Goldman shut down its Global Alpha hedge fund, and ­Morgan Stanley sold ­FrontPoint ­Partners — yet both banks appear increasingly committed to their funds-of-funds ­franchises.

Goldman Sachs Hedge Fund Strategies rises from No. 6 in 2011 to No. 4, with assets of $22.8 billion at year-end 2011. Kent Clark, co-COO of alternative investments and manager selection and CIO of hedge fund strategies, says a firm like Goldman can act as an extension of an institutional investor’s in-house investing ­operation.

“Many investors are resource constrained; they are looking for a partner to leverage what they know internally” and gain access to markets and capabilities they might not otherwise have, he says. With the bank’s global reach, Goldman can provide that. As client demands have evolved, the hedge fund business has become more resource intensive. Being part of a larger institution, “we have been able to add people, we have been able to add technology,” says Clark.

Morgan Stanley’s fund-of-funds business has a strong institutional heritage, thanks to its relationship with paper manufacturer Weyerhaeuser Co., whose pension plan was one of the first in the U.S. to invest in hedge funds. Morgan Stanley ­Alternative ­Investment Partners rises from No. 14 in 2011 to No. 10 on this year’s list, an ascent that has been aided by positive returns in its flagship fund.

Though theirs might be a more challenging route to success, some stand-­alone boutique firms are managing to hold their own. At No. 5, Chicago-­based Grosvenor ­Capital Management is one. Another is ­Irvine, California–based ­Pacific ­Alternative Asset Management Co., or Paamco, which stands at No. 8.

For much of the industry, what lies ahead is consolidation and contraction. In 2007, Chicago-­based hedge fund tracker Hedge Fund Research had almost 2,500 funds of funds in its universe; today that number stands at 2,000. That trend is expected to continue even if total assets under management pick up.

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