Excess talent on the market

“From now until the middle of next year, there will be lot of [talent] movement because of the Volcker role. In addition, many funds aren’t doing well. A lot of [employees] may not receive the best compensation this year or next year. If a manager is double-digit below his high water mark, there will likely be no incentive allocation this year and maybe not next year. A third factor is that certain strategies e.g. quant strategies, that had been doing well, aren’t doing well this year. Each of these factors alone creates increased talent but to have all three happen at once means it should be a good year for hiring,” comments Greg Racz, a principal at Hutchin Hill. It is not easy to raise assets for a new hedge fund. People who might launch a new fund might run into difficulty. Those who started small funds may decide it’s too hard (due to a number of factors such as new regulations) to run a $200-300 million fund. They may decide they will be better off going to a bigger fund or platform, adds Racz.

With excess talent now available on the market, hedge funds managers are reassessing expensive talent and adjusting expectations.

Sales and marketing positions

Recruiters agree that sales and marketing are the positions in strongest demand at hedge funds due to the challenging asset raising environment, the need to retain assets, plus the fact that the sales cycle for institutional investors has increased considerably. Investors are doing more due diligence, more vetting and have slower trigger points.

Third party marketer Mike Finnell, managing partner at Hudson Partners, says, “Assuming a good manager with a decent track record, it takes about a year. You need to send information and set up several meetings. No one has money burning a hole in their pocket to invest quickly. It is a buyer’s market especially if you are representing a manager that is relatively small and they have a long way to go before they hit capacity.”  

Portfolio Managers/Analysts

On the portfolio manager/analyst front, Robin Judson, managing partner and group founder of Robin Judson Partners, says: “Many [large] hedge funds are hiring analysts [in all strategies] who have two years of banking experience followed by one or three years of direct experience. They are in demand because they are not yet too expensive, they don’t have to be trained – only tweaked – and it is easier to figure out if they are going to be a good fit or not. They are not as entrenched in one way of doing things or as expensive as bringing in someone with more experience.” Infrastructure positions There is a growing emphasis on the non-investment side of the hedge fund business.

 Infrastructural positions e.g. operational due diligence are in demand due to the continued institutionalization of the hedge fund industry and impending regulation. Howard Eisen, co-founder and managing director of FletcherBennett, noted that a recent RFP broke down the percentage of decision weighted to several categories. The allocation weighted to operational risk soundness was actually greater than the weight to performance. As mid-size firms build out their infrastructure and expand their compliance efforts to meet the demands of both regulators and clients, these firms are looking to recruit chief compliance officers, chief operating officers, chief technology officers, chief financial officers and other operational executives, adds Eisen.

Funds of funds

At funds of funds, institutional sales and marketing professionals are still very much in demand, says Laurie Thompson, associate principal at Heidrick & Struggles. Jonathan Stadin, president of JR Stadin, agrees. Numerous candidates have recently accepted senior marketing roles at funds of funds of various asset sizes so there is clearly a need for capital raisers with an institutional rolodex Several caveats exist, however. Compensation is more reasonable. One fund of funds executive says he was able to hire a marketer this year at a reasonable price. Whereas there used to be many sales and marketing jobs available, there aren’t so many today. As a result, turnover at funds of funds is not as high as before.

While many established large funds of funds are emphasizing sales and marketing people, one needs to look at the funds of funds’ asset size, launch date, and how it is different from others. Some smaller, medium-sized funds of funds say their emphasis is not on sales and marketing at this point. As it is a chicken-and-egg situation, they need to build their infrastructure and research first. They believe that performance will lead to an inflow of assets.

Operational due diligence continues to be an active area at funds of funds, adds Stadin. “The operational due diligence function was given a bit of boost post Madoff. Since the financial crisis, operational due diligence analysts now have a seat on the investment committee and they can veto investment people,” says Michael Paciullo, global head of operational due diligence at International Asset Management. Michael Beattie, president and chief investment officer of Tradex Global Advisors agrees, saying that post-Madoff, they’ve gone from being trading/performance-focused to operations/valuation focused.

While many say operational due diligence analysts are in high demand, one fund of funds executive says that most funds of funds are not willing to spend money for experienced operational due diligence people but rather junior people. Paciullo agrees: “Operational due diligence is a focus but not necessarily the head role but junior and mid level positions.

Recruiters say some selective research/portfolio management roles are being filled at funds of funds. A repeated theme heard from funds of funds executives is the need to keep the research staff to a minimum.

Institutional inflows into hedge funds/funds of funds have been strong over the past year as some institutions have come into the space for the first time while others
increased their existing hedge fund allocations. Others have issued Requests
for Proposals for managers, funds of funds or specialized hedge fund
consultants.

Some institutional investors are looking to diversify their portfolios while others
are taking advantage of perceived attractive beta and alpha opportunities as
downside protection. Others are trying to boost their returns due to funding
shortfalls.

Lois Peltz, president of Infovest21, observes: “In the past year, several institutions made their first foray into hedge funds, such as Connecticut Retirement Plan & Trust
Fund, El Paso County Retirement Plan, Kansas City Police Employees’ Retirement
System, Los Angeles County Employees’ Retirement Association, Massachusetts
Water Resources Authority Retirement System, New York City Police, New York
City Employees’ Retirement, New York City Fire, San Jose Federated City
Employees’ Retirement System, Vermont State Retirement System and West Palm
Beach Firefighters’ Pension.”

Other institutions have increased their allocations such as Alaska Retirement
Management Board, City of Danbury, Metro Nashville, North Carolina Retirement
System, Ohio State Employees’ Retirement System, Orange County Retirement
System, Sacramento County Employees’ Retirement System, San Mateo County
Employees’ Retirement Association.

