Exclusivity is like fiat currency: It only works if everyone believes it’s real.
For decades that wasn’t a problem for Seth Klarman’s $29.5 billion Baupost Group. The only way to get money into its famed hedge funds was to already have some invested, and everyone knew it. Even for that coterie, Klarman would periodically slide some of their capital back, a potent reminder that Baupost didn’t need more — or your — money.
But doubts have begun to percolate within the elite investor class, an investigation by Institutional Investor reveals.
“We’re walking away,” says one capital allocator. It’s not clear whether or not Baupost knows this yet. The firm declined to comment for the story.
“Seth is running Baupost more like a wealthy person might run their personal money than like the aggressive hedge fund manager that he’s been over the years,” the investor says. “He has pretty considerable net worth and all of his money invested in that firm. Other people’s fees are paying for him to run his personal money. If you want to come along, come along.” But that allocator won’t.
“Even though we have terribly high regard for Seth,” the investor went on, “this isn’t what we want. Performance is slipping; the strategy changed. It’s not the consistent, thoughtful type of process and results that they had for a couple of decades.” Baupost’s best days have passed — at least for the firm’s clients, the investor asserts.
That opinion prevails among ten knowledgeable institutional and family office investors that II interviewed, agreeing to anonymity so they could speak freely. All are professional manager selectors, the people responsible for finding, vetting, cajoling access to — and eventually firing — the investment visionaries who can best grow a charity’s billions or secure a family’s $500 million nest egg. II approached these allocators more or less at random, seeking an unbiased sample, and asked about Baupost.
Given the opportunity, would you invest in Baupost now?
Just two out of ten said yes. And for several this wasn’t a hypothetical question.
Baupost quietly began fundraising in March, initially from existing clients and then by calling on allocators who’d previously knocked on its closed doors. Baupost gathered $1.8 billion in new commitments by June. Few hedge funds could rival that showing. Klarman clearly still has far more capital wanting in than he’s willing to accommodate.
But as a major Baupost client — Harvard University — demonstrates, true exclusivity goes beyond the ability to pick one’s customers. It’s about the caliber of who gets in, who doesn’t — and who rejects the chance.
“I know a couple of large, $1 billion-plus investors, and they did not take Baupost up on the offer” to upsize their stakes, says one former client. After existing clients had first dibs, a middling endowment got a shot as a newcomer. “I can’t believe I’m saying this, but I am passing on Seth Klarman,” an investment staffer says. “I thought Baupost would be great. But I went over the numbers and realized, nope. Not worth the headache and the lockup” of capital, which is longer than usual among hedge funds. Perhaps that’s because Baupost isn’t really a hedge fund anymore, according to several interviewees.
Klarman’s firm runs one wide-open strategy, or product, via ten Baupost Value funds operating in parallel but raised at different times. When the firm invested in insurance claims against bankrupt utility Pacific Gas and Electric, for example, investors got equitable exposure across the various vehicles. The vintage-year structure resembles private equity funds; the deal sharing does not. Hedge funds typically divide their funds by strategy: one long-short equity, another long-only, one focused on China, etc.
Baupost prefers carte blanche.
Investing with the firm means allowing Klarman’s team to do mostly whatever it wants with the money. Since the financial crisis, that’s often meant buying private assets, such as real estate, that linger for a long time in portfolio. “I’m not a fan of people in the hedge fund world taking what would be a five- to seven year real estate strategy,” the head of an elite institution gripes. “That’s not what a hedge fund is.” Klarman, observers say, has been doing more and more of these types of deals — and returning less and less. Baupost has delivered double-digit gains just once since 2010, II previously reported. “The return-on-equity numbers don’t stand up to top-tier private equity,” according to the allocator who opted out. “I would prefer to just be in private equity that says what it is. At least then it’s a defined approach.”
The most controversial thing that Baupost does with its wide-open investment mandate is nothing at all. Cash amounts to about one third of the portfolio on average, or about $10 billion. “The last thing you want to do is pay a manager to hold a lot of cash,” says one hedge fund specialist. Baupost charges clients 1.25 percent in management fees, regardless of performance or what the money is invested in. Charities, schools, and other clients pay Baupost upwards of $120 million for one year of cash management, given an average holding. Allocators really don’t like that — or at least they really like to complain about it.
The Boston-based fund has always been upfront about its radical cash, which may rankle investors but affords agility. In this year’s wild opening two and a half months, for example, Baupost plowed $1.5 billion into down markets, diminishing its cash stash from 31 percent to 27 percent, according to a source. That spree in part prompted the spring fundraising.
Klarman defenders archly suggest that investors sore over paying fees that they agreed to for a strategy they picked ought to do their homework better next time. “It’s a high-cash-level firm,” says an allocator who knows Klarman well but isn’t invested for policy reasons. “People need to understand what the firm does, and make the decision based on how it fits in their portfolio,” rather than complain post facto. “It’s cowardice. It’s like wanting a pot to boil pasta, but you only have a pan. You can’t be mad at the pan for not being what it isn’t.”
High cash levels and go-anywhere strategies make raising money harder, the allocator points out. “Not every manager can do the open-ended mandate. They have to have the right skill and system to filter through ideas and make good decisions quickly. You don’t see many firms like Elliott or Abrams Capital or Baupost that do everything. You have to assess them not just on what they do right now, but what they can do across the cycle. There are not many allocators equipped to do that.” Others, the investor adds derisively, just “focus on buckets.”
When elite investors become passé, plausible deniability lasts for years. Their businesses trundle along, replacing Ivy League investors with bush leaguers to staunch outflows, and holding on to portfolio managers with fat salaries and comeback-year dreams.
For a while.
The asset base shrinks. Top talent agitates for bonuses that only performance fees (remember those?) or the founder’s own pocket could pay. Shell out and buy time for a comeback? Or. . . shut it down and retire to family office life? Is the perfect hedge fund like the Matilda headmistress’s fantasy school: one with no investors at all?
“I see Baupost’s fate playing out over the next five to ten years,” says one current client. “If there is a distressed cycle and they make good use of it, they’ll be twice as big in ten years. If things continue as they are, they’ll leak assets and be half the size, a quarter of the size in five years.” Leakage (or healthy turnover) in the mid-single digits of total assets, about $1 billion to $2 billion per year, has been typical, according to someone close to Baupost. This year will be in that range.
Redemptions are, however, trailing indicators. “Look at Brevan Howard,” a Baupost client points out. Once among the world’s largest macro funds, at $40 billion, the firm has faded to $10 billion. Klarman has that much in cash. “If you don’t think that’s a potential for Baupost, you have no idea what you’re doing.”
Among the firm’s clientele — a clubby Northeastern set of high-end colleges, philanthropies, and their rich benefactors — “you hear things. ‘This endowment has trimmed, and that endowment is completely out. They’re letting in this or that person. It’s not an exclusive club anymore,’” the investor reports. “We’re not expecting great returns. Seth’s a good manager — but even the most skilled manager that’s fishing in an overfished pond is not going to catch great things.” After discreetly entertaining doubts for years, the investor says, the dialogue has broken out aloud. “It feels like ‘Oh, you’re getting out? Now I’m clear to get out.’ There is allocator safety in numbers,” the client says. “That can spiral.”
Surely that investor has put in notice to get its money back? Not so. “Redeem half. Then if the distressed cycle comes in, I’m not the idiot who cashed out of Seth Klarman right before he made a killing.”