Emerging Managers Fund

Schemes should ‘look at structured products’

IPE.com 22/Apr/05: SWITZERLAND - The pension fund world lacks risk management and should look at structured products, an investment conference in Geneva has been told.

Koray Simsek, a professor of finance at the Edhec business school, advocated pension funds gaining exposure to guaranteed structured products.

Such products, Simsek said, offer a guarantee on the capital initially invested. “I am in favour of using them. These are called third-generation portfolio insurance products so they are a bit more sophisticated,” he told IPE on the sidelines.

“They would be very desirable especially to underfunded pension products.”

Senior Watson Wyatt consultant Edouard Stucki agreed that they may be useful to underfunded pension funds, which have decreased their exposure to equities.

But healthy funds would cut their downside risks, but in the process do away with the up-side risk. “When you are a fully funded fund, you may want up-side,” he observed.

Simsek and Stucki were speaking at a conference organised by Edhec.

Simsek explained that pension funds have two ways of implementing risk management: diversification and risk hedging, with guaranteed structured products in the latter category.

He argued they have risk-reduction properties and that once pension funds used these products, there would be no further need of risk diversification.

“They are natural investment vehicles for institutional investors keen on non linear pay-offs,” he told delegates.

Allocation to these products would depend on the pension fund’s risk aversion. He said for instance that investors with strong risk aversion would replace bonds with such structured products, while those keen on risk could avoid them all together.

But institutional investors should watch out for counterparty risk.

“As consultants we want providers with significant experience and legal teams who understand where pension funds are coming from, Stucki said.

He also mentioned the issue of costs, which had alienated some Swiss consultants to the product.

“Many colleagues do not like structured products,” he said - explaining that the consultant community does not justify the costs involved, which he said could be lowered through a higher degree of transparency.

By Cecilia Valente

12/04/2005 Prince of Liechtenstein's firm made $6bn from hedge funds

Bloomberg reports, Liechtenstein’s Prince Hans-Adam II made his debut in hedge funds by investing in Long-Term Capital Management LP. LGT Capital Partners, his family firm, put $2.5 billion more into similar funds and has earned $6 billion for investment in buyout firms and hedge funds. Now, LGT is pushing to expand to compete with Man Group Plc and UBS AG. LGT Capital’s hedge-fund business, which reduces risk by spreading its money among multiple funds, helped the firm prosper when Hans-Adam battled parliament for more power and police probed allegations of money laundering in the country of 34,000 people. The political conflict was settled in the prince’s favour two years ago when an intergovernmental anti-money-laundering body ruled that Liechtenstein was in compliance with international reporting regulations.

Katherine Breedis, Chris Costanza, Tatiana Pohotsky and Joanna Shatney joined Schroder Investment Management as analysts on the U.S. large-cap equity team, said Martin Luz, spokesman. All are new positions. Schroder is searching for one more analyst to round out the team, which now totals 13, Mr. Luz said. The hirings are "part of Schroder's continuing program to build out its North American investing capability," Peter Clark, CEO of Schroder's North American operations, said in a news release. Schroder had $204 billion in assets under management as of Dec. 31. Ms. Breedis and Ms. Shatney were both vice presidents and senior analysts at Goldman Sachs. Mr. Costanza was an associate director and analyst at UBS. Ms. Pohotsky was vice president and analyst at Independence Investments. Kelly Frederick, Goldman Sachs spokeswoman, did not return a call by press time seeking information on Ms. Breedis and Ms. Shatney's replacements. Bill Dentzer, UBS spokesman, did not have information on filling Mr. Costanza's post. An official at Independence said the firm is evaluating whether it will replace Ms. Pohotsky.

Sowing the Seeding

By Chris Clair, Reporter
Monday, April 04, 2005 4:26:20 PM ET

Incubation can be a ticket to success and prosperity for start-up hedge fund managers. But not all new managers choose to take the ride.

Like singles in a lonely city, hedge fund incubators and start-up hedge fund managers find themselves drawn to one another by mutual desire and circumstance. Each has something the other wants, and amid the swirling colored lights and thumping dance music of what we can surely now acknowledge is a giant hedge fund party, many on both sides are taking steps to make sure they do not wake up alone in the morning.

