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Hedge funds navigate maze of redemptions

Date: Monday, November 10, 2008
Author: David Walker, Wealth-Bulletin.com

Investors are looking at future profitability by buying stakes in managers.

Millionaire hedge fund manager Andrew Lahde might have got it right. The man whose valediction last month to his industry peers announced that “with all due respect, I am dropping out”, left the industry while the going was still relatively good.

Admittedly, at the time of his speech, nine out of every 10 hedge funds were not able to take 20% of their profits as a performance fee, and the average hedge fund had lost about 19% of its value, reversing at least the two previous years’ gains. But hedge funds face withdrawals at year end that will match or exceed third-quarter record redemptions of $31bn (€24bn), according to data provider Hedge Fund Research.

The disappearance of incentive fees, the reduction of set charges based on assets, poor performance and redemptions, could be the final straw for many funds. HFR estimates 700 funds will close down this year. Sophia Brickell, fund of hedge fund investment specialist at asset manager GAM, estimates the eventual total will be nearer 900.

Tom Brown, European head of investment management at advisers KPMG, said the credit crunch had made it paramount to run a tight ship by reducing optional expenses.

However, as cash-strapped managers seek to survive, a growing number of investors are going against Lahde’s decision to “throw the BlackBerry away and enjoy life”, by buying into what they see as healthy future profitability. They are doing so by taking stakes in hedge fund management firms.

Patric de Gentile-Williams, chief operating officer at Financial Capital Advisors, the fund-seeding arm of $15bn hedge fund investor FRM, said: “Taking stakes in asset management businesses may make sense in the current environment.” He said some managers might plan to recruit people or launch products, but find the risks of doing this using only the management firms’ own money too great.

De Gentile-Williams said hedge fund investors might analyse more keenly the amount of capital managers set aside in their business before investing in their funds. He said: “It could be prudent to raise money for your capital base to solidify your company. Instead of, say, six to 12 times operating capital, managers may want to keep 12 to 24 times in the capital base and therefore it may be their sensible and legitimate requirement for capital is greater.”

FCA provides seeding capital for hedge funds rather than acquiring stakes in their managers. While de Gentile-Williams does not rule out doing so in the future, many investors already do.

Petershill, a fund established by Goldman Sachs last year, has acquired stakes in at least five managers, including London’s Capula Investment, Longacre Fund Management, Trafalgar Asset Managers and Winton Capital Management. Lehman Brothers was raising up to $5bn for a rival vehicle before it went bankrupt. Aladdin Capital also plans to raise $3bn to take stakes in 30 to 40 hedge fund managers.

US, European and Japanese banks have bought stakes in at least 15 management firms, according to US bank Jefferies Putnam Lovell. Furthermore, in the summer the alternative asset management arm of Switzerland’s Credit Suisse bought a controlling stake in Asset Management Finance Corp, which provides loans to hedge funds among others.

Aaron Door, managing director at Jefferies Putnam Lovell said alternative asset managers preferred to take minority stakes. Graham Phillips, partner at consultancy PricewaterhouseCoopers, said he expected further consolidation among asset managers.

However, not all stakebuilding has been mutually beneficial. The acquisition of the fund of hedge funds IAM by Dutch bank ABN Amro in 2006 was reversed this year by its management buyout from Dutch-Belgo bank Fortis, which had bought ABN Amro’s asset management arm holding IAM. The buyout was supported by UK financier Sir Ronald Cohen, who separately took a stake in manager Millennium Global Investors.

While purchasers’ motivations are typically based on profit, James Woolf, partner in transaction services at KPMG, said vendors often wanted to retain control of the business, “and not go back to the type of corporate environment many of them left to start hedge funds”.

He said the hedge fund manager might look for a business partner at least in part as an avenue for product distribution. Woolf said: “Big banks may have clients interested in accessing new hedge fund products, and there may be value to a hedge fund in having the business associated with a big-name bank.

“But when it comes to negotiating a deal everyone has to know what they want out of the transaction. If they’re not clear how it will work there’s not much sense in going further.”

David Goldstein, partner at law firm White & Case, warned managers to be cautious when selling stakes in their business. He said: “Loss of control over the business when you bring in a stake investor or seed investor is something to think about, because you will not be able to make changes involving the fund without the consent of the stake investor. You definitely have a partnership that needs to be managed.

“You will be subject to budgets, compensation caps and limitations, and changes to strategy that are permitted, and admission of people as partners. On all these things you will find yourself restricted.”

Goldstein said investors might also insist that the manager conduct all of its activities within the business in which the investor held a stake, ensuring all fee income would flow into that business. He said: “Stake investors also typically want to see some costs to the principal if they cease to be involved in the business, because the value being paid is premised on some duration of service.”

Nicola Meaden, chief executive of Alpha Strategic, said the pricing of such stakes is central to negotiations. However, tax issues arising from building stakes are also discussed. Alpha Strategic is listed on London’s junior Alternative Investment Market and takes a slice of hedge fund managers’ future fee revenue in return for shares in Alpha Strategic, or shares and cash.

Meaden said: “Most buyers want established managers with proven performance and a business management track record, and locked-up assets should command higher prices. The contribution of management and performance fees to the overall revenue will affect the price.”

De Gentile-Williams said that any opaqueness in the hedge fund firm, or a sense that investors were “just providing someone with a cushy retirement plan” would concern prospective investors.

Woolf said potential buyers would look to funds’ performance, and the stability of that performance, as well as how diversified the funds’ investors are. Given doom-laden predictions of outflows, buyers may add the phrase “loyal investors” to “diversified investors”, on their wish-list. He said: “If as a buyer you have based your valuation of the business on assets under management, you will be watching carefully given the recent reported and expected redemptions from hedge funds over the next few months.”

Woolf said uncertainty around how much in assets would flow from funds in the near future might restrict the number of transactions that will be completed. “Although there is undoubtedly still interest in acquiring stakes, people will tread very carefully in the coming months,” he said.

One investor said for at least the next six months he expected his peers would pull more money from hedge funds than they put in.

Woolf said in such uncertain times managers should be flexible in striking valuations for stakes in their firms.

He said: “The manager may have a view on the value of his business that has changed a bit, but if matters are… bad in terms of redemptions and the ability to get new clients and retain existing clients he might have to change his idea of the value if he wants to secure a business partner.”