In 2006, J. Tomilson Hill, CEO of Blackstone Alternative Asset Management, the fund-of-hedge-funds arm of private equity giant Blackstone Group, became alarmed by the massive growth in the subprime mortgage market. To protect BAAM’s investors from a massive meltdown — and maybe even profit from it — Hill and his team made a substantial customized investment with a hedge fund manager that was experienced in shorting subprime securities. The retail mortgage market imploded the following year, and Blackstone’s investment soared.
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“We think of ourselves as an intermediary between the largest pools of capital in the world and the most experienced money managers, expressing both top down and bottom up views on market opportunities through the use of hedge funds,” says Hill, who had been co-CEO of Lehman Brothers before being recruited to Blackstone by co-founder Stephen Schwarzman in 1993.
Who says funds of hedge funds can’t add value?
With its size, client base, resources and brand name, Blackstone is in a position to make these kinds of calls, helping it rise to No. 3 in this year’s Fund of Funds 50, our eighth annual ranking of the world’s biggest multimanager hedge fund firms, based on assets under management at the start of 2010. BAAM was No. 8 two years ago (based on June 30, 2008, assets), the last time we compiled the ranking.
The publicly traded, New York–based alternative investment manager has one of the few fund-of-funds firms that is even close to the level of assets under management today that it had before fall 2008, when the stock market collapsed, the credit markets seized up and the bottom fell out of the multimanager hedge fund industry. Myriad problems have plagued the fund-of-funds business, including massive redemptions by cash-strapped investors, gating by underlying hedge fund managers, poor investment performance and, of course, Bernard Madoff.
“The combination of poor returns and a few prominent frauds, as well as the systemic liquidity issues at the hedge fund and fund-of-funds level, have impacted investors’ appetite for hedge funds and funds of funds in a negative way,” says Richard Leibovitch, Boston-based chief investment officer of Swiss fund-of-funds firm Gottex Fund Management (No. 22, with $8.1 billion in assets). “The resulting decline in assets under management has been pretty dramatic.”
The firms represented by the Fund of Funds 50 saw their assets plummet by 43 percent, dropping from $877 billion to $503 billion. But rather than spell the end for funds of hedge funds, the massive shakeout may prove to be the industry’s salvation longer term — moving it away from asset gatherers and access sellers toward more institutional quality fund pickers with a focus on risk management, fund structures and investment returns.
Most hedge fund managers and investors were woefully unprepared for the collapse in confidence that roiled credit and equity markets around the world in 2008. Most hedge fund returns were negative that year, falling 19 percent, on average, according to Chicago-based data provider Hedge Fund Research. Funds of hedge funds did even worse, dropping 21 percent.
In terms of asset losses, the pain has been particularly great among many of the very largest funds of hedge funds. UBS Alternative and Quantitative Investments rises one place to No. 1 in this year’s ranking, but its assets actually shrunk by 43 percent, from $56.7 billion in June 2008 to $32.3 billion at the start of this year. HSBC Alternative Investments (No. 2, up from No. 4) lost nearly 35 percent in assets during the same period.
Contractions at UBS and HSBC were far less dramatic than those at some of their closest rivals. In 2008, Switzerland’s Union Bancaire Privée was the largest fund-of-funds manager in the world, with $56.9 billion in assets under management. Now it has $18.8 billion under management — a 67 percent drop in assets in just 18 months — and falls to No. 7 in the ranking. London-based Man Investments (No. 9 this year, down six places from 2008) saw its assets plummet 69 percent, from $55.1 billion to $17.1 billion. To put the overall industry decline in perspective, UBP and Man would have finished 18th and 20th, respectively, in the 2008 ranking, based on current assets.
Joseph Scoby, head of the Alternative and Quantitative Investments group at UBS, says the majority of his firm’s fund-of-funds redemptions were a result of negative asset flows from its private bank. Institutional investors were less likely to redeem, he adds, and if they did so it was largely as a result of liquidity problems in other areas of their portfolios — especially private equity and real estate. Although UBS obviously has seen a lot of assets come in over the years through its private bank, its fund-of-funds business started as an institutional product and advises on a $4 billion–plus customized portfolio for the California Public Employees’ Retirement System.
An April 2009 study by investment management consulting firm Casey, Quirk & Associates and Bank of New York Mellon Corp. supports Scoby’s claims. The report, titled “The Hedge Fund of Tomorrow: Building an Enduring Firm,” found that high-net-worth and retail investors accounted for 80 percent of all hedge fund redemptions in 2008 and early 2009. Moreover, 70 percent of those redemptions were pulled from funds of funds.
Funds of hedge funds with a large retail base, like Man and UBP, were hit the hardest. Jeremy King, executive vice president in charge of marketing and client services with Man Investments in New York, says the shakeout has caused his firm to focus more resources and attention on the U.S. institutional market.
“The U.S. is much more of a core strategic focus of Man than it was,” he explains. “Being successful here is very much on the firm’s radar for the first time in a serious way.” Man is beginning to see results, albeit on a more modest scale than the firm is used to. Its managed-account platform more than doubled, to over $7 billion, between June 2008 and March 2010.
One significant difference between UBS, UBP and Man, though, was that the latter two invested with Bernie Madoff; UBS did not. Scoby and his team could not see how an options arbitrage strategy — which is what Madoff told investors he was running — could produce the consistent returns that Madoff claimed to generate.