A number of the largest pension allocators to hedge funds have increased their target allocation to hedge funds. For example, Texas City and District increased the cap from 15% to 20% while New Jersey State Investment Council increased it from 10% to 15%. Texas Teachers Retirement System upped the target from 5% to 10%. Illinois
Teachers’ Retirement System increased the cap from 5% to 8%.

Many pensions have rebalanced their portfolios – firing some hedge funds/funds of funds while replacing them with others.

RFPs and searches are out (or expected soon) for Ohio School Employees’ Retirement
System, Orange County Employees’ Retirement System, Seattle City Employees’
Retirement System, State-Boston Retirement System and State of Wisconsin.

Meanwhile, a few pensions have been redeeming allocations to hedge funds e.g. PennSERS, Delaware Public Employees Retirement System, or avoiding them altogether after a bad experience e.g.Ohio Bureau of Workers Compensation.

Some interesting trends in the past fiscal year include:

 Strong overall portfolio returns in FY2011…Pension underfunding remains a factor motivating pensions to allocate to hedge funds

A strong stock market helped pension plans’ returns in FY2011. Returns in the 20%-23% range have been recorded by a number of systems including Alaska Permanent
Fund, CalPERS, CalSTRS, Florida Retirement System, MassPRIM and New York City
Pension Funds. In many cases, these are the strongest gains in 20+ years.
However, 10-year returns are still below the required level. For example,
CalPERS’ 10-year return is 5.36% while CalSTRS is 5.7%.¹

 Wilshire Associates says the annual return in the next 15 years will be 6.5%.²

Using government accounting standards, the aggregated underfunding for US state and local governments is about $1 trillion. But if using corporate accounting standards, the shortfall is about $2.5 trillion. A third approach, often used by economists who consider even the private accounting standards too lenient, yields a $3.5 trillion answer.³

The bill for retirement benefits is already straining budgets and is competing for
resources with other critical needs such as education, infrastructure and
health care.

To close the funding gap, some states have increased the retirement age and length
of service requirements while others increased employee contribution
requirements. Some systems lowered their discount rate assumptions. Some
pensions are looking to hedge funds as a means to close the funding gap.

 Momentum continues toward direct investing

Institutions are increasingly allocating directly to hedge funds rather than take the funds of funds route, especially if they have in-house capability to select hedge
funds. Relatively poor fund of funds performance in 2008 and 2009, some funds
of funds getting caught allocating to Madoff and other Ponzi schemes, the
pressure for lower fees, institutions and their consultants acquiring more
knowledge and expertise on hedge funds as well as some hedge funds becoming
more institutional in nature have encouraged some institutions to invest
directly with hedge funds.

Recent examples include Massachusetts Pension Reserves Investment Management’s pilot program to allocate assets directly with hedge funds. The pension plans to
allocate to 20 hedge funds managers in the fourth quarter. Ohio Public
Employees Retirement System, which initially used funds of funds, plans to
invest $1.2 billion directly to hedge funds.

There is no standard approach for pensions which are direct allocators to hedge
funds. Some use outsourced chief investment officers while others use
consultants or fund of funds advisors to support their direct allocating
efforts. ⁴

 First time users tend to prefer funds of funds

Some pensions, mostly first time allocators, prefer funds of funds. Recent examples
include Connecticut State Employees’ Retirement System,  El Paso County Retirement Plan, Kansas City Police Employees’ Retirement System, Los Angeles County Employees’ Retirement Association, Massachusetts Water Resources Authority Employees’ Retirement System, Metro Nashville, New York City Pension Funds, North Carolina Retirement Funds, Orange County and Vermont State Retirement System.

Smaller pensions which lack resources to select or access direct hedge fund investments may continue to have funds of funds as their core investment. Some institutions continue with the core-satellite approach where the core allocation is to a
fund of funds supplemented by a number of single strategy funds. Others seek more specialized funds of funds in place of, or in addition to, a diversified fund of funds mandate.

Hiring consultants for those pensions allocating directly to hedge funds

As more pensions consider investing directly with hedge funds, they are in need of
a specialized hedge fund consultant. For example, the Maryland State Retirement
Agency issued a Request for Information seeking a consulting firm to advise the
staff on its absolute return portfolio. MassPRIM hired Cliffwater in April 2011
as its hedge fund consultant while Texas Employees Retirement System hired
Albourne. CalSTRS hired Lyxor Asset Management as a consultant for its global
macro hedge fund portfolio.

 Fee reductions

Pensions have also been keeping a strict eye on fees – one reason that a number are taking the direct hedge fund route over funds of funds. For instance, New Jersey negotiated a $40 million fee savings in alternative investment fees. Texas County & District Retirement System and CalPERS also were among those pensions taking steps to limit fees.

 Growth potential with corporate plans

Whereas public pension funds comprise a larger number investing in hedge funds, the largest growth potential is with private corporate plans. The private sector
started investing later than public pensions and endowments. Recent activity
shows select corporate pensions are starting to make large allocations to hedge
funds.

Japan corporate pension funds are now more closely examining hedge funds. Surveys indicate that typically 2-5% of the corporate pension goes to hedge funds but
that percentage could increase to 10-15% over the next two years.

 European pension interest in hedge funds is strong

European-based pensions have the greatest appetite for new commitments. One survey found that 45% are seeking new opportunities.

Smaller endowments looking closer at hedge funds/funds of funds

On the endowment front, some smaller endowments e.g. Wilfrid Laurier University, are starting to look at and invest in hedge funds. Previously, large endowments had generally been the sole users of hedge funds/funds of funds.

