In the summer of 2005, mutual fund manager David Baverez was soaring. The French-born stock picker, who had joined London-based Fidelity International a decade earlier as a banking analyst, was being heralded as one of the asset management firm’s rising young stars. Since May 2001, when he took charge of the Fidelity European Aggressive Fund, its portfolio had gained 34.2 percent, far outstripping its benchmark, the MSCI Europe index, which had fallen 7.1 percent during the same period.
Baverez’s success had attracted public attention — and big inflows of capital. The European Aggressive Fund had grown from a mere $30 million when he began investing the portfolio to more than $2.5 billion. The total pool under his watch had swollen to $6 billion. For a manager intent on pursuing a value-oriented, concentrated approach to investing, the sheer bulk of the billions he had to deploy made investing more difficult.
“I felt like the victim of my own success,” says the 39-year-old Parisian. “I really wanted to put performance back in front of asset gathering — but that is not Fidelity’s business model, and it was tough to ask them to change the model just for me.”
Baverez knew he could leave and set up an equity hedge fund, but he didn’t really want to alter his investment style. Rather than join the burgeoning ranks of newly minted long-short managers, he decided to follow his contrarian instincts and launch a new, nontraditional, long-only investment firm, KDA Capital, with the backing of one of London’s most powerful hedge fund managers, Christopher Hohn of the Children’s Investment Fund Management U.K., or TCI.
Hohn, 39, had cemented his reputation as a fearless shareholder activist by successfully challenging Deutsche Bšrse’s bid for the London Stock Exchange in 2005 and was willing to support Baverez’s new business. In exchange for a minority equity stake in KDA’s management company, TCI agreed to provide Baverez and his team — KDA co-founder Krishnan Sadasivam, a longtime Fidelity colleague; and two Fidelity analysts, Stephen Ikle and Stefan Lindblad — with administrative, back-office and client services. Hohn offered Baverez and Sadasivam everything they needed except seed capital to launch the firm’s flagship fund, the KDA Capital European Fund, in December 2005. (The firm’s name, KDA, stands for Krishnan, David and associates.)
Baverez is at the forefront of a powerful trend in the hedge fund industry: the creation of long-only hedge funds. Though such funds have existed for more than a decade, they have begun to proliferate in recent years. Several of the best-known hedge fund firms have launched long-only products, including Lone Pine Capital, Tudor Investment Corp., Maverick Capital and Cantillon Capital Management. As of March 2006, according to Chicago-based data provider Hedge Fund Research, assets managed in long-only funds totaled $53.8 billion — just a fraction of the estimated $1.2 trillion invested in hedge funds worldwide — but an increase of 57.8 percent since the end of 2003.
Are investors ready to assimilate these awkward, hard-to-classify funds into their portfolios? The answer may depend on the manager’s profile. When a renowned stock picker like Stephen Mandel Jr. of Lone Pine launches a long-only product, he can count on tapping into investors’ pent-up demand. When a manager like Baverez — young, relatively untested and without a marquee name — launches a long-only fund, he’s likely to have a harder time raising money. Investors are still single-mindedly focused on hedge funds, and Baverez, despite his exceptional track record at Fidelity, has had a tough time convincing them that his pricey, long-only business model makes sense. Investors are not accustomed to paying performance fees for long-only management. Baverez has $550 million under management, but that is still a far cry from the billions he ran at Fidelity.
Even TCI’s Hohn has been taken aback by the cool reception KDA has received from institutional clients, especially since KDA’s master fund has delivered a gross return of 22.98 percent from inception through the end of April, handily outstripping the MSCI Europe index by almost 10 percentage points.
“We’ve actually heard investors say that they would have given him money if only he’d called KDA a hedge fund,” Hohn says. “Never mind that David is probably better than your average hedge fund manager. But he has not taken on the correct marketing label, so he has sort of been put away and forgotten.”
From a structural standpoint, however, KDA is indistinguishable from a hedge fund. Clients have to ante up at least $10 million to invest, and the firm charges a 1.25 percent management fee and a 20 percent performance fee. The latter kicks in if KDA beats the MSCI Europe index and applies only to the amount over the return of the index.
