SUSAN BARRETO, DEPUTY EDITOR, INVESTHEDGE
What was once thought to be a fad is now officially a phenomenon. Pensions and other institutional investors are now more apt to allocate directly to hedge funds rather than invest in a traditional commingled fund of hedge funds (FoHFs).
The way they are filling their portfolios to the brim is evolving. New ways to invest in hedge funds are emerging as both consultants and FoHFs take turns driving the next stage of the institutional influx into hedge fund strategies. In 2012, the main themes were credit and niche long/short equity allocations and a hope that positive returns would outshine the traditional long-only side of the portfolio. Going into 2013, event-driven is gaining in popularity as many see the esoteric credit strategies that outperformed in 2012 as being played out.
A brief snapshot of the institutional marketplace in 2012 shows a flood of direct allocations totalling more than $8 billion for the 12 months ending 31 December 2012, with the average institutional investor allocation amounting to more than $350 million. This group of investors (mainly US pensions) accounts for more than $650 billion in assets and are likely on average to hold total hedge fund allocations upwards of 10% of their overall portfolios.
The most active allocator in 2012 was the $71 billion New Jersey Division of Investment, which placed roughly $2.4 billion in single-manager hedge funds. The Trenton-based pension tapped 11 managers in 2012: BlueCrest, Claren Road, Cadian, Regiment Capital, Bay Pond Partners, Cevian Capital II, Blackstone, Och-Ziff Capital, Scopia Capital, MKP Opportunity Partners and Lazard Rathmore Fund. In a number of instances, officials were making additional allocations from previous years but, for the most part, they seem to be ramping up to meet the portfolio’s 15% target allocation to hedge funds. New Jersey’s absolute return portfolio, which includes FoHFs, was up 2.69% for the year ending 31 December 2012.
TOP MANAGER IN 2012
By far the largest allocation for the year was to Och-Ziff. Last summer, the manager was tapped for a significant increased investment in four new separate accounts.
On the hedge fund side specifically, OZNJ – Credit Strategies was slated to manage up to $400 million. The investments were partially funded through a $100 million redemption from the existing hedge fund investment in OZ Domestic Partners II LP. The move was not without some fee savings, in that staffers negotiated a discounted fee arrangement that allowed the Division of Investment to invest the first $267 million of the new capital, without increasing the management fees paid to OZ, due to the redemption out of the OZ Domestic Partners fund and the transfer of money into the lower-cost separate accounts. Netting of all the investment returns across OZ’s New Jersey separate accounts allows the payment of carried interest at the end of the investment term and is expected to reduce the likelihood of paying performance fees unless the overall separate account relationship is profitable.
Other institutional investors in Och-Ziff in 2012 include Texas County & District Retirement System, University of Texas Investment Management Company (UTIMCO), Cheshire Pension Fund in the UK and Florida State Board of Administration.
On the FoHF side, like many other US public plans, New Jersey has been able to create customised portfolios. As the $49 billion Massachusetts PRIM Board announced it would unwind its hedge fund holdings, thereby ending its relationship with Arden Asset Management, Grosvenor Capital Management, Rock Creek Group and K2 Advisors, the New Jersey pension fund was able to pick the holdings it would like to have. Director Timothy Walsh proposed an additional investment of up to $250 million in RC Woodley Park, a fund managed by the Rock Creek Group, and an investment of $500 million in a fund managed by Arden.
Walsh describes the potential investment as an attractive one-off opportunity. “The division had a first look at a portfolio of investments that Arden and Rock Creek are liquidating for a large state plan,” he says. “The additional capital would allow the division to ‘cherry-pick’ the highest-quality managers from the group, as well as to take advantage of future opportunities of a similar nature that develop.”
Numerous US institutions are going into 2013 trying to ascertain whether to retain their FoHF as an adviser, customised separate account provider or a commingled fund provider. These discussions tend to be held in conjunction with negotiations to lower fees.
ILLINOIS BUILDS ALLOCATION
The second-largest direct hedge fund allocator of 2012, the Illinois Teachers’ Retirement System in Springfield, knows this discussion well. Quietly and diligently, Grosvenor and K2 have assisted staffers with previous hedge fund allocations. Last year, the $38 billion pension fund system added almost $900 million to three managers – Pine River, AQR and Standard Life.
With more than $2 billion allocated to hedge funds, Illinois Teachers has returned 8.15% for the year ending 31 December 2012, investment staff has reported.
Adding credit strategies, the $18 billion Texas County & District Retirement System seems to have bypassed the FoHF route altogether in hiring managers that are prevalent in many of the world’s largest hedge fund allocators. Since February 2012, the system has placed nearly $2 billion in hedge funds across its portfolio. The $5 billion hedge fund programme returned 7.6% gross of fees for the year ending 30 September 2012. Last year’s allocations, from $30 million to $200 million apiece, included OZ European Credit Opportunities, AG Select Partners Advantage Fund, Highfields Capital IV, Asian Century Quest and Graham Global Investment Fund. Cliffwater is the pension fund’s consultant.
Another large hedge fund player in a Texas context is Bridgewater, which has enjoyed a unique relationship with the Texas Teacher Retirement System in Austin. The $101 billion pension fund struck a deal in 2012 to invest $250 million in Bridgewater Associates Immediate Holdings. Texas Teacher already had investments in the firm’s strategies, but the deal is part of a multi-year process aimed at making a steady transition to an ownership and capital structure that is consistent with Bridgewater’s commitment to ensuring the $120 billion firm remains employee-controlled and financially self-sufficient.
Fellow investors that made allocations to Bridge-water funds in the past year include UTIMCO, Ohio Public Employees Retirement and Church of England Pensions Board.
CONSULTANCY VERSUS FOHF
This year, many will decide whether they should rely on a specialist consultant or a FoHF to make the right hedge fund decisions. In fact, firms such as Towers Watson have been heavily encroaching into the FoHF space recently. The firm says that institutional investors continue to diversify their investment portfolios into alternative assets, increasingly via direct funds rather than FoHFs.
“Throughout the past five years, the alternative fund managers that we have put into client portfolios have shown their ability to adapt to the changing environment to generate good net-of-fees performances,” says Craig Baker, global head of investment research at Towers Watson. “Larger institutional funds are likely to continue to invest in funds directly for most alternative asset classes rather than via funds of funds as investors continue to focus on better fee structures and greater transparency.”
The only questions remaining are whether investors can adequately assess how much they are really paying for alpha in the long run, and whether or not all direct hedge fund investors are getting the same price for the same slice of the alpha pie.