In recent months, funds of hedge funds have scrambled to get back on to the front foot. Average declines of 18% in 2008, coupled with large-scale redemptions, hit many firms hard. Worse, the imposition of gates to limit or ban redemptions served to spark investors’ ire. The fund of funds model has never faced tougher challenges. The severity of the issues confronting the sector has seen Man Group merge and rebrand its two remaining funds of funds as Man Investments, while one-time sector leader UBP has lost more than half its assets.
A multi-boutique model
Perruccio had several key objectives in setting up anew. One was getting the right people. Another was to link with a partner offering strong financial backing and a big distribution capability. The third was finding a partner willing to create the space necessary for an entrepreneurial environment to flourish.
“I was taken aback at what a perfect partner Hermes is for us,” Perruccio says. “First, it is a long term fit with our perspective of building a business over time and avoiding doing things that would be wrong just to make short-term profits. Hermes is respected for having an incredibly good reputation for governance and doing the right thing, being a leader in responsible investing – all things that we thought gave a sense of confidence to institutional investors. Plus it is an institutional brand, not interested in retail or wholesale. And Hermes has compliance, legal and operational infrastructure – all the things we wouldn’t have had but would need to plug into and know were robust.”
Perruccio is keen on Hermes’ strategic vision of creating a business made up of a series of investment partnerships. He also speaks highly of the pension fund’s underlying dedication to alternatives and its reputation for being innovative, something underscored by its relatively early move into commodities investing in 2005. “All those things together just made the possibilities endless,” he says. “Also what I liked about the discussions with Hermes was that it was always very much about partnership. Not just the legal manifestations of partnership, but also the psychological and philosophical approach to it.”
The fund of hedge funds venture is Hermes’ latest in a process of opening up and becoming much more commercially minded. The pension fund manager already has equity ownership, real estate and commodities ventures. It is expected that the boutique model will eventually move into other areas. The new venture means Hermes’ existing internal fund of hedge fund allocations are being wound down. Hermes BPK will be the sole provider of funds of hedge funds for Hermes Fund Managers, though the pension fund will continue to invest directly in single manager funds.
Perruccio readily acknowledges it is a good time to be a start-up. The difficulties hedge funds experienced in 2008 with performance, liquidity and due diligence make it attractive to build a new platform without legacy issues. But it also raises questions about what the BPK partners took away from the crisis and how the new firm is being positioned to avoid the mistakes that shook the industry to its foundations.
“Without sounding presumptuous or arrogant, some of the things that happened I was expecting to happen,” Peruccio says. “I didn’t have a crystal ball and didn’t forecast the dimension of the debacle – but the issue of liquidity mismatch, for example, had become increasingly disconcerting to me.” He compares the explosive growth in the sector to a brand that becomes popular in one field and is then leveraged into another completely different area. “I think that happened to funds of funds,” he says. “A number of funds of funds had always been institutionally focused, and prudently managed low volatility funds for that constituency. With the dramatic growth in the industry, there was the opportunity to grab billions through high net worth, mass affluent investors and even some quasi retail channels.”
This development set up the liquidity squeeze to come. “The problem is the lower you go down the food chain from institutional to retail, the greater the need for liquidity,” Perruccio says. “You cannot match the liquidity needs of the underlying investor, the portfolio and the underlying funds while retaining a diversified portfolio because many of the strategies are illiquid.”
Of course the mismatch was amplified by the fact that history showed a heavy redemption month might be 5% of a fund’s assets. If the worst-case scenario was judged to be double or triple that figure then a 6% cash holding and a similar sized liquid long/short equities allocation could be expected to provide enough of a cushion. But when redemptions ran to 25% and more, the prevailing liquidity structure in a typical fund of funds was unable to cope. Redemptions gathered pace, creating a vicious circle. If a fund of funds had conditions governing diversification, selling a couple of investments would drive them overweight in others and thus ended up precipitating more sell orders. “There was no opportunity to counteract that by new investing,” Perruccio says. “You couldn’t go and buy another fund to balance your portfolio because everyone was gating or shutting down. It became this horrific spiral. Deleveraging, deleveraging and deleveraging.”