Baverez concedes that the structure is costly for investors. During his tenure at Fidelity, the European Aggressive Fund delivered a net return above its benchmark of 10 percentage points a year. If KDA’s performance fee had applied to that fund’s performance, the net return to investors would have been 8 percentage points. But at KDA, Baverez argues, he will have an opportunity to outperform his benchmark by an even greater margin — and deliver higher total returns — because he has the freedom to put his fund in cash or hedge out some of his equity exposure by shorting the index with options if he’s feeling bearish.
A few institutions are starting to take a kinder view of the long-only approach. “There is tremendous alpha to be had from allocating money to nontraditional long-only managers,” says Omar Kodmani, head of international investment activities for Permal Investment Management Services, the London subsidiary of Permal Group. The New York–based fund of hedge funds, which has $25 billion in assets under management, uses long-only funds in its multistrategy products and launched Permal Global Multi-Long Holdings, its first dedicated fund of long-only hedge funds, in October 2005. The fund, which is not an investor in KDA, has $40 million in assets under management.
“What many investors seem to miss is that the hedge fund mentality can be very liberating for creative, long-only portfolio managers if they truly have an absolute-return orientation,” says Kodmani.
Baverez GREW UP in a household of lawyers. Both of his parents were attorneys in Paris, and Baverez traces the practice of law back through two generations of his father’s family and three generations of his mother’s. Although Baverez was never tempted to study law, he was fascinated by politics. But late in his teens he came to the conclusion that Europe’s future would be shaped more dramatically by market forces than by politics, so he chose to study business. He earned a BA in 1988 from the HEC School of Management in Paris.
At that time military service was compulsory in France, and young men could fulfill their enlistment requirement by spending one year in the army — or working 18 months for a French company overseas. Baverez opted to work in London for automaker Renault. “I thought my contribution to the country would be greater if I could sell some Renault cars to English people rather than trying to kill Russians,” he says. “But I am very bad at cars.”
After his tour of duty at Renault, Baverez joined Hambros Bank (now SG Hambros Bank & Trust). He moved to Germany in 1991 — after the Berlin Wall had come down — to work on privatizing companies in what had been East Germany. The excitement and intellectual thrill, he says, was unlike anything he had ever experienced. But Germany’s economic difficulties proved greater than anyone had anticipated, and Baverez moved back to London in 1992 to take a job working on mergers and acquisitions at Schroder Investment Management (now Schroders).
Two years later he left the firm to earn an MBA from France’s Insead. After graduation in 1995, he went to work for Fidelity International in London, starting as a European banking analyst. His experience working for Hambros in Berlin had fueled his appetite for exploring industries undergoing swift, massive strategic transformation. At the time, Italy, Portugal and Spain were lowering their long-term interest rates from about 10 percent to 5 percent, and as a consequence, he says, “bank stocks were just on fire.”
In 1997, he switched to the telecommunications sector. Across Europe many formerly state-owned telecom companies were being privatized, and Baverez enjoyed the challenge of focusing on a highly politicized industry undergoing massive realignment. By 1999 Baverez was overseeing Fidelity’s global telecom portfolio.
One of his early investments was a stake in Telecom Italia. Baverez remembers a shareholder meeting in 1999 at which he noticed a slight, dark-haired, boyish investor who was fearless in his condemnation of a hostile bid for the company made by Olivetti’s then–chief executive, Roberto Colannino. The investor was TCI’s Hohn, who was then a portfolio manager for ex-Goldman, Sachs & Co. investment banker Richard Perry’s event-driven arbitrage hedge fund, Perry Capital Management. “He was very vocal,” Baverez says with a laugh.
Hohn and Baverez saw each other at conferences, but their paths did not formally cross again until 2003, when Hohn began to build TCI. Baverez’s close friend Patrick Degorce, formerly with Merrill Lynch Investment Management, had just joined TCI, and he encouraged Hohn to talk to Baverez about working at the hedge fund.
“I met David through Patrick when we first set up the fund, but he was too high-flying for us in his career at that point,” Hohn says playfully. Baverez jokes that what Hohn really means to say is that he was “too eclectic an investor” for Hohn’s pure value-oriented mandate at TCI.
