The End of the 3 and 30

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IT SEEMED an odd weekend for a death. The Boston weather was warmer than usual; the July haze sporadically coated the city skyline. Most people of means were on the Cape, Nantucket, or the Vineyard, but Harvard Management Company cub Jeffrey Larsen, by this day in 2007, a very wealthy man and principal of hedge fund Sowood Capital, was sitting in a cold sweat in his Back Bay office.

Larsen was sweating because, by that day, the 29th of July, he had lost nearly 50% of his fund’s capital, or approximately $1.5 billion, with a bet gone poorly. What had started as a quotidian trade—going long senior debt while simultaneously shorting junior debt and stock, with large amounts of leverage—had turned into a trader’s nightmare. Two days previously, a Friday, he had been down 10% on the month. Now, two days later, he was on the phone to Ken Griffin’s Chicago-based Citadel Investment Group, hoping to salvage a semblance of value by selling his positions onto the larger hedge fund. By that evening, his firm was dead.

It did not end there. As with any hedge fund implosion, the reverberations of capital losses were felt far from the nerve center of the fund’s 500 Boylston Street offices. In Sowood’s case, investors saw their sizeable investments cut in half in one weekend. Numerous capital pools—including Harvard University—lost tens, even hundreds of millions of dollars, having been directly invested in the fund. One other fund—the Massachusetts Pension Retirement Investment Management Board (MassPRIM)—also felt those reverberations, but in a different way: The firm to which they were paying approximately $5 million (the 1% management fee on a $525 million investment) and 10% of profits to perform due diligence and provide diversification—fund of hedge funds Arden Asset Management, of New York—had been invested with Sowood. Arden had taken many millions in fees in the first few successful years of Sowood’s existence. Arden would take none of the losses.

Superlative Yale endowment leader David Swensen once famously decried these hedge fund pooling vehicles as “a cancer on the institutional investor world.” This metaphor is not entirely appropriate. Cancer, in the extreme, swiftly decimates its host, ending the life of both intruder and intruded. With hedge fund blowups, however, history has shown that the institutional investor is harmed while the middleman survives—albeit with less fees and reputation. With numerous funds of funds seemingly exposed to every recent hedge fund implosion or scandal—including Amaranth Advisors, Level Global Investors, Diamondback Capital Management, and, of course, Bernie Madoff—has the time now come for the cancer itself to die?

THE SEARCH for uncorrelated alpha came relatively late to the world of pension and endowment funds. Alfred W. Jones created the first hedge fund in 1949. The Rothschild family created the first fund of hedge funds in 1969—Leveraged Capital Holdings—which was followed shortly by the first American permutation, Chicago-based Grosvenor Capital Management. For decades, hedge funds and funds of funds were the domain of the high-net-worth crowd; the goal was shoot-the-lights-out performance, and assets were gathered as much via Geneva or Upper East Side cocktail chatter as through more traditional means. Leverage was high. Stakes were high. Institutions, as a whole, did not play this game.

Enter the 1990s. In general, endowments were the first to allocate to these alternatives, the result of savvy CIOs and Board members who had been privy to the social milieu of the 1980s. Their access came via two routes: Like Harvard’s Jack Meyer and Yale’s Swensen, some institutional funds invested directly with hedge funds; others opted to take the funds-of-funds route. Pejoratively, this second group was often considered less sophisticated than the first, with the aggregator access point considered a quasi-outsourcing of the hedge fund allocation decisionmaking process. Whether this criticism was valid, this group certainly was paying for the pleasure: on top of the dominant 2% and 20% hedge fund fee model, hedge funds of funds often charged an extra 1% and 10% to their clients, ostensibly for the due diligence, access, diversification, and the benefits of capital aggregation that they ostensibly provided. As a general rule, larger funds—better staffed and with more resources—took the direct route, while smaller funds (and larger funds lacking resources, such as American public pensions) invested with the aggregators. The balance between the two styles of access subsisted for the better part of two decades.