 Some endowments seed

Meanwhile, some of the larger endowments who have been allocating to hedge funds for a while are seeding hedge fund managers e.g. University of London seeded a Calamos fund.

Sovereign Wealth Funds’ allocations to hedge funds stay flat

Surveys indicate that SWFs’ allocations to hedge funds are about 36% of their portfolio – about the same as last year.

Sampling
of Largest Public Pension Fund Allocations to Hedge Funds

Infovest21’s annual white paper examines trends on a global basis. The white paper looks at recent (June 1, 2010 to June 30, 2011) hedge fund interest and activity by
pensions, endowments, sovereign wealth funds. Summary highlights of recent
activity as well as plans for moving ahead are provided for a sampling of
institutions.

Institutional activity is examined in North America, Europe, UK and Japan. Special emphasis is placed on the largest allocators i.e. those allocating $1 billion or more to
hedge funds.  The white paper also provides a survey of smaller institutions making allocations as well as those issuing RFPs or conducting searches. Those institutions deciding not to allocate or who have reduced their hedge fund allocation are also listed.

While we try to provide the most recent information available, in some cases, such as
sovereign wealth funds, endowments or private pensions, current information may
be difficult to get. As a result, in those cases, the latest information may be
from 2009 or early 2010. And on a geographic basis, information is more readily
available for US institutions than other locations such as Japan.

In its just-released Special Research Report, Infovest21 finds that the average large public pension fund which allocates at least $1 billion to hedge funds/funds of funds, allocates 5.7% to hedge funds/absolute returns
funds in FY2011, an increase from 5.4% in FY2010 and 4.5% in FY2009.

Average
Asset Allocation of 25 Large Public Pension Funds (%)

The table above, which shows aggregated results for the past three
fiscal years, highlights that the average allocation to equities increased to
48.2% in FY2011 from 46.6% in the prior year. However, the average allocation
to fixed income declined from 23.9% in FY2010 to 22.4% in FY2011.

Private equity increased slightly from 5.5% in FY2010 to 5.8% in
FY2011. Real estate exposure dropped from 8.4% in FY2009 to 8.2% in FY2011.
Other alternatives increased from 2.7% in FY2009 to 3.9% in FY2011.

In compiling these results, Infovest21 tracked the asset
allocation trends for 25 large public pension funds as far back as annual
results were provided. Of those, 22 were based in the US and three were based
in Canada. The sampling includes those pensions that allocate at least $1
billion in assets to hedge funds/funds of funds and publish their asset
allocation on at least an annual basis. These findings make up Part 1 of the special
research report.

Part 2 includes asset allocation findings of another 18 US pension
plans whose allocations to hedge funds are under $1 billion.

Institutional investors are driving some of this change as they are more aware and demand different types of consulting relationships. Many clients may feel they can handle traditional investments on their own and may just want help on the alternative side, says Dowling. Or, after 2008, they may want help on asset allocation or investment policy statements. Some organizations that have limited resources or issues arriving at consensus are becoming more open to outsourcing the actual implementation.

Some of the change is also motivated by consulting being a fairly mature business. Consulting firms are looking for new ways to leverage their investments in technology, reporting, risk management and research.

As pensions outsource more of their investment decisions, the competition between funds of funds and consultants increase. And the lines are increasingly blurring between consultants and funds of funds as more consultants offer funds of funds and more funds of funds offer advice.

Janine Baldridge of Russell Investments says the outsourcing decision is generally based on several criteria: internal versus external investment expertise and resources, ability to access and successfully structure a desired portfolio, and best practice expectations for both investment and operational due diligence processes.

“Clients with fewer internal resources or expertise are more likely to outsource hedge fund selection and construction to fund of funds providers and focus on understanding the investment strategies, risks and return expectations. On the other hand, organizations that have experience in selecting and monitoring hedge funds are able to make timely investment decisions. Those that have expertise in structuring multiple hedge funds are more likely to seek advisory services and retain discretion internally,” she adds.

Baldrige says it is important for sponsors to seek clarity on their desired level of fiduciary liability, discretionary actions and due diligence capabilities from their hedge fund providers. “The range of capabilities and offerings can be quite different between the two model types. An institution hiring a consultant to help them select and structure individual hedge funds likely has very different expectations than an institution hiring a consultant to recommend discretionary funds of fund managers,” adds Baldridge.

Infovest21‘s Just released: Evolving Consultant Business Models and the Implications for Hedge Funds/Funds of Funds

Includes examination of:
How the consultant community is evolving
Specialist versus generalist consultants
The blurring lines between consultant and funds of funds
Potential conflicts of interest
Institutions’ current appetite for hedge fund/funds of funds
The evolution of institutional investing in hedge funds
Table comparing select consultants

Order your copy by calling Infovest21‘s 212-686-6440. 30+ pages including tables and footnotes, $500

The world has increasingly become bifurcated in the manager community between “the haves” and “the have-nots.” George Mazin, partner at Dechert observes, “The haves” – those managers that have plenty of assets – can have all they want. “The balance of power has shifted back to “the haves.” They are less conciliatory and less willing to make deals. The “have-nots” continue to struggle to raise assets and will be a lot more flexible.”

Major institutional investors continue to drive hedge fund investments. The most demanding investors are clearly the state plans. The rest of the institutional community takes their lead from the state plans.

Ricardo Davidovich from Tannenbaum Helpern Syracuse & Hirschtritt LLP
agrees. “The investor is demanding better terms in exchange for their big ticket. The investments are being negotiated more than in the past. The institutional investor is looking more like seeding deals.”

