Many on Wall Street are bemoaning the decline in investment bank proprietary trading wrought by the Volcker rule and tougher capital requirements. For Jay Willoughby, CIO of the $45.5 billion Alaska Permanent Fund Corp., those regulatory changes spell opportunity.
In April 2012, the Alaskan sovereign wealth fund agreed to invest $500 million to set up an incubator fund for nurturing new hedge fund talent at Mariner Investment Group, a $10 billion alternatives asset manager. Alaska hopes the new relationship will turn promising talent into new sources of alpha. For New York-based Mariner, the deal offers an opportunity to develop new business lines at an opportune time.
“Between Dodd-Frank, Basel III rules, and so forth, there are good managers now available,” Willoughby told the Alaskan sovereign fund’s board of trustees, in explaining the deal. “Mariner will identify teams with longer histories and fund them with capital in the Incubation Fund to try and grow a business.”
Mariner is not alone. A growing number of large alternative investment firms are seeking to build out stables of hedge fund offerings. This is a significant change for the industry. Previous attempts to establish so-called “hedge fund hotels” usually failed to attract A-list talent; star managers were more likely to work for an investment bank prop desk or start their own hedge fund. But a number of factors — regulatory changes sparking an exodus of trading talent from investment banks, challenges in raising investment capital, and the desire of alternatives managers to diversify their product offerings — are opening a new avenue for hedge fund creation.
In late July, KKR & Co. announced that it had hired Todd Builione, the former president of the $26 billion alternative investment firm Highbridge Capital Management, to build out its hedge fund business. KKR was one of the first beneficiaries of the Volcker rule in 2010 when it hired Lazard’s nine-person principal strategies asset management division, headed by Bob Howard. Lazard Asset Management, the asset management division of the investment bank Lazard, is also in the process of developing its own hedge fund platform, as is the private equity firm Carlyle Group and the investment bank and asset management firm Perella Weinberg Partners.
A big reason these firms are seizing the initiative is the Dodd-Frank Wall Street Reform and Consumer Protection Act’s so-called Volcker rule, which limits the amount of prop trading investment banks can do. The rule has yet to take full effect but Standard & Poor’s ratings agency has projected that Volcker rule cutbacks will reduce U.S. banks’ annual pretax earnings by a total of $8 billion to $10 billion. Higher capital requirements, which Dodd-Frank imposes in the U.S. and the Basel III accord promulgates globally, are also driving the trend. The new requirements have forced major reductions in banks’ trading books and reduced their ability to hold illiquid assets. As a result of these forces, a lot of top trading talent has been fleeing big banks for the buy side.
The pullback by investment banks is creating an opening for long-term asset owners such as sovereign wealth funds and pension funds. Like many big institutions, the Alaska Permanent Fund is looking for better ways to generate alpha and take over some of the risk-taking functions previously carried out by the major banks. Investing with a large, established, alternatives firm can offer a simpler, and safer, way to execute on this strategy. Few large institutions want the risks and management headaches of being the main capital provider to a start-up hedge fund firm, or providing $5 million or so of seed capital to a large number of new firms. Better to partner with an established player that has the experience and resources to do the hands on work.
“Investors need to get diversification” from the U.S. equites market, says Bracebridge Young Jr., CEO of Mariner Investment. “A lot of what we are looking for is strategies which are diversified and uncorrelated.”
Not all the traders leaving banks are looking to go onto an investment platform or take seed capital. Boaz Weinstein, the former co-head of credit at Deutsche Bank, launched his New York-based hedge fund firm, Saba Capital Management, in 2009 with close to $150 million in assets and no seed funding. Today the firm manages more than $5 billion and counts among its investors the $9.4 billion San Diego County Employees Retirement Association. But, as Willoughby pointed out in explaining the rationale for Alaska’s deal with Mariner, it is much tougher for individuals to launch a hedge fund today. The regulatory requirements are greater, as managers with $150 million or more in assets now have to register with the Securities and Exchange Commission. Prime brokers have fewer capital resources to work with, making them more selective in which managers they support. Investors, meanwhile, are much less willing to take a chance on a start-up at a time when hedge fund returns have lagged generally.