Not all relationships work out, however, and some managers are deciding it's better to fly solo than hook up with a partner they may later wish they'd never met. Not to draw out the relationship analogy too far, but some managers have learned by word of mouth or through personal experience that while incubators can make for fine suitors early on—plying the funds with seed capital, advice and client introductions—down the road they can sometimes wind up taking more than they give.

To consummate a seed capital or incubation relationship, start-up hedge fund managers not only must provide the incubator with capacity in the fund, they must also sell to the incubator an equity stake in the business. This guarantees that the incubator both reaps the rewards of what hopefully is a wise and early investment in the manager's fund and that it also shares in whatever financial gain there is to be had in the growth of the manager's business.

It can be a win-win, as it has been for Lyford Group International Ltd., New York. Chief Operating Officer Joseph Bucci says Lyford got a timely boost from J.P. Morgan Incubator Strategies, which infused the former Bermuda-based family office fund with US$12.5 million and provided valuable help finding a New York office and working through the intricacies of opening the fund to outside investors. "The family liked the idea of—since they didn't have much awareness of the hedge fund industry—of having someone more involved in the marketplace assist them in meeting their goals of getting the fund up and running," Mr. Bucci says.

Lyford's case is somewhat unusual in that the fund wasn't technically a start-up. Chief Investment Officer Samer Nsouli had been running this particular family's money since 2002 using the same global macro strategy Lyford has now opened up to outside investors. When it came time to broaden the fund's reach, Mr. Nsouli went looking for help. He found it at J.P. Morgan, with which Lyford already had a private banking relationship.

In August 2004, J.P. Morgan Incubator Strategies made Lyford the sixth hedge fund manager in which it had taken an equity stake. Simon Lack, chief executive of J.P. Morgan Incubator Strategies, said the fund and its investors currently have placed about US$100 million in seed money with seven hedge fund managers. An eighth fund is on tap to join in April.

This relative handful of funds has been selected out of more than 1,100 proposals. "Obviously that's a tiny percentage, which means that the average new hedge fund manager isn't that strong," Mr. Lack says.

Yet there are still any number of large investment banks, and even smaller firms, eager to provide seed capital and incubate emerging managers. The rationale is simple: Good managers grow faster, so finding them early and securing capacity is crucial. Find the right manager, and an incubator or seed capital provider can ride a nice gravy train. Or maybe several.

That the number of firms seeking new managers with offers of incubation or seed capital has increased is not surprising to Mr. Lack. "Since we set our business up three years ago, there's certainly more capital and more opportunities out there," he says. "You can think of it having grown at roughly the same pace as the industry itself."

Indeed stacks of articles and hours of seminars have been devoted to dissecting how managers can find seed money and secure incubation. Just as many of those have targeted the firms that provide those services, telling them how to find the best managers.

An article in Absolute Return magazine about raising capital described the simple formula for raising money if you're a start-up hedge fund manager: You have worked for Tiger Management, SAC or other top hedge fund; have a proven record for making money; drop US$1 million or so on infrastructure; and have a strategy that's all the rage with investors. Simple.

For everyone else—which turns out to be a lot of people—incubation and seeding are ways to gain an advantage. It worked for Cognis Capital Partners LLP, London, a European distressed and high-yield-credit, event-driven fund that J.P. Morgan Incubator Strategies seeded in December 2003. Last year the fund, which relies on fundamental credit analysis to identify opportunities in distressed, mezzanine and high-yield corporate debt in Europe, was up 24%, according to Chief Executive Myra Tabor, and as of February 2005 had US$311 million under management.

Ms. Tabor said Cognis was spun out of the Royal Bank of Scotland, and immediately knew it wanted to find a partner. "We all came from private equity backgrounds, so we understood the value of a partner," she said.

A number of firms contacted Cognis offering help and capital, but the principals were "pretty choosy." Ms. Tabor said she got the impression that the firms they heard from early on thought that because Cognis was new and eager to get up and running that its principals would take the first deal offered to them. They didn't. Instead a number of institutions approached them and they eventually were introduced to Mr. Lack via J.P. Morgan's London office. "J.P. Morgan understood our strategy and people there had known us for a long time," Ms. Tabor said, and that upped the confidence level.

Mr. Lack says Cognis would have generated the returns even without J.P. Morgan's help, but it would not have reached its capacity nearly as fast. Doing so has allowed the fund to collect more management fees, making everyone, including J.P. Morgan, a lot more money.