“Hedge fund documents are definitely moving toward the LPs’ favor but good managers can still command the best terms. It’s on a deal-by-deal basis,” adds Gray.

While hedge fund documents have become more balanced [between investor and manager power] than three or four years ago, they still lag behind private equity fund documents which are more balanced than hedge fund documents, observes another attorney. “Private equity documents have investor driven provisions as investors are in private equity funds for a longer time period. The more institutional investors are driving the terms,” says Irwin Latner of Herrick Feinstein.

In its current white paper, Infovest21 explores the trends in terms from different perspectives – case studies of institutions, some managers designing product to meet institutional investor demands, investor surveys and interviews with attorneys and accountants (who represent diverse manager bases by asset size, client base and geography) who prepare manager documents.

Some specific trends are evident, such as:
 Gates – Most funds have gates. The trend is toward increased use of investor-level gates. Gates are strategy dependent.

 Lock-ups – Some managers will give concessions on the incentive fee in exchange for longer lock-ups. With a two to three year lock-up, the investor may pay a 15-18% performance fee.

Strategy is again an important factor. Funds that are longer term focused will lock up investors longer. Funds that are trading-oriented by nature are less concerned on the lock-up side.

 In Kind Distribution – The documents are being more specific on what can be done to satisfy redemptions. Documents are specifically addressing redemptions in kind, suspensions etc. These actions were taken in 2008 and 2009 on the assumption that managers had the right to do it. Now it is being written into the documents.

 Side Pockets – Some funds are without side pockets if they’re invested in very liquid assets. Some funds have stricter rules on side pockets e.g. if the manager is going to side pocket something, they must do so within a specified time of buying the position. Some funds have modified side pockets – the net effect is that a fund can side pocket an investment but it will not lower the high water mark/carry loss forward. More information is disclosed in their documents.

 Fees and Expenses – Most attorneys and accountants preparing hedge fund documents say fees haven’t changed significantly in the past few years i.e. they are not seeing a change in industry standards. There has been some increased flexibility, more attention to hurdle rates and high water marks, and some customization but not any wholesale change.
Some managers have attracted new assets by carrying over high water marks i.e. no incentive fees are charged on new capital until all losses on old capital have been recovered from old capital profits.

Some have also carried over high water mark to other affiliated funds including funds with different strategies.

Excerpt from:
Infovest21 White Paper: Trends in Fund Terms

*Balance of power/alignment of interest
*Case studies: select managers designing product to meet institutional investor needs
*Gates, lock-ups, in kind distribution, side pockets, most favored nation, key man provision
*Fees and expenses
*Funds of funds and seed capital

20+ pages including graphs and footnotes
Advance Price; $450 through May 23. Thereafter: $500

For additional information, call 212 686 6440

They have raised the bar in areas such as liquidity and transparency.  Institutions generally want greater liquidity from their hedge fund managers i.e. funds with shorter lock-up periods. They generally prefer conservative strategies and reduced leverage. As a result, they are searching for hedge funds which can produce lower annualized returns than requested before e.g. 6-7%.

Institutional investors are increasingly differentiating alternative investments by liquidity and risk.

Rather than separating hedge funds out as a separate asset class, some industry experts expect pension funds to use hedge fund managers within their existing equity and fixed income buckets as a best-of-breed solution.

They want fees based on long term rather than short term performance.

Fall-out from 2008 financial crisis
The global financial crisis of 2008 resulted in some institutions putting their hedge fund allocation plans on hold while others re-evaluated their portfolios and asset allocation. Pension & Investments estimated institutional inflows into hedge funds in 2009 were $21.51 billion, down 49% from 2008 and down 68% from 2007. It was not until the fourth quarter of 2009 that inflows started and were estimated at $12.4 billion.

Hedge Fund Asset Flows P&I
($B)
Q1 2009     3.8
Q2 2009     4.5
Q3 2009    0.8
Q4 2009     12.4
Source: Pensions & Investments

Despite disappointing hedge fund performance in 2008, the Madoff Ponzi scheme and other scandals, gates and related illiquidity issues, institutional investors continue to find hedge funds attractive – realizing they performed better than most other investments during 2008.

According to Russell Global Survey, the average institutional allocation to hedge funds was 4.2% in 2009 and is expected to increase to 5.7% by 2012.

Recent activity
In the past year, several institutions made their first foray into hedge funds, such as California State Teachers Retirement, Denver Employees Retirement Fund, Florida State Board of Administration, Kentucky Retirement System, State of Wisconsin Investment Board, Employees’ Retirement System of Texas and Vermont Pensions. In Europe, Ireland’s National Pension Reserve is on brink of making its first allocation.

Other institutions have increased their allocations such as Arizona Public Safety, Chicago Teachers Pension Fund, Illinois Teachers Retirement, Iowa Public Employees, Kern County Employees Retirement, New Hampshire Retirement, New York State Common Retirement Fund, Ohio School Employees Retirement System and West Virginia Investment Board. In Europe and UK, British Telecom, APK, ATP, Clywyd Pension Fund, UK Universities Superannuation Scheme and West Midlands are among those increasing hedge fund allocations.

RFPs and searches are out (or expected soon) for Chicago Policemen’s Annuity & Benefit Fund, Connecticut Investment Council, Los Angeles Police & Fire, Ohio Public Employees Retirement System, San Antonio Fire & Police, San Bernardino County, Santa Barbara County, and Texas Permanent School Fund. In Europe, searches are on for AP1, Fife Council, Lincolnshire Pension and Waltham Forest.

Some institutions, despite filing lawsuits in connection with hedge funds e.g. Amaranth’s collapse, Madoff-related cases or WG-related cases, continue to allocate to hedge funds. Two examples are Iowa Public Employees Retirement System and San Diego County Employees Retirement Association.