Certainly the new landscape is an interesting one for funds of funds. Though the model is under scrutiny, many investors, including pension funds, don’t have the resources of, say, a CalPERS to invest directly. With fewer hedge fund managers, less leverage and thinner competition among funds of funds the opportunities for new entrants with the right skill set – and money, of course – are potentially terrific.
Perruccio agrees that the new venture faces an interesting juncture. “Most fund of funds are very distracted by the mistakes and legacy problems that they are working out,” he says. “And the underlying universe of hedge funds has gone through a Darwinian culling. The guys who are surviving are the better ones, mostly. They certainly are the more prudent ones or the ones who had a bit of business sense about how to manage their business. We have an added value in that we are a long term source of capital with 20 years’ experience in the industry and we are known to the underlying fund managers.”
Alignment, transparency, liquidity
Alignment, transparency and liquidity are key components of the Hermes BPK proposition to investors. Perruccio says hedge fund managers are getting the message about transparency, governance, performance fees and fund terms being aligned with the needs of both end investors and funds of funds. “Our experience in six or seven cases is that we have changed long standing policies of some of the hedge funds we work with by engaging them constructively and fairly,” he says. “A lot of hedge funds haven’t changed just because it has not been explained to them from the investor’s perspective.”
On transparency, Hermes BPK is giving investors full visibility into the managers and exposures within its two funds, subject to a non-disclosure agreement. It is using a proprietary forward-looking exposure tool to show portfolio sensitivities to different market conditions and asset classes. “The world realises now you need to know what you are buying,” Perruccio says. “That was one of the big problems. Institutions thought they were diversified with their funds of funds but found they had bought beta.” The firm has a tough love approach to liquidity issues. It is up front in pointing out that investors need to understand the liquidity constraints that are commensurate and appropriate for its underlying strategies. “We are not going to adapt what we have because it will then no longer be the investment that they should be buying,” he says.
The biggest part of the Hermes BPK’s seed capital is over £600 million allocated to the Hermes BPK Fund, a multi-strategy, low volatility product. Over £200 million is going to the Hermes BPK Restructuring Fund with a small portion reserved for a niche strategy fund that is still being defined. The restructuring fund, almost fully allocated, is to be highly concentrated with eight to 12 managers and will look to take advantage of the growing opportunities in credit markets. The larger fund, which is about half allocated, is a more typical fund of funds and will have 25 to 30 underlying managers. “Obviously it will have certain biases at different periods in time depending on where we see the markets,” Perruccio says. “Clearly we are going to have a bias eventually in the next year or so to some credit strategies because there are opportunities that are pretty extraordinary in the distressed space.”
Hermes BPK is targeting the development of new distribution relationships in Australia, Switzerland and the Middle East. The aim is to leverage off the infrastructure of Hermes and provide institutional and direct sales as well as advisory services to overseas institutional hedge fund investors. The pension fund manager’s central sales team will service the UK and continental marketplace, but in other areas where Hermes has no strong presence new relationships are being cultivated. In Australia, partner Plus Capital is creating a domestic vehicle to offer Hermes BPK funds to pension schemes. The venture’s rationale is that Australian superannuation rules and pension funds are positively disposed to allocating to alternative investments. “It is a natural place for us to be,” Perruccio says. “Competition has come down substantially in the market place. There is an opportunity for us there, particularly with our backdrop of good governance and the reputation of Hermes.”