"They [Cognis] are very qualified and would have been successful in any event," Mr. Lack says. "But we feel they've been more successful more quickly through the strategic partnership."

But for every Cognis there are 175 proposals from hedge fund managers that J.P. Morgan decided to pass on. For whatever reason, whether it was the business plan or the strategy or some flaw uncovered during due diligence, those managers were deemed too big a risk. And when it comes to incubation and seeding, there is more at risk than the manager's own money. When banks get involved the stakes go up—for everyone. Fund failure means not only the manager loses, but a major firm with shareholders to whom it must answer has to take a business loss. The potential doom is magnified for the incubator or seed capital provider by the fact that it is dealing with an emerging manager, an inherently more risky bet given the lack of a track record and the fact that statistically between half and two-thirds of all new businesses ultimately fail. A study from Columbia University paints a slightly more upbeat (if by "upbeat" you mean that instead of breaking your ankle in a fall you only severely sprained it) picture, claiming 30% of new funds don't last more than three years.

"The downside clearly is that start-up funds are more risky," says Mr. Lack. And while good return comes without risk, those risks can be managed. Hence the large number of proposals J.P. Morgan discards.

Those managers may find what they're looking for elsewhere. Or they might not, and then they will be forced to go it alone or give up the dream. Sometimes, though, it is not the incubator that isn't interested in a seeding or incubation arrangement. It's the manager.

There are any number of managers out there who do not fit the successful-pedigree, hot-strategy criteria outlined earlier. Yet they pursue their strategies as self-contained units; as solo artists. They prefer not to get bogged down with seeding and incubation, agreements that require them to give up a part of their company and share profits for the length of the contract. Weigh the cost of the relationship before they start, and decide to operate alone. They take on all the risk, bear all the burden but if they're right, they reap all the reward.

Occasionally, Lyford's Mr. Bucci says he hears of managers who get into seeding or incubation relationships where everything works great in the beginning, but sharing success causes a strain that grates on the manager. Some of that depends on the relationship between the manager and the seed capital provider or incubator. Some firms are very hands-on, getting involved in day-to-day decisions and demanding sign-off power for everything from office space to prime brokers. Others are less involved, essentially writing the manager a check and letting him operate freely, within the constraints of whatever risk profile the manager has agreed to. And to that end, the manager must provide full transparency and position reporting.

Sometimes managers and incubators looking for the same thing find each other. Then life is great. Other times, though, mismatches occur and feelings can get hurt.

The process is getting more refined. As it does mismatches will probably become less common and success stories will multiply.


CClair@HedgeWorld.com



Story Copyright © 1999-2005 HedgeWorld Limited All rights reserved.

Public Employees' Retirement System of Mississippi, Jackson, issued RFPs for a tactical asset allocation manager and a global all-cap equity manager to handle $75 million each, said Frank Ready, executive director of the $17.5 billion fund. The firms chosen will be the first for the plan's alpha fund, established to allocate up to 5% of the $9.24 billion equity portfolio to new, alpha-producing strategies. The RFPs are available at http://www.pers.state.ms.us/rfp_index.html and do not specify deadlines for proposals, but the fund is close to closing both searches, he said. Plan officials will likely make selections in June.

Separately, fund officials will review private equity strategies over the course of the year for possible first-time investments, Mr. Ready said. The state Legislature recently approved a bill allowing the system to invest in private equity. A target allocation has not been set; "the statute allows us to invest up to 10% to private equity, but I doubt it will be that high," Mr. Ready said. "Right now it's way too premature to say what it will be." Callan Associates is assisting.

Public Employees' Retirement System of Mississippi, Jackson, issued RFPs for a tactical asset allocation manager and a global all-cap equity manager to handle $75 million each, said Frank Ready, executive director of the $17.5 billion fund. The firms chosen will be the first for the plan's alpha fund, established to allocate up to 5% of the $9.24 billion equity portfolio to new, alpha-producing strategies. The RFPs are available at http://www.pers.state.ms.us/rfp_index.html and do not specify deadlines for proposals, but the fund is close to closing both searches, he said. Plan officials will likely make selections in June.

Separately, fund officials will review private equity strategies over the course of the year for possible first-time investments, Mr. Ready said. The state Legislature recently approved a bill allowing the system to invest in private equity. A target allocation has not been set; "the statute allows us to invest up to 10% to private equity, but I doubt it will be that high," Mr. Ready said. "Right now it's way too premature to say what it will be." Callan Associates is assisting.