Scoby knows a thing or two about options trading: He began his career with Chicago options market maker O’Connor & Associates, which was acquired in 1992 by Swiss Bank Corp. and became part of UBS when the two Swiss firms merged, in 1998.
Scoby and his team were right, of course. In December 2008, Madoff revealed to authorities that he had been running a massive Ponzi scheme, crushing the funds of hedge funds that had invested billions of dollars with him and changing the hedge fund business forever.
Before the economic collapse and the unmasking of Madoff, many funds of hedge funds made their money by being the gate keepers for managers that were largely closed to new money or investors. “There were a lot of fund of funds that just sold access,” says Judith Posnikoff, co-founder of Irvine, California–based Pacific Alternative Asset Management Co., No. 11 in our ranking, with $16.3 billion in assets. “That era has passed.”
In the past it was often difficult for even the most questioning of investors to differentiate truly good fund-of-funds managers from the bad. When Investcorp entered the U.S. in 2005, says Deepak Gurnani, head of hedge funds at the $12 billion Bahrain- and London-listed investment management subsidiary of the investment bank Investcorp Bank B.S.C., most managers looked alike and provided similar products. Few funds of hedge funds, he adds, were talking about risk management, transparency of underlying managers, separate accounts, customization, asset allocation and portfolio construction. Investcorp strove to differentiate its fund-of-hedge-funds business (No. 43, with $4.4 billion in assets) by focusing on those attributes — which has since become de rigueur among investors. “The events of 2008 forced the fund-of-funds industry to adapt,” says Gurnani.
Fund-of-funds firms are also becoming more quantitative in how they assess managers, spending more time and resources on due diligence. “The qualitative decision is still what rules,” says William Ferri, deputy global head of Alternative and Quantitative Investments at UBS. “But we are spending time, effort and money” building up the quantitative tools and processes that can support that decision.
The road back will be hard for funds that are now a shadow of their former selves. For Ivy Asset Management Corp, which once managed more than $16 billion but has seen its assets shrivel to less than $5 billion, it could be impossible. In January, Ivy CEO Sean Simon stepped down, as the firm’s parent, BNY Mellon, began consolidating its fund-of-funds businesses under one head — Phillip Maisano, chief investment strategist for BNY Mellon Asset Management (No. 17 in the Fund of Funds 50). Now, several of Ivy’s funds are being liquidated and, as of last month, Ivy was looking to sell itself to a third party, a well-placed source confirms. But as assets dwindle, a sale becomes less and less likely.
Consolidation will continue as firms falter or their struggling owners seek to raise capital. In January, Royal Bank of Scotland Group announced the successful sale of its fund-of-funds business, RBS Asset Management, to Aberdeen Asset Management (No. 30). And the $1.5 billion New York–based hedge fund seeding firm SkyBridge Capital is believed to be in discussions to acquire Citigroup’s fund-of-hedge-funds business, Citi Alternative Investments (No. 29).
Richard Bookbinder, co-author of a recently published book on funds of hedge funds and CEO of the small fund-of-funds firm Bookbinder Capital Management, says he sees consultants advising their clients away from multimanager platforms and toward direct hedge fund investing. Others disagree.
“Anybody who thinks that there is no market for fund of funds is not grasping the full range of asset owner’s perspective,” says Howard Eisen, co-founder of New York–based hedge fund consulting firm FletcherBennett.
SkyBridge founder Anthony Scaramucci agrees. “The institutional community has accepted that they need to have some investments in alternatives, and many do not have the capacity to invest directly,” he says. Funds of hedge funds are “a necessary force,” Scaramucci adds.
The Casey Quirk report argues that funds of hedge funds will continue to be “the primary hedge fund distribution channel, capturing almost 60 percent of net flows between 2010 and 2013.” By that year, Casey Quirk concludes, funds of hedge funds will be responsible for close to 50 percent of hedge fund flows, up from 36 percent in 2005 — provided the industry makes the necessary reforms to its products and processes.
As part of those reforms, fund-of-funds managers are improving their fund structures, focusing on issues like liquidity and duration of their underlying investments. “People have had to match assets to liabilities,” says Jacques Chappuis, head of Alternative Investment Partners, which oversees Morgan Stanley’s fund-of-funds businesses, including hedge funds (No. 16). They are also paying more attention to counterparty risk, particularly after hundreds of hedge fund managers ended up with assets trapped in bankrupt Lehman Brothers Holdings’ U.K. prime brokerage business, says Mustafa Jama, CIO of Morgan Stanley Alternative Investment Partners fund of hedge funds.
As the industry reshapes, investors will likely gravitate toward larger funds of hedge funds, those that have the backing of an investment bank, or brand-name boutiques such as Grosvenor Capital Management in Chicago, which vaults to No. 4 from No. 10 in this year’s ranking, with $22.5 billion. Founded by Richard Elden in 1971, Grosvenor is the oldest U.S.-based fund-of-funds manager and was an early investor in such hedge fund stalwarts as Citadel Investment Group.
New York–based Prisma Capital Partners (No. 45, with $4.1 billion in assets) has also seen a pickup in business, says Girish Reddy, Prisma’s co-founder and managing partner. He adds that funds of hedge funds are increasingly being used by investors in areas of their portfolios typically reserved for traditional managers. Blackstone’s Hill sees the same trend as Reddy. “Where we see growth is with sophisticated investors who want to express a view on the markets and don’t want the beta attached to long-only investing,” he says.
Despite the industry’s recent problems, fund-of-funds managers are not in retreat. In fact, their mandates are expanding.