One person who knows just how hard it can be to make the transition from prop-trading star to hedge fund proprietor is Pierre-Henri Flamand. The former London-based co-head of Goldman Sach’s Principal Strategies Group, one of the bank’s top-producing proprietary businesses, Flamand founded his own hedge fund firm, Edoma Capital Partners, in the spring of 2011 and raised $2 billion in capital, but the firm closed late last year after posting below-market returns.
Mariner has been a multi-strategy trading business from its inception, a fact that executives believe gives the firm an edge over rivals in developing its incubator platform. William Michaelcheck, a former member of the investment committee of Bear Stearns & Co. who co-founded the investment bank’s mortgage bond trading department, founded Mariner as his family office in 1992 after retiring from Bear. Originally intended as just a retirement project, by 2007 the firm had 22 different trading teams and more than 400 investors.
The new incubation strategy “plays to Mariner’s strengths,” says Young, who joined the firm in 2001 after retiring from Goldman in 2000. In 20 years at the investment bank, he had risen to partner and headed up its European debt capital markets business in London.
Mariner has launched three portfolios with capital from Alaska. In early April, the firm announced it had hired Eric Pellicciaro, a former portfolio manger with asset management giant BlackRock, to run a global macro portfolio, the Alarium Global Macro Fund. Later that month, the hedge fund firm also announced the hiring of Richard Rumble, previously head of global markets equity proprietary trading at Goldman Sachs, to run an emerging markets equity portfolio to be called Mariner INOX GEM. In June, the firm hired Peter van Dooijeweert, who had been a proprietary trader and head of equity trading with Citi, to run an equity volatility portfolio known as the Mariner Equity Volatility Strategy. Neither the firm nor Alaska Permanent disclosed the size of the investments nor the sovereign fund’s economic interest in the start-ups. Both parties hope that the three start-ups will develop into their own firms operating under the Mariner umbrella.
Mariner’s deputy CIO, Basil Williams, says the firm has interviewed over 250 potential investment teams for the incubation platform and is looking to add two more strategies. “We would like to add an equities events-driven team and we are open for options on the fifth space,” he says.
Other firms looking to foster hedge fund talent are taking the seeder route and providing start-up capital to new stand-alone hedge fund firms. Typically, a seeder will provide some investment and equity capital in return for a cut of the firm’s profits. Goldman Sachs Asset Management and Blackstone are among the firms to have launched funds to seed hedge funds since 2008. A challenge with seeding, however, is that it can feel more like a venture capital investment — making a bet on a new business — than a typical asset management investment. Firms that prefer the hedge fund platform model say their approach has less business risk and offers the advantage of an existing distribution system.
The in-house incubator model can have its own issues — especially when it comes to sharing the wealth among different teams and management. FrontPoint Partners, the multi-strategy firm founded in 2000 by Philip Duff, Gill Carfrey and Paul Ghaffari, was once regarded as one of the most successful examples of the form. Internal disputes over compensation sparked the departure of a star team — which went on to form Ivory Capital Management — early in the firm’s history; then in 2011, the firm shut down after one of its portflio managers was charged with insider trading.
Williams stressed that Mariner would offer sufficiently attractive compensation to portfolio managers on its incubation platform. His personal experience is instructive. He joined Mariner at the start of the year when the hedge fund firm aqcuired Concordia Advisors, a $1 billion New York-based alternative investment firm that Williams headed. Like Young and Michaelcheck, Williams has a background as a bank trader, having started his career on the fixed-income desk at Merrill Lynch & Co. He believes Mariner now offers the kind of atmosphere that once prevailed on investment banks’ prop desks. He’s hoping the profits will be similar as well.
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