If Australia offers an immediate opportunity, the Middle East provides a tougher challenge. “The sovereign wealth funds and the pension funds and the large asset allocators in the Middle East are still overseeing huge amounts of money, but they aren’t allocating,” he says. “They are very cautious. They’ve been burnt once or twice. At the same time they are very interested in credible, respectable counterparties, of which the universe has reduced demonstrably.” Such investors, who generally don’t have the resources to select managers or invest directly in hedge funds, may yet offer a substantial business opportunity for well-positioned funds of funds. But in order to qualify for some of that business, a fund needs robust infrastructure, the right policies on transparency and a proven reputation for effective due diligence.
Evolution of Hermes
The decision to bring on an external team to manage the fund of hedge fund exposure and market its services externally came from a realisation that Hermes couldn’t keep devoting more and more resources to alternatives. So the solution was to develop a closely integrated team with high levels of transparency and communication; it could provide funds of funds as well as playing an advisory role in direct investments to hedge funds.
How funds of hedge funds allocate can be problematic: the time delay between decision making and allocation limits flexibility, especially for fully invested funds that may require at least 90 days notice of redemption. Hermes BPK is using what co-CIOs and founding partners Mark Barker and Gregory Knott call a dynamic allocation model. Using the credit sector as the leading indicator of markets, the world is broken into three environments – improving, static and deteriorating.
The aim is to determine when movement from one regime to another is occurring and begin a reasonably significant change in the asset allocation policy from a top down perspective. This complements the liquidity constraints funds of funds work with and also helps to finalise the risk budget for each underlying investment strategy. The aim is to get the highest level of alpha from any strategy, while having tighter control over tail risk.
“One thing that became very clear in the last static phase is that most credit managers were giving you a very equity-like risk return profile,” says Barker. “Therefore, as you went into that static environment, if you were going to be getting an equity-like risk return profile from your credit managers you might as well use the more liquid strategies. So bring down your credit and put it into more equity-driven strategies. What we are also doing in each of those environments is assigning a risk budget in terms of how much beta and how much volatility you are prepared to give to any of the underlying strategies. The analysts are therefore given a beta budget. Clearly, if they produce a portfolio that is undershooting on the beta then you can have a higher weighting than the band would suggest. So it’s not a rigid fixed discipline.”
The model shows that the credit environment is still deteriorating. Until the deterioration begins to slow, the aim is to have a low exposure to equities and credit and a much higher exposure to macro directional strategies and relative value plays that capture volatility. This might see volatility arbitrage strategies attract capital but not, say, fixed income arbitrage strategies, which run pronounced tail risk in this environment.
Assessing manager sensitivity
“What we’ve tried to do from a bottom-up perspective is to assign a very qualitative assessment of sensitivity to a variety of different environments,” Barker says. “What is a manager’s potential sensitivity or beta to equity markets, to credit markets, to volatility, to liquidity? We come up with a -10 to +10 rating. It is subjective as it is based on the analysts’ interpretation of where the manager is going. The index number relates to an expected level of loss or gain in extreme movements for those factors. You can then take that and weight it for a portfolio and then try and have a qualitative understanding of the portfolio’s sensitivity to movements. It’s done on a forward-looking basis. It is something we have always done, but we are now putting a more formulaic methodology over it. A big part of it is to make sure the people that work for us really understand the thought process that goes into the portfolio construction.”
In the current market environment, the multi-strategy and restructuring funds are overweight with trading-orientated managers. Such managers generally have a clear macro view and then trade in line with those macro convictions. The goal is to concentrate on managers who can remain nimble in an environment of above-trend volatility and, for the time being only cautiously add exposure to fundamental distressed managers who buy assets.
“With a long/short credit manager our focus is on those managers that have much more liquid portfolios and are prepared to swing the net to fit in with their short- to medium-term macro view,” says Knott. “Rather than a real directional credit manager buying assets, what we want to be buying at the moment is volatility or the ability to create alpha opportunities out of volatility.”