Momentum grows toward direct investing
Another trend is institutions allocating directly to hedge funds rather than take the funds of funds route. Relatively poor fund of funds performance in 2008 and 2009, Madoff and other Ponzi schemes, the pressure for lower fees, institutions and their consultants acquiring more knowledge and expertise on hedge funds as well as some hedge funds becoming more institutional in nature have encouraged some institutions to invest directly with hedge funds. Recent examples include Boeing, South Carolina Retirement System and Pensioenfonds Zorg en Welzijn.

Yet some pensions are searching for funds of funds e.g. Ohio Public Employment Retirement System, Croyden and Lincolnshire Pension. Some institutions continue with the core-satellite approach where the core allocation is to a fund of funds supplemented by a number of single strategy funds.

Growth potential
Whereas public pension funds comprise a larger number investing in hedge funds, the largest growth potential is with private corporate plans. The private sector started investing later than public pensions and endowments. Recent activity shows select corporate pensions are starting to make large allocations to hedge funds.

In the endowment space, growth is limited with the larger endowments as they were early and heavy adopters of hedge funds.  The main opportunity is a new manager replacing an existing manager or with smaller endowments increasing their allocations. Following the 2008 financial crisis, endowments are no longer copying the Harvard and Yale models but reassessing what is best for their specific needs.

Outside the US
It appears that European institutions have terminated or reduced hedge fund allocations more  than their US counterparts. Lack of diversification, lack of transparency during the financial crisis as well as poor performance during 2008 are often-cited reasons. Some institutions in this category are Unipension (Denmark), VER (Finland), Ilmarinen Mutual Insurance (Finland), TNO (The Netherlands), Nedlloyd Pension (The Netherlands), AP2 (Sweden), BLVK (Switzerland), Luzern Pension (Switzerland) and Tate Gallery (UK).

Nevertheless, European pension plans as a whole are still looking to increase their exposure to hedge funds/funds of funds. According to an IPE survey, the average European institution has about 2.3% of its portfolio in hedge funds. Swiss pensions have the highest average allocation at about 6%. While most European institutions have increased their allocations, Italy was the exception and almost halved it.

Japanese pension funds have become more cautious of hedge funds. Estimates are that hedge funds account for 7-9% of Japanese pensions; a 2% reduction occurred in the past year. Hedge funds’ role seems to be changing from a fixed income substitute to a middle-risk type asset. Japanese pension fund preference is for low risk and transparent products.

Other trends
Other interesting trends include more focus on due diligence. While the weighting of the various attributes varies among investors, focus is increased on operational due diligence and risk management policies, notes Don Steinbrugge of Agecroft Partners.

Lois Peltz, president of Infovest21, observes, “Some institutions are taking a more active role in seeding hedge fund managers because they hope the best hedge fund managers will spin out as bigger independent firms. The rationale is that by getting involved early on with a hedge fund manager, the institutional investor has more control over its assets and can better control its investment cost. It creates the possibility of locking in and aligning interests early on with top teams without paying high compensation costs.”

The above information is an excerpt from Infovest21’s just-released Institutional Interest/Allocation in Hedge Funds, an annual white paper examining trends on a global basis. The white paper looks at recent hedge fund interest and activity by pensions, endowments, sovereign wealth funds. Commentary is also provided on consultants, corporate pensions and insurance companies. For each institution, summary highlights of recent activity are provided as well as plans for moving ahead.

Institutional activity is examined in North America, Europe, UK, Japan and Australia. Special emphasis is place on the largest allocators i.e. those allocating $1 billion or more to hedge funds, as well as the next tier i.e. those allocating between $500 million and $999 million. A survey is also provided of smaller institutions making allocations as well as those issuing RFPs or conducting a search. Those institutions deciding not to allocate or who have reduced their hedge fund allocation are also listed.

Over the past several years, many funds of funds have been reassessing how to conduct operational due diligence. Different variations exist.

Infovest21 interviewed a number of experts in the area including operational due diligence specialists, consultants, attorneys, certification specialists, prime brokers and recruiters to determine, among other things, what qualities an investor should look for in assessing a fund of funds’ operational due diligence team. The findings, which are detailed in its just-released white paper, include:

•  Dedicated and independent
Operational due diligence has be separate and independent from investment due diligence, says Daniel Celeghin at Casey Quirk. “End-investors should look closely at the operational due diligence team at a fund of funds. How does it relate to the investment due diligence team? Is there overlap? Are they independent?” Celeghin emphasizes that operational due diligence at a fund of funds should be a dedicated role. “It isn’t an added responsibility for an investment team member, the risk manager or the chief operating officer.”

•  Qualified talent
Operational due diligence professionals require a combination of skills as they encompass a variety of areas including hedge fund operations, accounting, legal review of the offering documents and governance structures and incentives. “It can be challenging if not impossible for a single person to pull it all together. Some may have strength in one area and general knowledge in another. An effective operational due diligence group must have all the bases covered,” says Herr.

•  Veto power
Some investors look for an operational due diligence veto. Celeghin says, “The operational due diligence head is a dedicate role where absolute veto power exists. If the founder of the firm pounds his fist on the table, what the operational due diligence individual says at the end of the day is the ultimate decision. It is not so much the decision to hire but the decision not to hire. A manager may check all the boxes from the investment perspective but the operational due diligence head can veto.”

Herr says that investors should recognize that many firms define “veto” differently. What’s more important for investors to understand is what veto really is, who has it and what the firm’s incentive and reporting structures are.

