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The End is Nigh for Smaller Funds of Hedge Funds |
Date: Friday, May 4, 2012
Author: Simon Kerr on Hedge Funds
For some time there have been questions raised about the sustainability of
the business models of funds of hedge funds as a category. There is no doubt
that they will continue to exist and that there will be winners as well as
losers. But the rising tide of assets in the hedge fund industry is not
lifting all the FoF boats. Only this week quoted hedge fund company Man
Group reported minor growth in its single manager businesses and minor
shrinkage in its multi-manager business (see
previous article).
There are solid reasons for the changing
composition of the shape of the FoFs sector, mostly related to the source of
the whole industry's net flows, i.e. American investing institutions. A
typical example is the
Ohio Public Employees
Retirement System which had had allocations with
FoFs Prisma Capital and K2 Advisors LLC.
In the middle of last year the Ohio
System hired specialist hedge fund consultant Cliffwater LLC to provide due
diligence and manager recommendations to staff on a non-discretionary basis.
The existing fund of hedge funds allocations of the Ohio System will remain
in place, but from that point on new allocations to hedge funds would go to
single managers with consultant input.
The new "new thing" for
state plans starting from scratch in hedge funds is to do as the
State of Wisconsin Investment Board has done
and go straight to single manager hedge funds without an interim phase of
allocating to FoFs. The Wisconsin Investment Board has taken a decision to
invest directly in 15-20 single manager hedge funds.The first allocation was
to Capula GRV Fund, followed by MKP Credit
Fund, Claren Road Credit Fund,
Ascend Wilson Fund and
BlueCrest's BlueTrend. The Employees Retirement System of Texas has
announced an intention to do the same - direct investment in hedge funds, in
their case a 5% allocation amounting to over a billion Dollars phased in
over three years.
That
is, the marginal flows to the industry are being disintermediated as far as
FoFs are concerned, with consultants and advisors taking a bigger role in
allocations. This has been great for the business of Albourne Partners and
Cliffwater and the like, but what about the funds of hedge fund businesses?
How are they getting on?
Fund of Funds In Aggregate
Each year PerTrac, the hedge fund software provider, produces an analysis of the composition and size of the single-manager hedge fund and fund of hedge fund industry. The 2011 study was produced by aggregating investment data from eleven of the world’s largest alternative databases - BarclayCTA, BarclayHedge, CogentHedge, Eurekahedge Hedge Fund, Eurekahedge Fund of Funds, HedgeFund.net, Hedge Fund Research, MondoAlternative, MorningstarHedge, Tass, and TassCTA. The combined number of investments from these eleven databases was nearly 56,000 entries. Duplicate records for single-manager hedge funds, CTAs and FoFs were removed so that a single record per fund was retained in the study to create a holistic industry list.
According to PerTrac's data, the reported
AUM of funds of hedge funds were essentially unchanged y-o-y (+0.23%) at
$447bn at the end of 2011. Given the industry had a negative return of
between 5 and 8% at the single manager level last year, that implies some
positive flows to FoFs in aggregate. Plus, the total number of funds of
funds reporting to databases at the end of 2011 was down 4.8% on 2010 at
3,388. That is there were more assets by value overseen by fewer fund of
funds managers. Someone in the fund of funds sector was doing a bit better
last year!
The answer to the question "who?" is the
largest funds of funds. FoFs that reported managing in excess of $1 billion
were the only group to experience a positive growth in fund numbers from
2010 to 2011 as shown in graphic 1 below.
Graphic 1. Number of FoHFs by AUM Size and
Percentage Change from 2010 to 2011*
*Figure excludes515 funds in 2010 and 522
funds in 2011 that did not report AUM, source:PerTrac
Taking a look at the different size
categories of funds of funds in turn, there is other evidence that the very
biggest funds of hedge funds are getting bigger. The top 10 FoF management
companies (as opposed to individual funds, and as covered in the PerTrac
study) added assets in 2011, according to InvestHedge data. The ten largest
FoF groups managed $227bn at the end of 2011, an increase of 2.6% over the
start of that year, and equivalent to 50.7% of the FoF industry's assets. In
addition there were 16 FoF management companies with $10bn of AUM or more at
the end of 2010. There were 17 at the end of 2011. So the very large funds
of funds groups were slowly growing in aggregate.
The larger funds of hedge fund companies
(those managing a billion dollars or more) have shown stability in assets
recently. The InvestHedge Billion Dollar FoF Club managed $622bn of assets
between them at the end of 2011, only a tad down on end-2010 levels (-0.7%).
The number of FoFs containing assets of
$500m-$1bn shrank last year according to the PerTrac study - there were 5.9%
fewer of them by the end of 2011 than at the beginning of the year, but that
size category is not where the industry squeeze is most evident. More than
one-in-seven of the FOFs sized between a quarter and half a billion dollars
in AUM closed down last year. It is in this size band that numbers of funds
of hedge funds are shrinking most.
This has been a long time coming - the
demise of the smaller fund of hedge funds was prophesised nearly ten years
ago. Very few of the mid-tier FoFs benefited from the growth of the hedge
fund industry through institutional flows in the period 2003-2008. But that
is not the same as saying the circumstances forced smaller FoFs out of
business - they just did not grow much.
In the period since the Credit Crunch
institutional investors have completely dominated the capital inflows to the
hedge fund industry. And they go big for their suppliers. HNWI investors
were a major source of redemptions in the industry in 2008-9, and there have
been few-to-no net flows to the industry from HNWIs in the last two years or
so. It was the HNWI that was historically prepared to invest through the
smaller fund of hedge fund. So in aggregate the smaller FoF experienced,
say, a 35% drop in capital because of redemptions and capital losses in
2008, and little or no recovery in assets since.
So while 47% of the funds of hedge funds
managing $1bn or more experienced positive inflows last year, their smaller
bretheren have seen the industry tide of capital go out and not come back
again. Most modest-sized FoF managers will be running a business with the
same level of income as seen in 2004-5 with the cost structure of 2012. That
is not sustainable.
Reaction To Conditions - M&A
Hence the corporate activity in the fund of
funds sector. For example, Nexar Capital Group was founded to pursue a
roll-up strategy amongst funds of funds, and bought Allianz's fund of hedge
funds business in 2010 and Caledonia Investment's Ermitage fund of funds
business last year. Nexar itself agreed to be bought by UBP at the beginning
of March this year. Other FoF takeovers in the last year include William
Blair's acquisition of most of Guidance Capital's assets under
management; Athena Capital Advisors acquired Stonehorse Capital Management;
and Cantor Fitzgerald started its planned expansion into hedge funds with
the acquisition of Cadogan Management. Other forms of deal seen in the last
year, apart from complete takeover, have been merger and stake sale.
Evercore Partners bought a large minority stake in ABS Investment
Management, the $3.5 billion fund of hedge funds. The merger between
Gorelick Brothers Capital and Access Fund Management may have been defensive
as the combined entity had only $100m under management when the deal was
announced.
A dealer in second-hand hedge fund assets
said this week that the wind-down of some fund of hedge fund businesses has
given his own business a fillip. "I see another 18 months of funds of funds
mergers and acquisitions. It is great for me because it throws up holdings
in companies and funds to be disposed of - there are a lot of buyers for
these sorts of assets out there," he said. "But there is a limited window
for this activity, and we are in it now." What has he seen as the driver?
"The funds of funds business is dying at the lower level."
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