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March 27, 2005
If I Only Had a Hedge Fund
By JENNY ANDERSON and RIVA D. ATLAS

T seemed like an ordinary evening at Crobar, the trendy Manhattan nightclub. Two weeks ago, as Counting Crows performed on stage, young women dressed in expensive jeans pushed toward the front with their khaki-clad, mostly older boyfriends. Few, however, were regulars. On this night, the very rich and the merely rich intermingled on the club's two floors - V.I.P.'s upstairs ($1,000 a ticket) and the rest down below ($250).

Most of the 1,250 people gathered for the event, the Robin Hood Foundation charity ball, were part of the city's unlikely new "it" crowd. Richer than Wall Street rich and more willing to take risks than their traditional money management peers, they are the managers behind the staggering growth in hedge funds, those private, lightly regulated investment vehicles aimed at the ultrawealthy, the run-of-the-mill wealthy and, increasingly, the not-so wealthy.

To critics, the frenzy has a very familiar ring. A flood of capital to the latest investment fad. Spectacular accumulation of wealth in a short time. New ventures created easily and often. Those, too, were the hallmarks of the dot-com boom, and, as everyone knows, the bursting of that bubble was far from pleasant. The stampede to hedge funds, some people fear, will be no different.

"It is completely obvious that this will end badly - for the firms, investors, everyone," said Seth Klarman, founder of the Baupost Group, which manages $5 billion. "No area of financial endeavor is immune from the effects of competition."

The numbers are mind-boggling: 15 years ago, hedge funds managed less than $40 billion. Today, the figure is approaching $1 trillion. By contrast, assets in mutual funds grew at an impressive but much slower rate, to $8.1 trillion from $1 trillion, during the same period. The number of hedge fund firms has also grown - to 3,307 last year, up 74 percent from 1,903 in 1999. During the same period, the number of funds created - a manager can start more than one fund at a time - has surged 209 percent, with 1,406 funds introduced in 2004, according to Hedge Fund Research, based in Chicago.

In a way, hedge funds are to mutual funds what Evel Knievel was to weekend motorcyclists. Unlike mutual funds, which are restricted in the ways they can invest, hedge funds can use leverage, trade derivatives and bet that stocks will fall, a technique called shorting. And unlike mutual funds, which generally try to beat a market average, hedge funds seek positive returns, even in down markets.

THE meteoric rise of hedge funds has had a huge impact on the markets, investment banks and investors, who increasingly include institutions like pension funds or endowments. A recent report published by Credit Suisse First Boston said that hedge funds were responsible for up to half of all activity in major markets, including the New York Stock Exchange and the London Stock Exchange.

Investment banks are tripping over one another to service them. According to the same report, Wall Street made $25 billion catering to hedge funds - lending them money, trading for them, helping to structure complex derivative transactions or lending them stock to bet against a company. That's one-eighth of the street's total revenue pool.

Signs that hedge fund managers have become the financial industry's new elite abound. Young, ambitious talent is fleeing Wall Street in search of hedge funds' overnight riches. In hedge fund offices, employees have perks like swimming pools and basketball courts. And in the wedding announcements of The New York Times, hedge fund managers are often well represented.

At cocktail parties throughout Greenwich, Conn. - the informal capital of the hedge fund world - investors sip apple martinis and discuss which funds are in vogue. Because few people outside the industry know exactly how they trade or what they trade, there is a certain mystique to the hedge fund set, which only adds to their allure.

Then there's the wealth effect. Billionaire hedge fund managers are pushing up the price of everything from luxury apartments to artwork. Kenneth Griffin, founder of the Citadel Investment Group, based in Chicago, dished out $60 million for a Cézanne. James G. Dinan, founder of York Capital Management, paid $21 million to buy the Fifth Avenue apartment of $6,000 shower curtain infamy, the one once occupied by L. Dennis Kozlowski of Tyco International.

Predictably, most people in the hedge fund world scoff at the notion of a bubble. "Hedge funds are not an asset class, so there is no asset class to burst," said Jane Buchan, chief executive of Pacific Alternative Asset Management, a fund made up of hedge funds with $7.2 billion under management. "It's not like real estate. Even if you think about people doing silly things for silly reasons, it's not a bubble. If you look at people traveling on the fringes, it might be a bubble."