Recent research suggests that this balance is shifting, although decisive it is not. According to Connecticut-based Greenwich Associates, public pension hedge fund use was down in 2010, with funds of funds falling to just 28% usage; Hedge funds were used by 35% of public funds (but this was also down from the year before). London-based research firm Preqin provides clearer trend lines; 32% of those investors currently allocating toward funds of funds will start investing directly in the next three years, the firm says, with another 8% considering such a move. Although anecdotal, it is telling that one of the funds forsaking the funds-of-funds approach is the Massachusetts state pension. After more than half a decade of accessing the hedge fund market via funds of funds—and being exposed to Amaranth, Level Global, Diamondback, Madoff and, of course, Sowood—MassPRIM in February announced that it would alter its strategy, hire a hedge fund consultant, and turn a significant amount of capital toward a direct route. “This brings us more in line with the strategy of the majority of our peers,” MassPRIM spokesperson Barry Nolan said at the time. “We’re not going to do a thing just because other funds are doing it, but we’re doing it on the belief that performance will be enhanced.” According to Nolan, the fund pays approximately $30 million in fees to its five funds of funds—Arden Asset Management, K2 Advisors, Grosvenor Capital Management, PAAMCO, and The Rock Creek Group—and hopes to avoid a significant amount of these by shifting assets toward hedge funds.

SIX hundred miles southwest of Boston, ensconced in the hills of West Virginia, sits a pension fund that diverged from the MassPRIM path and simply skipped the aggregator stage.

“We’ve always been direct,” says Kristy Watson, Chief Investment Officer of the $12.5 billion West Virginia Investment Management Board (WVIMB). “’Always’ being a relative term. We started our hedge fund program in July 2008 with a target of 10% of the portfolio in hedge funds.” In contrast to MassPRIM’s approach, WVIMB decided that a consultant-driven direct model was optimal. It hired Albourne Partners of London to advise on which funds to invest with—paying mere basis points, as opposed to the 1% of assets and 10% of profits that a fund of funds would receive—and have swiftly allocated capital to 19 funds. “We looked at the funds-of-funds route,” Watson says. “It got you immediate exposure, and immediate diversification, and the due diligence, so it would have been less of an administrative hassle, but we opted not to—because of fees. We didn’t feel it was worth it at an institution of our size. We felt we could go direct.” Watson and her colleagues at WVIMB also worried about the lack of control with the funds-of-funds approach. “We were worried that we couldn’t be able to determine who is in the portfolio,” she says.

Anyone of institutional size can do the direct program more or less, Watson believes, “the same way you do a long-only equity program. You need time and resources—front- and back-office due diligence is required there.” Essential, however, is the consultant. “It’s critical for the way we operate,” she says. “Our consultant doesn’t have discretion or complete control—we have that and can still pick and chose—and we’ve said no to a lot of funds who lack our back-office operational standards. However, [the consultant] more or less operates as a funds-of-funds operator.” The fees, however, are “materially less” when comparing consultants to funds of funds, in addition to the “alignment of interests” a former brings. “It’s much more what we’re looking for,” Watson concludes.

Despite being across the country, the California State Teachers’ Retirement System (CalSTRS) is in a similar mindset to the WVIMB regarding hedge fund allocations. “We’re relatively late to the hedge fund space,” says Christopher Ailman, CIO for the $150 billion fund. CalSTRS only invests directly, he says, a structure that makes sense because of its size. Funds of funds are a classic example of “fee-on-fee” arrangements, he believes, and as such should be avoided if possible—and, for the second-largest pension plan in America, it is. Hedge funds shouldn’t think of this as a decisive victory over funds of funds, however, for Ailman is decidedly lukewarm on the prospect of large hedge fund allocations to come, and has some harsh words for the business as a whole. “We think of hedge funds as a business structure, not an asset class. The term has gotten so amorphous and so bland, it doesn’t really mean anything other than two and 20,” he says, referring to the typical hedge fund fee structure.

