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FoHF consolidation: buy-out or lift-out?

Date: Wednesday, February 8, 2012
Author: Niki Natarajan, Hedge Fund Intelligence

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If investors are no longer buying products with verifiable track records, just how are investors supposed to know how to pick a good adviser?

As the mythical phoenix – with a multi-coloured plumage of gold, scarlet, purple, blue and green –nears the end of its life cycle, it builds a nest that ignites and reduces to ashes, from which a new, young phoenix arises, reborn to live again. So too the new generation of multi-managers are being re-born from the legacy ashes of the commingled funds era.

As portfolios become individualised, and the bespoke is favoured over the commingled, performance becomes much harder to track. If investors are no longer buying products with verifiable track records, just how are investors supposed to know how to pick a good adviser? What else can they use to judge those with whom they will invest billions of pensioners’ dollars? And are they right to trust their consultants without question?

Part of the answer I believe lies at the very beginning of the process: with the people that manage the money. After all, looking into the whites of the eyes of the person who actually manages the money is one way of “knowing” whether one should hire them in the first place.

So why do so many institutional investors abdicate this responsibility to arguably less qualified others? Probably because the art of knowing without knowing is hard work that requires an investment of time, money and energy. But above all to achieve mastery in intuition it requires practice.

Performance starts and ends with the people who produce it. Even in the black box world it is still a human being that programmes the algorithms. So honing one’s expertise in “reading” people is as much a key skill in picking stocks as it is in buying hedge funds.

Expertise and track record in due diligence, start-up manager selection and portfolio construction are just some of the immortal skills that are honed with time and experience to become what Malcolm Gladwell calls the “unconscious database of experience” in his book Blink. It is this individual’s unconscious experience that allows intuition to work its magic.

And it is the true understanding of the contribution of individuals that will see 2012 become the era of the lift-out as the FoHF industry in particular starts an accelerated process of consolidation. After all, asset management companies are merely collections of talent, plus lots of expensive accessories.

We are in a period of austerity, which is why the lift-out is the smart investor’s consolidation. While the eager head-hunters are likely to agree wholeheartedly, I suspect the M&A boutiques will not. They only paid if a company is sold as a multiple of assets under management.

But here is the problem with applying the asset multiple formulae to funds of funds, especially now that the industry is being controlled by the consultants. In this new consultant-led era, buying assets could end up being as mythical as the phoenix, disappearing in a puff of smoke after the deal is done.

Typically, consultants rush to put asset managers on watch lists at the slightest sniff of change in personnel or performance, an act that in itself often damages companies whose assets start to falter further. With FoHFs as their rivals, multi-managers are likely to see themselves dropped without so much as even seeing a watch list. Direct allocations, as can be seen in cases like Diamondback, are likely to have a reprieve – as consultants are going to be less likely to want to be seen as having recommended duds.

But this discussion is not one about conflicts of interests. It is about understanding that track records and the assets they support are only worth investing in if one can guarantee that the person who creates them will stay. Otherwise, in the hedge fund world at least, wherever the good manager goes, so too does the money. And the savvy intuitives at the oft-maligned FoHFs are usually the first to know of these plans, as Markham Rae found out on day one.

Consolidation of the unprofitable FoHFs is inevitable this year. But most that are looking to sell either want to get out of the game or are in a distressed state. Neither of these scenarios offers a real bargain. But housed within many of the ailing groups, as Cantor Fitzgerald has arguably found, could be gold. It might be arduous work, but panning will be worth it.