•  To outsource or not to outsource?
Herr points out that many firms may outsource because it provides an insurance policy – someone to fire in the event of a disaster. Outsourcing can also be a popular choice where it can be charged to the fund. If done in-house, it may be more difficult to allocate those costs.

She says that outsourcing can also serve a complementary role i.e. supporting one’s team or providing a second opinion.

Another large institutional fund of funds says it doesn’t outsource operational due diligence because the process is highly integrated to the investment process. “We use quantitative/qualitative research, portfolio, risk, operational due diligence and legal. They all collectively play a role. As long as you have the right controls in place, you won’t want any of those functions to be a “lap dog” to the hiring process. You want to exercise judgment if you can roll that into an approach. You get a balance of integrity, independence versus insight.”

Reality: Only 27% have dedicated operational due diligence
Based on Corgentum’s study of approximately 275 funds of funds, 27% had dedicated operational due diligence (i.e. at least one employee’s full time responsibility was dedicated to operational risks), 21% used the shared approach (i.e. operational due diligence was conducted by the investment due diligence team), 28% had a hybrid structure (some combination of the various approaches) and 14% were modular (i.e. the operational due diligence process is categorized into functional components and parsed out among different specialists e.g accounting, lawyer etc).

Corgentum found that 46% of the funds of funds with assets under $1 billion used a hybrid approach while 29% used a shared approach while dedicated frameworks accounted for 14%. For funds of funds over $1 billion in assets, 32% had a dedicated framework while 30% had a shared framework and 23% used a hybrid approach and 234% took a modular approach.

As investors demand more operational due diligence reviews, funds of funds will likely dedicate more resources to operational due diligence in an effort to differentiate themselves among their peers.

Excerpts from just-released Infovest21 White Paper

Infovest21‘s just-released annual white paper on trends and outlook, looks at each of these trends in detail.

Institutionalization

Pension underfunding, a major concern worldwide, is leading to increased institutional interest in hedge funds/funds of funds as a possible solution in pensions’ search for alpha.

More institutions are becoming comfortable thinking about sources of alpha as opposed to traditional buckets. For example, long/short equity is now becoming part of the equity traditional allocation. Instead of a 5% allocation to alternatives now, 20-30% of traditional equity allocation may be put into long/short equities.

Pension plans are increasingly using hedge fund allocations for both fixed income and equity replacements whereas in the past, hedge funds were usually used as absolute return.

Another related trend is the search for structural efficiency. To achieve this, some pensions are allocating directly to hedge funds, accessing fund managers at a reduced fee and/or combining replication strategies. Other institutional investors are combining long-only managers with hedge fund managers as long-only managers generally can generate alpha at a lower fee level.

Regulation and its implications

A number of regulations are affecting the hedge fund community and having numerous repercussions. For example:
-        A number of compliance experts expect to see more enforcement actions against advisers for a full host of issues but particularly insider trading. The SEC is becoming more educated to what the risks are, how managers manage their book of business and what some of the conflicts are.

As a result, hedge funds are taking a closer look at their insider trading policies. They are putting together compliance policies on expert networks which they hadn’t done before. Lawyers advise managers to have documentation showing what caused them to trade in a particular stock.

Improved but challenging asset raising environment

While improving, asset raising remains challenging and more difficult than most managers expected. While launches are increasing from the past few years’ doldrums, new launches tend to be relatively small in size.

Consequently, seeders are in big demand which has resulted in more seeding platforms being set up and more specialization occurring. Institutions are starting to show more interest in emerging managers and seeding funds.

Momentum is growing in Asia as investors and seeders search for new managers and higher rates of return.

Inflows generally are going toward high transparency, liquid products such as managed accounts/funds of one and Ucits. Retail products such as mutual funds using hedge fund strategies are gaining in popularity.

The asset raising environment is also impacting the evolution of funds of funds. The medium-to-larger sized funds of funds increasingly find themselves competing against consultants, wealth managers, multi-strategy funds and specialist consultants. Some funds of funds are developing advisory businesses.Some are also moving into the subadvisory business as some pensions are looking for a fund of funds that can facilitate knowledge transfer so they may ultimately become more active in the internal management of its hedge fund program.

The above are excerpts from Infovest21‘s white paper: Major Trends Occurring in 2011 – Implications for Hedge Funds/Funds of Funds.

2008 also brought to many investors’ attention the fact that their actual risk profile was different from what they thought it was.

Different investors demand different types of access. Typically, the managed account is the domain of the ultra high net worth investor and institutions because of the high managed account minimums for the top quality managers. Mutual funds appeal to the financial adviser who wants to give his retail client diversification.  Some see the hedge fund mutual fund as a cost-effective way to gain access to an institutional quality offering with daily liquidity, daily pricing, transparency, a small minimum investment and a timely 1099. These advantages appeal to investors who were hurt by lock-ups and side pockets in 2008.

As the Infovest21 white paper details, none of these vehicles are a panacea and challenges exist for each structure. Yet they do reflect evolutionary forces taking place in the hedge fund arena.

Alternative to funds of funds?
Hedge fund managers are increasingly using managed account platforms, Ucits and mutual fund  hedge funds to gather assets and diversify their client base.

Some investors see these products as an alternative to funds of funds. “As large institutions leave funds of funds industry, many want to allocate directly to hedge funds but they may have a small staff and may not be equipped to do the stringent due diligence. They can hire a consultant for advisory services. Others, however, may choose to use managed accounts.  The investor gets due diligence on the managed account platform and doesn’t have to do the operational due diligence on all the managers they want to hire,” says Martin Gagnon, co-chief executive officer of Innocap.

Some financial planners say they could also see investors moving out of funds of funds and into mutual funds because of value, simplicity of tax issues and greater liquidity.