CalSTRS’ and WVIMB’s sentiments are echoed in other asset-owning silos—and even by one fund that, at its size, would traditionally be ushered down the funds-of-funds route. Anne Martin, newly appointed CIO of the $580 million Wesleyan endowment, sees no reason for her even relatively small fund to invest with funds of funds—which is not altogether surprising, since Martin is a David Swensen protege, having run the natural resources and venture capital portfolios at Yale for the better part of the past decade. “For Wesleyan, it doesn’t make any sense for us [to go the funds-of-funds route],” she says. “People say they want diversification—but diversification isn’t necessarily always a good thing. You need a certain amount, but we don’t need 20 or 30 hedge fund managers. We need seven great ones.” Like Watson, Martin also cites a lack of control as justification for avoiding the aggregators. “We’d rather control our risk by controlling a smaller but growing allocation than allowing them to pick managers we don’t know as well,” she says. “Why do we want to be two steps removed from our managers—and why do we want our fate linked with a bunch of LPs we don’t know?”

Even some in the corporate pension space agree. Carol McFate, CIO of the $4 billion Xerox pension plan—well-known for its recent reverse-outsourcing from Promark, now General Motors Asset Management—also chose the direct route when the pension re-entered the hedge fund space after a multi-year hiatus following 2006. “We made the decision to go direct,” she now says. “It’s cheaper. It’s also more work, but it forces us to get up the learning curve quickly. We will have a more direct relationship with the managers, which is important with hedge funds—more so than long-only managers. Hedge funds are more fluid, so we need to stay on top of them.”

A decade ago, before the world fell apart, “access” was often the first point pitched when a fund of funds walked into a pension board presentation. A remnant of the cocktail conversation of the 1980s—“Oh, Jerry’s invested with so-and-so…maybe he can introduce you…”—the ability to inject capital into a certain fund signaled sophistication. Funds of funds openly claimed to be the gatekeeper.

Enter Bernie Madoff. “Madoff killed ‘access,’” John Trammel, CEO of New York-based fund-of-funds Cadogan Management, says. “Ten years ago, one of the primary selling tools of many funds of funds was access. They would have this portfolio of supposedly closed managers, and they’d claim that ‘you need me to get you in.’” It was a pitch that preyed on insecurities and the seemingly universal desire to be part of an elite. When it became clear that Madoff built his Ponzi scheme largely out of this human weakness, that pitch died.

The access pitch has been replaced with the customization pitch, the agglomeration pitch, the tactical tilt pitch, and the risk management pitch. Customization, for one, appeals to the control freak. “The question with a traditional fund of funds and hedge funds is of nimbleness and transparency,” comments Todd Groome, Chairman of the Alternative Investment Management Association (AIMA). “Numerous funds of funds now provide a managed platform structure to varying degrees. They take 30 or 32 funds and, if I’m a large state pension, I can choose six or 10 funds, and move my money at will and place them on a managed platform.” Noncommingled capital pockets are another version of this pitch, Groome and others note, one that increasingly is seen as the future of not just funds of funds, but many other pension- and endowment-focused products as well.

Agglomeration, on the other hand, appeals to the penny-pincher. “Increasingly, smaller funds need to combine their market positions to access larger hedge funds,” Groome says. “By combining assets in a fund of funds, numerous small funds can collectively increase their ability to access large managers with limited open capacity. The $2 billion, $5 billion pensions, foundations, endowments—which are all over the U.S. and other parts of the world—are often funds-of-funds clients for this reason.” As good as some consultants are—and Groome has credibility here, being an adviser to alternative consultancy Albourne Partners—they have a hard time getting better conditions of investments than large funds of funds. Groome hypothesizes the situation of a university endowment manager, far from a financial hub such as New York, who would be looking to put “$200 to $300 million into the hedge fund space. They might want five or six hedge fund exposures, but are adamant in wanting clout. ‘My $25- to $5o-million investment may not attract more established managers or funds,’ they would say, ‘but if I combine with VV G IfiaV others, I can get better access.’”