Indeed, the so-called smart money - rich investors like Thomas H. Lee, the famed leverage buyout maven - could not seem less worried. "Every investment board I am in touch with is interested in hedge funds," said Mr. Lee, ticking off the names of such giants as Calpers and Harvard's endowment fund. Mr. Lee himself has invested a substantial portion of his estimated $1.2 billion net worth in a portfolio of dozens of hedge funds.

Yet, as Mr. Klarman said: "How many venture capital investors in 1999 said, 'We are doomed because of all the money flowing in?' "

Whether the hedge fund boom is a bubble may still be open to debate. But it is certainly not alarmist to wonder about the consequences of such torrid growth, built as it is on the leverage that banks provide managers to double or triple their bets. The Federal Reserve seemed concerned enough last fall, when it set up a group to examine what systemic risks had been created by the explosion of entrants into the market and the aggressiveness with which Wall Street was welcoming them.

The Fed also encouraged the revival of a high-profile watchdog group formed in the wake of the market-shaking 1998 collapse of the Long-Term Capital Management hedge fund. Called the Counterparty Risk Management Policy Group II, it will examine everything from narrow credit spreads - a result of low perceived risk - to the cavalier ways that Wall Street lends to hedge funds.

"Hedge funds are significant market players," Stephen M. Cutler, director of enforcement at the Securities and Exchange Commission, said in an interview. "They use leverage that mutual funds cannot, so the power of that $1 trillion is magnified. Your concern is not just the investors in the hedge funds but the hedge fund's impact on the market."

To impose a modicum of order on the industry, the S.E.C. has required that most hedge fund management firms register as investment advisers by February 2006, a move that an industry trade group has protested.

CONCERNS about hedge funds, however, extend beyond finding out where they are based and whether their managers are felons (two of the objectives of S.E.C. registration). Among other things, it remains a mystery - even to investors - what kind of bizarre financial products are traded by the funds, and how they value them. Given the potential returns, the incentives for investors to bet the house are huge. And many seasoned money managers have closed their funds, opening the door to newcomers to satisfy demand for ever more funds.

Perhaps topping the list of concerns is the proliferation of funds of funds, pools of hedge funds that are meant to lower risk but that also come with another layer of fees on top of what standard hedge funds charge. By the end of last year, assets in funds of funds had soared to $359 billion, from $84 billion just four years earlier. Traditionally, investors have needed a minimum of $1 million to get into a hedge fund; with the newest funds of funds, investors with as little as $25,000 to spend can gain entree.

Hedge funds may hit Main Street in other ways. At least one fund of funds, Grosvenor Capital, with $15 billion under management, is weighing an initial offering or a sale, people close to the company said.

Hedge funds are the new blackboards on which dreams of high finance are drawn. For Karim Samii, who enjoyed a successful career at the investment firm W. R. Huff of Morristown, N.J., the decision to start his own hedge fund came on a bright, snowy morning in December 2003, when he and his wife were visiting his in-laws in Hamburg, Germany. "I was jogging around the lake and I said to myself, 'Where do I want to be five years from now?' " he said.

His firm, Pardus Capital, will open for business on April 1. "It's a big bet," said Mr. Samii, 42. "But if you think you're good, you take the risk."

Philip Broenniman, a 39-year-old trader, spent five months in 2003 cobbling together $20 million to start Cadence Investment Partners in New York. In late October, a week before his firm was set to open, two investors pulled $13 million. "We opened our doors with just $7 million," he recalled. A year later, after posting 16 percent gains, the fund has grown to $119 million.

Managers of funds of funds and other entities that invest in hedge funds say they are overwhelmed by the numbers of start-ups. "We saw 600 pitches last year," said Ted Seides, director of investments at Protégé Partners in New York, which invests in new hedge fund firms. Of that number, he said, Protégé ended up backing just nine. "There are a lot of hopes and dreams," he said. Of course, not all dreams come true.

Ask new managers why they are starting funds and the answers often recall the late 1990's: to build something, to test the "pure art of investing," to be an entrepreneur. One two-year industry veteran with $60 million under management describes why he did it: "Because I could."

Even hedge fund experts who pooh-pooh the notion of an investment bubble acknowledge the possibility of a compensation bubble. Instead of just receiving a fixed percentage of the funds they manage, hedge fund managers generally make "1 and 20" - that is, 1 percent of assets under management and 20 percent of profits.