Some funds of funds, however, disagree and have been actively developing their own managed account platforms as a way to differentiate themselves in a difficult environment. Some are providing a niche such as having smaller managers or strategy-specific managers. One platform provider says early fund of fund adopters of managed account programs will probably grow faster than traditional fund of fund firms.

Outlook

Transparency, risk aggregation, granular information
Institutions will continue to be the driving force behind these evolving products. Institutions’ requirement for transparency will be a major factor going forward.
Managed account platform providers say they are delivering aggregated information to investors more frequently and will continue to enhance what is provided. Investors may eventually be able to see their aggregated exposures on a daily basis. Emphasis is on how to use the data to make improved investment decisions which will ultimately lead to better performance over time.

Managed accounts, providing access to real-time trading, will increasingly be used by some investors as a tool to invest with newer managers.

Major platforms dominate with niche platforms filling a need
The large major managed account platforms are expected to dominate as managed accounts are operationally intensive. Some industry veterans expect to see more banks become involved as they see the platforms providing another source of revenue.

Some expect the platforms to add other sources of revenue as margins get squeezed. This could include providing advisory/risk management services or acting as third party marketers to funds on the platform etc.

A place will exist for independent managed account platforms as they are attractive to banks who don’t have their own managed account platform.

Innovative pricing
In response to fees being pressured downward, both banks and asset manager/independent platforms are looking for ways to become more innovative with their pricing and still maintain some margins. Some platforms will charge investors platform fees while platforms will charge distribution/administrative fees.

Innovative technology: Point click invest
With technology, transparency may eventually be expanded to existing hedge funds (as opposed to just managed accounts). Some platforms are looking at connecting investors and managers online. One platform is currently in the beta phase with “point click invest” where investors will be able to subscribe electronically.  Roll-out is expected this summer.

Growing overlap: Managed account platforms complement Ucits and hedge fund mutual  funds
Ucits and managed accounts are separate structures but they overlap and may be complementary. A managed account can be used as a basis for Ucits vehicles, index products, structured products etc.

For those who want to do a Ucits-type product, it is much easier to base that product off of a managed account where there is independent liquidity, transparency and control of actual assets. “A managed account platform in an independent vehicle that has daily transparency, daily valuations, excellent governance and risk management. Managers want to get all those elements in one place,” says Caleim Parkes of MSS Consultancy.

“Investors are realizing that managed accounts and Ucits are not a binary choice. They are part of a continuum of solutions. Ucits are one investment option in the spectrum of investment solutions. There are a number of hedge fund strategies that are not suitable for Ucits e.g. fixed income arbitrage,” adds Gabriel Bousbib of Gottex.

Some investors e.g. sovereign wealth funds in Middle East, don’t need Ucits vehicles. They are happy to invest in an offshore structure. Other investors like French insurance companies aren’t willing to invest unless it is a Ucits format.

Similarly, managed accounts and mutual funds are more likely to overlap when managed account platforms provide the manager access that mutual funds require.

Regulatory clarity required

Other managed account platform providers are a bit more hesitant on the growing overlap of these products. They feel regulatory clarity is needed before they add Ucits. “Our platform is onshore and we could easily transform it into Ucits. We have the tools to do it but we haven’t. You need to make sure all the rules comply with Ucits regulation. Some convergence exists between Ucits and the Alternative Investment Fund Managers Directive (AIFM). We need some clarity with AIFM which we will have in coming months. I hope European regulators will get together and there will be some convergence between Ucits and AIFM to offer the public a better product,” comments Gagnon.

Regulatory clarification is also needed on the managed futures mutual fund side. Interest exists in the industry for the SEC and the CFTC to harmonize rules. A number of funds of funds say they’d offer mutual funds once those regulatory issues are resolved. Issues exist over the lack of transparency on fee structures in some existing managed futures mutual funds.

Some institutional investors are looking to diversify their portfolios while others are taking advantage of perceived attractive beta and alpha opportunities as downside protection. Others are trying to boost their returns due to funding shortfalls.

Lois Peltz, president of Infovest21, observes that in the past year, several institutions made their first foray into hedge funds, such as Connecticut Retirement Plan & Trust Fund, El Paso County Retirement Plan, Kansas City Police Employees’ Retirement System, Los Angeles County Employees’ Retirement Association, Massachusetts Water Resources Authority Retirement System, New York City Police, New York City Employees’ Retirement, New York City Fire, San Jose Federated City Employees’ Retirement System, Vermont State Retirement System and West Palm Beach Firefighters’ Pension.

Other institutions have increased their allocations such as Alaska Retirement Management Board, City of Danbury, Metro Nashville, North Carolina Retirement System, Ohio State Employees’ Retirement System, Orange County Retirement System, Sacramento County Employees’ Retirement System, San Mateo County Employees’ Retirement Association.

A number of the largest pension allocators to hedge funds have increased their target allocation to hedge funds. For example, Texas City and District increased the cap from 15% to 20% while New Jersey State Investment Council increased it from 10% to 15%. Texas Teachers Retirement System upped the target from 5% to 10%. Illinois Teachers’ Retirement System increased the cap from 5% to 8%.

Many pensions have rebalanced their portfolios – firing some hedge funds/funds of funds while replacing them with others.

RFPs and searches are out (or expected soon) for Ohio School Employees’ Retirement System, Orange County Employees’ Retirement System, Seattle City Employees’ Retirement System, State-Boston Retirement System and State of Wisconsin.

Meanwhile, a few pensions have been redeeming allocations to hedge funds e.g. PennSERS, Delaware Public Employees Retirement System, or avoiding them altogether after a bad experience e.g.Ohio Bureau of Workers Compensation.