To avoid the high correlation among divergent asset classes that bludgeoned funds of funds, Barker and Knott’s team aim to understand at a fairly fundamental level what the drivers of return for any manager are going to be, particularly on the tail. Will, for example, a manager be long or short equity tails, credit tails, liquidity tails? “The idea is to get a sub-section of the portfolio that is going to really generate strong returns from, say, another liquidity breakdown,” Barker says. “When correlations go to one, you end up, in effect, with two negatively correlated blocks of portfolios. It’s probably the best you could hope for if we had a repeat of last year’s environment.” He says the hedge funds that did well in the 2008 tsunami were those with substantial allocations to very long volatility strategies and some real volatility arbitrage strategies, while some macro funds prospered after predicting yield curves steepening. “There are certain environments where you have to go into as protective a mode as you can,” he says. “I don’t think anyone is suggesting any asset class is the magic bullet for all environments, certainly when it gets that extreme.”
One of the more onerous parts of a fund of fund manager’s job is managing net exposure at the portfolio level. Hermes BPK calculates net exposure by asset class, with a view to anticipating where each may be going. The firm’s analysts seek a forward-looking understanding of how a manager will adjust their portfolio and offset risk on a one- to two-quarter time horizon.
The minimum position for the flagship fund of funds is 2% with a limit of 6% rising to up to 8% in the future. This means that the minimum allocation for the multi-manager fund is $10 million but that will move to around $20 million as further seed assets are drawn upon. No allocation can be more than 20% of a manager’s assets and, if there is a degree of illiquidity, the limit is 10% to avoid redemptions hurting asset sales prices. Therefore Hermes BPK is really looking for managers with assets in excess of US$200m.
With the Restructuring Fund, the portfolio started long investment grade debt, and ratcheted down in quality as the market rallied, while remaining fairly hedged all the way through. Today, short exposure is increasing and the portfolio is fairly neutral. It is expected that 60% to 70% of the book will eventually be with managers making significant directional, less-liquid restructuring plays. One of the few areas where the fund is buying assets on a relatively unhedged basis is a small allocation to mainly US residential mortgage-backed securities.
With fewer hedge funds, much less leverage available to survivors and the shuttering of many bank proprietary trading desk activities, the amount of active money in play has shrunk markedly. This is juxtaposed with alpha opportunities that look to be the best for many years. In consequence, diversification in the multi-strategy fund is higher now than it will be in a few years.
“In the past we believed that because each manager was offering a chunk of beta, the more diversification you had the more that beta multiplied and the alpha got diversified away,” Knott says. “It was the common theme of beta that became the dominant part of the portfolio. Today it is a bit different. If you diversify a series of idiosyncratic risks then you should end up with a fairly attractive, reasonably pure alpha stream. The opportunity to deliver it today and over the next couple of years is higher than it’s been for a long time. Diversification should work for you. As you see the environment shift and the world go back to being more beta driven then it makes sense to shrink the diversification.”
For now, Hermes BPK won’t seed emerging managers since the risk policy of the multi-strategy fund is too tight for that. “I would like to see a seeding book in the not too distant future,” says Knott. “We have a number of candidates and we’ve got the qualitative strength.” Adds Barker: “You can get an awful lot more today as the seeder than you could two or three years ago. But we don’t have the vehicle for seeding right now and it would be irresponsible to move onto something that requires a very different process. The focus at the moment is to concentrate on building the core business, but it is something we want to continue to consider as the year goes on.”
Three-pronged allocation process
Getting the right balance between quantitative and qualitative analysis and operational due diligence is important to Barker and Knott. They believe it is a mistake to do a lot of quant work on a manager in the first instance. “Ultimately, if an analyst has seen that a manager is sensitive, say, to a spike in volatility in high yield credits, the work he does is probably going to validate that rationale because the numbers have told him that that is the case,” Barker says. “It’s very beneficial for the analyst to have not reviewed any significant quant work before they go in and develop a thesis on how the manager takes risk, how he offsets risk and ultimately what he is sensitive to, what environments are going to be helpful to him and what environments are going to be challenging and why. We want to make sure that we understand the why and the implications of those factors. Once you have generated the thesis you can then go and test it to destruction through the quant side. Ultimately, if the qualitative and quant analysts agree then you can have a lot more confidence in the thesis. If they disagree, you have to go off and find out why, reinvestigate the process and come back and see if you can get agreement. If you really can’t, and most importantly, you can’t understand why you can’t, then there comes a stage when you have to walk away. If you don’t get it, you shouldn’t be buying it.”