To put that in context, a mutual fund company managing, say, $100 million and earning 1 percent of assets under management makes $1 million. By comparison, a hedge fund making the 1 percent management fee and a 20 percent "carry" takes in $1 million for opening the doors, and an additional $10 million if the fund returns 10 percent. That's $11 million in revenue.

"Hedge funds are an innovation of compensation," said one fund-of-funds executive. "It's a compensation system, not an asset class." The comment is meant to be positive: in hedge funds, compensation is aligned with absolute performance. In the mutual fund industry, by contrast, compensation is usually tied to performance against a benchmark, like a Standard & Poor's index, or assets under management.

Will fees come down? Few people think so. "If you lower your fee, they think something's wrong with you," said one longtime manager who described the fees as "absurd."

In fact, fees have been moving higher. When Carl C. Icahn, the famed takeover trader, raised a $2 billion fund last year, he demanded 2.5 percent of assets and 25 percent of the profit.

In 2003, the 25 highest-paid hedge fund managers earned more than $200 million, on average, according to a survey by Institutional Investor magazine. The top-ranked manager, George Soros, took home $750 million that year. At No. 2 was David Tepper, manager of the $3 billion Appaloosa funds, who earned $510 million, according to the magazine.

The lure of hedge funds, of course, is not supposed to be the high pay but the outsized returns. Lately, the results have been less than compelling. Over the 10-year period that ended last December, hedge funds had an average annualized return of 12.57 percent, according to an index maintained by Hedge Fund Research. That is just slightly ahead of the 12.07 percent return of the S.& P. 500 during that period, though hedge funds earned their return with half the volatility.

During the market downturn, however, hedge funds did hold up well. In both 2000 and 2001, for example, the average hedge fund rose nearly 5 percent, according to Hedge Fund Research. That compares with declines of 9 percent in the S.& P. 500 in 2000 and nearly 12 percent the next year.

IN 2004, however, the average hedge fund rose around 9 percent, lagging behind the S.& P. by nearly two percentage points, Hedge Fund Research has reported. During the first two months this year, the latest data available, hedge funds were up nearly 2 percent, compared with a flat return for the S.& P.

Many in the industry say the sharp increase in both supply and demand won't destroy the fundamentals of the business. "It is so much the better way of managing money," said Julian Robertson, who got out of the business five years ago after forging a reputation at Tiger Management as one of the most successful hedge fund managers. Today, he keeps a hand in the industry by providing seed money to new hedge funds. "Hedge funds have had about a 10-year place in the sun," he said. "I don't see any reason for that to stop."

Many industry veterans say the party will continue, partly because of the shift in who invests in hedge funds. As recently as 2000, hedge funds were almost exclusively for the very rich. Now institutions want a piece of the action. Pension funds and other institutions are expected to invest as much as $250 billion in hedge funds over the next five years, according to a recent study by the Bank of New York and Casey, Quirk & Associates, a consulting firm. That would ultimately account for half of all money flowing into hedge funds.

But as the pension money comes in, hedge fund returns are likely to go down, as fund managers adapt their strategies to suit the new clientele. Pension funds prize predictability over outsized returns; the average pension fund is looking to make just 8 percent, net of fees, on its hedge fund investments, the Casey Quirk report concluded. That is a far cry from the 25-percent-plus returns generated by rock-star managers like Mr. Soros and Michael Steinhardt.

A possible check on hedge funds is the simple fact that while anyone can start one, the industry has a high casualty rate - especially for the smallest funds, which struggle to attract and keep investors. Untested managers whose returns languish often see their capital flee and are forced to shut down.

"There are very low barriers to entry but very high barriers to staying in business," said Philip Duff, chief executive of FrontPoint, a $4.3 billion hedge fund, citing the average annual life of a hedge fund of 3.5 years. "That's problematic for investors," he said - particularly institutional investors who do not relish moving money around.

"There's a reasonable probability a hedge fund will have a significant problem," Mr. Duff added. The fund, he said, "will be high-profile, and the question is, if and when that happens, does it materially change the growth in demand? My answer is no."

While new funds have flourished, seasoned managers are also absorbing the demand generated by institutions. "In 2004 we saw nine $1 billion-plus start-ups, and 2005 is on track to outpace that number," said Gerard Coughlin, a head of Morgan Stanley's prime brokerage services. "While the high-profile start-ups command great attention, many established managers are busy broadening their product offering and expanding their footprint. The capacity created by these proven managers and high-profile start-ups is effectively raising the bar on what it takes to be successful as a new manager."