Whatever their philosophical differences, Baverez and Hohn grew closer through their mutual friendship with Degorce. By the beginning of 2005, the three men unexpectedly found themselves on the same side of the table in confronting the management of Deutsche Bšrse over its proposed takeover of the London Stock Exchange. The German exchange’s then–chief executive, Werner Seifert, and board chairman, Rolf Breuer, ignored TCI’s warning to back off on the bid. Other Deutsche Bšrse shareholders — including Fidelity, which held a 5 percent stake — also opposed the merger.
Deutsche Bšrse was forced to withdraw its bid in March 2005. In May, Seifert resigned and Breuer announced his decision to step down after a successor could be found. The victory was bittersweet for Hohn, who had been excoriated by Seifert in the press, but it cemented his reputation as an unflinching shareholder activist. Despite the media attention on his activism, Hohn says it’s not a core tenet of his investing style.
Hohn’s investment discipline resonated with Baverez, who confided to the hedge fund manager in the spring of 2005 that he was worried about the flood of money he was managing at Fidelity. Hohn renewed his invitation to Baverez to work with TCI, but this time the offer was different: He asked Baverez if he wanted to launch his own business on the TCI platform. “The genius of Chris is that he didn’t say, ‘Come and work for me,’” Baverez says. “He said, ‘Come and work alongside me.’”
Baverez was not the first manager to receive that offer. Hohn helped in the 2004 creation of Parvus Asset Management, founded by Edoardo Mercadante, a former European small-cap expert at Merrill Lynch Investment Managers, whose firm now oversees $1.2 billion in long-only and long-short funds. In October 2005 he assisted emerging-markets manager Madhav Bhatkuly launch New Horizon Investments, a value- and growth-oriented fund focused on India. This spring Hohn began helping Davide Serra, who ran Morgan Stanley’s global banking research, to prepare a long-short fund, Algebris Investments, for launch this fall.
“Chris is our benchmark,” says Mercadante, 38. “Last year I thought I’d had a really lousy year because my funds were only up about 30 percent net, and TCI was up 50 percent.”
The new firms share TCI’s infrastructure and support services and are located side by side on two floors of an elegant Georgian building on Clifford Street in London’s tony Mayfair district. Although the teams are new, the friendships are not: Baverez met Degorce more than a decade ago in Paris, through mutual friends. Degorce and Mercadante used to work together at MLIM, and Serra has known Mercadante, Degorce, Baverez and Hohn for years, having provided them all with research as a banking analyst for Morgan Stanley.
From Hohn’s perspective, supporting talented managers is a great way to build TCI’s intellectual power base, no matter what type of fund they choose to run — long or long-short. “I believe that the pendulum may have actually swung too far in favor of hedge funds,” says Hohn, who has seen TCI’s assets skyrocket from $500 million to more than $7 billion in the three years since its launch. (His TCI Master Fund is now closed to new investment.) “There are some long-only managers who are absolute rather than relative as in the hedge fund world. My concern is that investors are paying too much attention to ticking a label of hedge fund or long-only when they ought to be payingmore attention to looking for talent.”
Talented as Baverez may be, it takes moxie to convince prospective clients that investing in a long-only fund charging performance fees makes sense. When he was running Fidelity’s European Aggressive Fund, investors paid 5.25 percent on their initial investment and a management fee of 1.5 percent — but no performance fee. KDA, by contrast, charges a 1.25 percent asset management fee and a performance fee of 20 percent on returns above the MSCI Europe index for shares with a three-year lockup.
Baverez freely admits that many of his former investors have balked at KDA’s business model. Viewed in the context of most hedge funds, however, the firm’s fee structure is relatively modest. Unlike the typical long-short equity manager, Baverez doesn’t charge a performance fee if the fund doesn’t outperform the market. He also has a high-water mark. If KDA underperforms the MSCI Europe index, the firm cannot charge a performance fee until the fund outperforms the index by the same amount.