Vincent Vandenbroucke, Head of Operational Due Dilligence, is a member of the investment committee. His work forms the third point of the research triangle. Operational due diligence often comes last, partly due to the time requirement of half-a-dozen on-site meetings – separately meeting the COO, CFO, CCO, CRO and others as well as service providers – and partly due to the cost burden of full background checks.
The qualitative research, the quantitative analysis, and the operational due diligence are customised to suit the fund being researched. Hermes BPK focuses more energy on understanding the trading platform for a strategy executing 100,000+ bargains a day rather than, say, a low trading frequency value fund. Conversely, the valuation policy of a large cap US equity long/short fund would require less time to verify than, say, a credit distressed manager with more complex and less liquid positions. But a higher volume long/short fund will see more time spent on execution, initiation, trading, market communication, matching, counterparty, brokerage commission and soft dollar arrangements as this is where the potential risk lies for such a strategy.
The Hermes BPK research teams, led by Head of Research Tommaso Mancuso, look to understand the goals and plans of each manager in terms of where they expect to be a quarter or one year later, whether new strategies are being added and how quickly a shop may be looking to expand. Thus a manager with $200 million which plans to do just one strategy will be looked at differently than another who has similar assets under management but is seeking to expand the range of strategies. “We will have different expectations from a people standpoint, from a counterparty standpoint,” says Barker. “I think we have done a good job with getting a high level of transparency – that’s a reflection of the industry’s change. But it is very important that you are as forward looking as possible in every aspect of the research and the portfolio construction process.”
Vandenbroucke says operational conclusions are never universally positive or negative, but always somewhere in the middle. “It’s an accumulation of subjective criteria that basically leads to a conclusion that is yes or no,” he says. “There are a lot of in-the-middle types of example where we do like what we see and we recognise potential, but not exactly to the level of requirements we have. Therefore we do engage a lot with our managers to help them reach the standards we need.”
Ongoing due diligence means that operational and background checks are renewed annually. Vandenbroucke says about 60% of his time is spent on probing existing managers. On-site visits by both the qualitative and operational due diligence teams occur at least twice annually to complement the regular analysis of returns, changes in AUM, financial statements, regulatory filings, prospectus and proxy filings – as well as delving into any operational, personal or valuation policy alterations. He is quick to add that he has redeemed for operational reasons more frequently than rejected managers out right. The implication is that the hedge fund world is one in constant mutation.
“The plan is not to obtain more than the manager is giving to other investors,” Vandenbroucke says. “We are big believers that hedge funds should treat investors fairly. Whatever we get we try to encourage the manager to give to everyone. Everything we have obtained is offered to other investors.”
Policy of engagement
The level of engagement managers can expect with Hermes BPK is substantial. Even when managers don’t get an allocation, an analyst will communicate to the manager what is in the formal written report. Given the hundreds of managers the firm sees, such feedback offers single manager funds a useful assessment of strengths and weaknesses. Small wonder that Vandenbroucke, once an auditor, now says he feels more like a consultant.
“This is somewhere we want to offer real leadership,” says Barker. “Let’s not be naïve: we have an opportunity today because we have capital – managers need capital and it is pretty scarce. The ability to make demands is higher in this environment than it has been for a long time and higher than it will be in a couple of years’ time. The industry is going through a point of change. Managers are aggressively re-orientating their business to serve more of an institutional client base. That sort of consulting service to allow them to get there is particularly well received.”