The tactical pitch, of course, appeals to those who despise a static portfolio. According to a principal at one of the large funds of funds, who wished to remain anonymous, investing via a fund of funds lets a limited partner “circumvent having to get Board approval for every shift in managers. We can move in and out of a hedge fund much quicker, hopefully to avoid problems and take advantage of market opportunities. It is much harder to do that at a small fund with direct investments.” An increasingly popular route for mid-size pension funds—that sweet spot in the $2 billion to $5 billion range, he says—is to use funds of funds in a core/satellite approach. “Some smart investors are going direct for their core investments, and then using funds of funds to gain access to smaller markets, niche strategies, and a more tactical approach,” he says.

Risk management, unsurprisingly, appeals to a wide swath of investors following 2008 drawdowns. Diversification is part of this—having exposure to 30 funds means that the effect of any fund implosion is mitigated—but it also extends to the outsourcing of risk management skills. Returning to the hypothetical of a university treasurer, Groome notes that they “would likely be less concerned about funds of funds, if they can obtain first-class risk and portfolio management skills they may not have in-house, which is part of what they sell. They would be happy to pay the extra bit to outsource the day-to-day of the hedge fund portfolio. It is the outsourcing of worry, really.”

At least one CIO agrees to some degree with these pitches— and adds a reason of his own for investing in these vehicles. “I will always have a fund of funds in my portfolio for four reasons: Diversification, transparency, access, and knowledge transfer,” says Jim Dunn, leader of the $1.5 billion Wake Forest University endowment. “With a staff of seven, it’s unrealistic to believe we can identify, negotiate, monitor, and benchmark hedge funds in Sao Paolo, Singapore, Geneva, and Minneapolis. I need our fund of funds to be on a ‘full court press’ all the time with our managers while building a bench and a dialogue with us.”

These pitches, either implicitly or explicitly, are meant to compete with consultants. “There is both a symbiotic relationship and an uneasy relationship between funds of funds and consultants,” says Cadogan’s Trammel. On one hand, consultants do direct clients toward funds of funds—although paying fees to consultants, 1% management and 10% profits to a fund of funds, and 2% and 20% to a hedge fund seems slightly redundant—while on the other they can allow funds to circumvent the hedge fund aggregators. “Albourne is a great firm,” Trammel admits, noting that much of the consultant business recently has been flowing their way. “Yet, consultants can’t do two things: They don’t provide active management of a portfolio of hedge funds, and they don’t provide protection if you’re making a mistake. You can fire them, of course, or quit paying them, but any time you’re in a commingled vehicle of several billion dollars—30 to 50 hedge funds—and something goes wrong, the impact is de minimis. You don’t get that protection with consultants.” It might be tempting to brush off such criticism as sales-based banter, as David Swensen certainly does. However, the Yale CIO isn’t exactly pro-consultant either. In the same 2009 interview in which he called funds of funds a “cancer,” he also argued that “consultants make money by giving advice to as many people as possible, but you outperform by finding inefficiencies most of the market has not yet uncovered. So, consultants ultimately end up doing a disservice to investors.” Hardly an endorsement for consultants to hang their collective hat on.

“We are not immune to fraud,” says WBIMB’s Watson, commenting on the obvious critique that investing directly in hedge funds can just as easily expose a fund to implosions driven by regulatory investigations, turning markets—or another Bernie Madoff. “We may be a victim ourselves one day—but we still think it’s the right way to do it. At least we’ll be in control.” Besides the likes of Wake Forest’s Dunn, who views the cost and control issues as secondary to arguments for knowledge transfer and diversification, this is a common sentiment: I may be harmed, but I’ll be harmed because of something I—and not a vendor—did. 

This sentiment will lead to two distinct bifurcations in the hedge fund industry. The limited partner bifurcation, as suggested by hard data (Greenwich Associates, Preqin) and anecdote (McFate, Watson, Ailman, and Martin), will separate those who remain with funds of funds from those who invest directly, with the latter increasingly outweighing the former. The funds-of-funds bifurcation, on the other hand, will see established players—K2, Cadogan, Grosvenor, and a handful of others—survive while newer and smaller funds will remain in stasis or decline. “It’s very hard to start a [funds-of-funds] business today,” says AIMA’s Groome. “You’ll see the major players stay strong, and not much change from there.”

Put a more colorful way: The “cancer” that David Swensen speaks of won’t die—but it won’t spread further either.