Baverez faces a challenge in persuading clients to let him lock up their money for a minimum of three years — especially when he’s invested in highly liquid European equities. “I have zero time for long-only managers who impose multiyear lockups on their clients,” says Shonda Warner, founder of London-based fund of hedge funds Chess Capital Partners. “Long-only funds really ought to be more liquid than most hedge funds, and if they’re not, you have to ask yourself why. Is it greed? Laziness? What is the real motivation?”
Baverez says that his three-year lockup ensures that clients’ time horizons match his own. Although that may be true, most managers are acutely aware of redemption risk, and Baverez is no exception. Seeking to protect his portfolio from the potential volatility created by investors’ pulling out their money in down markets may be both smart and selfish.
Permal’s Kodmani is concerned that some managers are imposing long lockups to duck registration with the Securities and Exchange Commission, which exempts funds with lockups of two years or more. KDA’s three-year lockup is purely strategic, says Baverez, and he has voluntarily registered his firm with the SEC.
The other obvious difference between KDA and a traditional hedge fund is that Baverez doesn’t have the added pressure of shorting. Although most investors still view short-selling as desirable downside risk protection, Baverez considers it a risk center in its own right. He managed Fidelity’s European FAST (Fidelity Active Strategy Fund) fund from October 2004 through July 2005 and was allowed to short up to 15 percent of the portfolio. He readily admits that his pool of similarly managed long-only funds, led by the core European Aggressive Fund, performed much better than the FAST fund.
“Given the current market environment in Europe, it’s very difficult to find good shorts right now anyway,” he says. “Even the hedge funds are struggling. I could probably find some decent trading ideas, but not very many fundamental short ideas, so I made the decision to be long-only.”
Mercadante takes a slightly different approach. He runs about 60 percent of his assets in a long-only, European small-cap equity fund; the rest are in a long-short equity fund. Mercadante warned investors that he thought it would take him about three years to learn short-selling, and now he says he probably underestimated by at least two years.
For his part, Baverez says he has all the tools he needs to manage downside risk. Unlike most mutual fund managers, he can put up to 50 percent of his portfolio in cash — or hedge out some of his equity exposure using index futures. But the greatest downside protection of all, he says, is being able to run a concentrated portfolio with fewer assets under management.
Baverez and his team have about 25 investments in the portfolio at an average size of $22 million apiece — far fewer than the 40-plus positions they had to oversee at Fidelity. They look for investments in which they expect to realize a minimum return of 20 to 30 percent. When they find extremely high-conviction ideas, they have the latitude to dedicate up to 15 percent of the portfolio to a given investment; the minimum position size is 2 to 3 percent.
Prospective investors’ frosty attitudes toward long-only funds may finally be starting to thaw. In recent months, Baverez says, about 80 percent of KDA’s capital has come from U.S. institutions — foundations, family offices and endowments — that view his fund as simply an offbeat form of active management and a way of getting exposure to Europe. Despite her objection to KDA’s three-year lockup, Chess Capital’s Warner likes Baverez’s approach.
“What he is doing, in going back to basics, is probably one of the most interesting, avant-garde, cutting-edge things that he could possibly do,” she says.
Even some of the funds of hedge funds are starting to look at long-only managers as diversifiers among their multistrategy products. “We’ve begun using carefully selected dedicated long-only funds as building blocks alongside other hedge funds, recognizing that both styles provide alpha-driven returns,” says Adam Geiger, chief investment officer of Jericho, New York–based Ivy Asset Management, a fund-of-hedge-funds firm with $15 billion in assets. “In our vernacular, a fund can be long-only and still adhere to basic hedge fund principles.”
Although investors are unlikely to start replacing their traditional long-only managers with long-only, non-hedged hedge funds anytime soon, the model Baverez has created at KDA is gaining followers. Investors have been raising the level of assets under management at KDA by about 10 percent a month. At $1.2 billion, Mercadante’s Parvus is already closed to new investment after just 18 months of operation. KDA is still too rare a model to pose a major threat to most long-short equity hedge fund managers, but Baverez’s willingness to separate alpha from beta — and, he adds, charge his investors only for the alpha — ought to give his peers in the hedge fund industry cause for concern.