Longtime hedge fund investors have faith in the power of Darwinism. "It will be survival of the fittest," said Michael Price, former manager of the Mutual Series mutual funds, who now invests $1.6 billion - a good chunk of it in hedge funds - on behalf of family, friends and two college endowments. "The guys who are not creative or don't know what they are doing won't last."

That is not to say that there is anything stopping them from starting up - and potentially losing investors' money. "There's zero shame involved in launching a fund and failing," said one fund of funds manager who, like many executives in the ultrasecretive hedge fund universe, asked not to be identified.

INDEED, it is not unusual for managers to get a second chance. William A. Ackman once ran Gotham Partners, one of the most successful hedge funds in the 1990's, boasting a list of blue-chip investors that included the Ziff family and Martin Peretz of The New Republic.

By the end of 2002, Mr. Ackman and his business partner, David P. Berkowitz, were forced to shut the fund after they became stuck in a private equity investment they couldn't sell, and some investors demanded their money back. Since then, Mr. Ackman has raised $410 million for a new firm, Pershing Square; he has promised investors in his new fund that he will not make private equity investments.

In the same way that there is no quelling the bulls, there will be no quieting of the critics. The Horvitz family of Cleveland, which made its fortune in road construction, media and real estate, started investing in hedge funds in the 1990's. A decade or so later, it has virtually no money in such funds, said Jeffrey Horvitz, who oversees his family's investments. Too often, he said, the funds produced disappointing returns.

"Hedge funds are no longer attractive," Mr. Horvitz said, noting the influx of start-ups. "I see no relief in sight, especially for taxable investors like us."

Copyright 2005 The New York Times Company

Barron's Online
Monday, March 28, 2005
FUND OF INFORMATION

Trading Places
Ex-hands of investment banks find running money on their own is a different game

By LAWRENCE C. STRAUSS

IF TOM WOLFE WERE WRITING Bonfire of the Vanities today, chances are his "master of the universe" character would be a proprietary-desk trader at a prestigious investment bank who launches a hedge fund.

Sherman McCoy, the investment-banker protagonist of that classic 1980s novel, would have a new title: general partner of the Distressed Event-Driven Arbitrage Opportunities Fund.

A few recent high-profile examples of people on the trader-hedge-fund-manager career path include Eric Mindich and Dinakar Singh, who both left Goldman Sachs to start multibillion-dollar hedge funds.

In many ways, it's a sensible move. Mindich and Singh offer considerable trading talent, not to mention the institutional knowledge they soaked up at a well-regarded firm like Goldman -- which has become perhaps the premier farm team for hedge-fund talent.

"Prop desks," as they are known, are "one of the few viable avenues to recruit talent for hedge funds," says Neal Berger, president of Apogee Asset Management, which runs a multi-strategy hedge fund.

The Goldman cubs aren't necessarily representative of this trend, which has been unfolding for a long time. For one thing, these two startups have tremendous scale. When a fund launches with billions of dollars under management, it has the resources to buy the necessary infrastructure, whether for monitoring risk control or compliance. As one hedge-fund manager who opted for anonymity, puts it, "You can afford to hire a lot of smart people."

Hedge-fund trade publications, however, are chock full of items about prop-desk traders launching hedge funds, many of them much smaller than Mindich's Eton Park Capital Management.

But investors considering plunging into a new hedge fund run by a former prop-desk trader should be cautious.

"There's great talent" working on prop desks, observes Cynthia J. Nicoll, chief investment officer at Tremont Capital Management, which invests in hedge funds on behalf of its clients. "But just because someone has run proprietary money doesn't necessarily mean they're going to run a great hedge fund."

There are big differences between trading money for an investment bank's house account and running an independent hedge fund.

"On a prop desk, it's not as if you have $1 billion or $5 billion in front of you every single day," says a hedge-fund manager who uses a long/short equity strategy. "The capital is allocated as the opportunities appear." But in running a hedge fund, there is the "pressure of earning returns on a static pool of assets," the manager continues.

"That very institutional infrastructure they have taken for granted is no longer available to them," says Joan Kehoe, head of international operations for PFPC, which handles administration for asset managers, including hedge funds.