Some interesting trends in the past fiscal year include:

Strong overall portfolio returns in FY2011…Pension underfunding remains a factor motivating pensions to allocate to hedge funds

A strong stock market helped pension plans’ returns in FY2011. Returns in the 20%-23% range have been recorded by a number of systems including Alaska Permanent Fund, CalPERS, CalSTRS, Florida Retirement System, MassPRIM and New York City Pension Funds. In many cases, these are the strongest gains in 20+ years. However, 10-year returns are still below the required level. For example, CalPERS’ 10-year return is 5.36% while CalSTRS is 5.7%.1

Wilshire Associates says the annual return in the next 15 years will be 6.5%.2

Using government accounting standards, the aggregated underfunding for US state and local governments is about $1 trillion. But if using corporate accounting standards, the shortfall is about $2.5 trillion. A third approach, often used by economists who consider even the private accounting standards too lenient, yields a $3.5 trillion answer.3

The bill for retirement benefits is already straining budgets and is competing for resources with other critical needs such as education, infrastructure and health care.

To close the funding gap, some states have increased the retirement age and length of service requirements while others increased employee contribution requirements. Some systems lowered their discount rate assumptions. Some pensions are looking to hedge funds as a means to close the funding gap.

Momentum continues toward direct investing

Institutions are increasingly allocating directly to hedge funds rather than take the funds of funds route, especially if they have in-house capability to select hedge funds. Relatively poor fund of funds performance in 2008 and 2009, some funds of funds getting caught allocating to Madoff and other Ponzi schemes, the pressure for lower fees, institutions and their consultants acquiring more knowledge and expertise on hedge funds as well as some hedge funds becoming more institutional in nature have encouraged some institutions to invest directly with hedge funds.

Recent examples include Massachusetts Pension Reserves Investment Management’s pilot program to allocate assets directly with hedge funds. The pension plans to allocate to 20 hedge funds managers in the fourth quarter. Ohio Public Employees Retirement System, which initially used funds of funds, plans to invest $1.2 billion directly to hedge funds.

There is no standard approach for pensions which are direct allocators to hedge funds. Some use outsourced chief investment officers while others use consultants or fund of funds advisors to support their direct allocating efforts. 4

First time users tend to prefer funds of funds

Some pensions, mostly first time allocators, prefer funds of funds. Recent examples include Connecticut State Employees’ Retirement System,  El Paso County Retirement Plan, Kansas City Police Employees’ Retirement System, Los Angeles County Employees’ Retirement Association, Massachusetts Water Resources Authority Employees’ Retirement System, Metro Nashville, New York City Pension Funds, North Carolina Retirement Funds, Orange County and Vermont State Retirement System.

Smaller pensions which lack resources to select or access direct hedge fund investments may continue to have funds of funds as their core investment. Some institutions continue with the core-satellite approach where the core allocation is to a fund of funds supplemented by a number of single strategy funds. Others seek more specialized funds of funds in place of, or in addition to, a diversified fund of funds mandate.

Hiring consultants for those pensions allocating directly to hedge funds

As more pensions consider investing directly with hedge funds, they are in need of a specialized hedge fund consultant. For example, the Maryland State Retirement Agency issued a Request for Information seeking a consulting firm to advise the staff on its absolute return portfolio.

MassPRIM hired Cliffwater in April 2011 as its hedge fund consultant while Texas Employees Retirement System hired Albourne. CalSTRS hired Lyxor Asset Management as a consultant for its global macro hedge fund portfolio.

Fee reductions
Pensions have also been keeping a strict eye on fees – one reason that a number are taking the direct hedge fund route over funds of funds. For instance, New Jersey negotiated a $40 million fee savings in alternative investment fees. Texas County & District Retirement System and CalPERS also were among those pensions taking steps to limit fees.
Growth potential with corporate plans
Whereas public pension funds comprise a larger number investing in hedge funds, the largest growth potential is with private corporate plans. The private sector started investing later than public pensions and endowments. Recent activity shows select corporate pensions are starting to make large allocations to hedge funds.
Japan corporate pension funds are now more closely examining hedge funds. Surveys indicate that typically 2-5% of the corporate pension goes to hedge funds but that percentage could increase to 10-15% over the next two years.
European pension interest in hedge funds is strong
European-based pensions have the greatest appetite for new commitments. One survey found that 45% are seeking new opportunities.

Smaller endowments looking closer at hedge funds/funds of funds
On the endowment front, some smaller endowments e.g. Wilfrid Laurier University, are starting to look at and invest in hedge funds. Previously, large endowments had generally been the sole users of hedge funds/funds of funds.

Some endowments seed
Meanwhile, some of the larger endowments who have been allocating to hedge funds for a while are seeding hedge fund managers e.g. University of London seeded a Calamos fund.
Sovereign Wealth Funds’ allocations to hedge funds stay flat
Surveys indicate that SWFs’ allocations to hedge funds are about 36% of their portfolio – about the same as last year.
Infovest21 annual white paper examines trends on a global basis. The white paper looks at recent (June 1, 2010 to June 30, 2011) hedge fund interest and activity by pensions, endowments, sovereign wealth funds. Summary highlights of recent activity as well as plans for moving ahead are provided for a sampling of institutions.
Institutional activity is examined in North America, Europe, UK and Japan. Special emphasis is placed on the largest allocators i.e. those allocating $1 billion or more to hedge funds. The white paper also provides a survey of smaller institutions making allocations as well as those issuing RFPs or conducting searches. Those institutions deciding not to allocate or who have reduced their hedge fund allocation are also listed.