Tom Ortwein, president of Highbrace Capital, a fund of hedge funds in Greenwich, Conn., notes that in a hedge fund, "you don't just lighten up and capital gets reallocated." Working on a prop desk, he says, is "not the same as having a single pool and a finite set of parameters in which you're operating." Ortwein was formerly head of capital markets at CIBC.

Apogee's Berger, a former prop-desk trader who went on to start his own hedge fund, notes that on a trading desk, "There's no concept of I'm up 1%."

He adds: "In investment-banking terms, you're really just talking about nominal profits and losses, with no regard to any type of capital base; it's very difficult to manage risk in the same way you would in a hedge fund."

Working at a large investment bank offers other advantages, including oversight of trading. But when you're working on your own, nobody's looking over your shoulder anymore to make sure you're not nuts.

Another advantage of working on a prop desk is getting a sense of a firm's order flow, which can provide a definite edge. "Like it or not, prop desks take advantage of that," explains Ortwein. "Certainly, they know which way the order flows are going."

Investment banks also have the benefit of numerous trading contacts, as well as proprietary research. For hedge funds, "It is a whole lot different to rely on a brokerage firm to find the other side of the trade for you," says Ortwein.

"Sitting on a prop desk, you have access to a very large organization, contacts and research," says Tremont's Nicoll. "Unless you can duplicate that at the hedge-fund level, it's not necessarily a good result."

She says that plenty of traders have done that, including Brevan Howard Asset Management, a firm launched in 2002 by Alan Howard, formerly Credit Suisse First Boston's global bond trading chief.

In vetting funds, Tremont and other funds of funds wrestle with these issues constantly. A key consideration, Nicoll says, is whether the traders founding a fund were "credible and meaningful decision makers at the prop desk."

That's not always easy to discern.

"As a trader at a bank, I am well aware of my trading performance," says Berger. "However, an employer looking at my track record will have a hard time verifying my claims."

Nicoll points out that as prop traders launch a hedge fund, they need to demonstrate that they can generate ideas in a new setting. And, she stresses, the fund's compensation scheme "has to make people want to work as a team and want to stay."

There are other contrasts between trading desks and hedge funds.

"Prop-desk traders have the benefit of trading flexible risk capital with strict guidelines and are judged over a yearly time horizon," explains Bruce Amlicke, chief investment officer of Blackstone Alternative Asset Management, a $9.3 billion fund of funds. "In a hedge fund, performance is scrutinized on a monthly basis. That's a lot of pressure, especially when you're building a business -- and the success of that new business is largely driven by those early returns." (Hedge-fund investors typically review returns each month.)

Amlicke maintains that it's a much easier transition coming from another hedge fund than from a trading desk. Assessing traders-turned-hedge-fund managers hinges on two questions, in his view: "Does the trader have what it takes to generate outsized returns outside of a structured institutional setting, and can that trader build and run a business?"

Running a business requires a different set of skills than trading does, often entailing outsourcing, which costs money.

PFPC's Kehoe estimates that startup firms need at least $100 million in assets under management "to sustain their expense base."

The startups she has seen close within 12 months of launching -- they weren't all founded by traders -- typically weren't able "to garner the assets quickly enough to sustain their expenses."

Investors can face a dilemma: A new hedge fund with a big-name trader has no track record. But if an investor waits too long, even a few months, to see a record develop, there's a risk the fund will be closed to new investors.

Ortwein says "there are a ton of talented" prop traders. But running $3 billion out of the gate is a daunting task. So "one does need to be cautious," Berger, the hedge-fund manager, avers. "The last chapter has yet to be written on whether these superstar guys spinning out of investment banks are going to live up to the hype."

Going Long

There's been considerable interest lately in long-only funds, which account for a tiny portion of the roughly $1 trillion of hedge-fund assets.

At least one hedge-fund firm is ditching that strategy, however. GoldenTree Asset Management, based in New York City, announced recently that it was returning $1.2 billion in long-only separate- account business to investors.

GoldenTree oversees $6.5 billion in bank loans, high-yield bonds, distressed stocks, real estate and other assets. In a statement, the firm's chief investment officer, Steven A. Tananbaum, said that "in the current environment for high-yield we believe we can offer the best value to our clients by being total-return managers."

The long-only accounts were hampered by not being able to short or use leverage, as well as being measured against an index, he said. Sound sort of like expensive mutual funds, don't they?

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