Big Institutions Hungry for Asian Single Managers

"The secret of business is knowing something that nobody else knows."

Aristotle Onassis (1906-1975)

How does a big eater search for filling crumbs on a crowded table? When the US$220 billion public pension fund called CalPERs makes any announcement regarding alternative investments, people listen.

The reason they listen is twofold. First, it is often regarded as the "early adoptor" in the hedge fund space so when it comes to investing other like-minded U.S. institutions will not be too far away (perhaps 12-18 months). The other reason involves the likely direction of fees. Believe it or not, many of the funds that CalPERS invests in effectively "pay" for the privilege by offering lower fees, capacity guarantees or both. As one U.S. based fund of fund manager said several years ago "you hardly make any money on fees from those guys". It is a well-known fact that they drive a hard bargain. So why do hedge fund firms want CalPERs as an investor? Ego. It sounds good at cocktail parties, like a badge of honor to show off to other potential institutional investors (who might pay full fees hopefully...)


So what might CalPERs be thinking of, after all, they already have allocations to Asian hedge funds through 3 well-known Asia-based fund of hedge fund firms (FoHF): Sparx, Vision and KBC Alpha. There is also a lone European on the list in Ermitage European FoHF.

The announced plan ensures that an additional US$400 million will find its way into single managers before the end of 2006. The timing couldn't be any more interesting given the pathetic absolute performance of many Japan managers and the equally disappointing performance of those Asian FoHF firms mentioned e.g. through Sep 2006, Vision Maximus FoHF was up a paltry 0.91% YTD and looking to post its worst annual performance in its 5 year existence.

It seems that CalPERs without an office in Tokyo or Hong Kong still feels comfortable enough to make their own investment decisions regarding many potential single manager funds in Asia - hardly a ringing endorsement of their existing Asian HFoF exposures. But at least they have taken a cautious approach building a potential list of managers through the 3 HFoFs that they already are invested in!

Look at the decision recently taken by the equally forward looking Yale Endowment. Many institutional investors are probably revising down return expectations from many hedge fund strategies including HFoFs and that includes those in Asia and Europe.

One approach may be to cut "losers" and focus on low cost, passive exposure to a region and tilt the portfolio towards more focused, absolute return opportunities - and in this regard CalPERs might prefer a value bias. That could mean going more illquid into the distressed/private equity arenas or even via infrastructure or real estate. After all, where will Asia's newly minted middle-class want to live in the next 20 years? The same old shanty towns? Hardly.

Where in Asia might the money flow? CalPER's Japan investments already have approx. US$500 million in a couple of activist funds run by WL Ross and Sparx. India looks toppy with SENSEX continuing to hit new highs although private equity is still very much sought after, while China has rebounded already very nicely this year so how far can that opportunity go?

Which brings up the issue of single manager hedge fund capacity in Asia. Where is it coming from? And will it make sense for an established investor like CalPERS to put money into the same large asset managers it probably already has exposure to in its FoHF programs? Probably not. Diversification is the name of the game be it related to geography, strategy and firm size - probably in reverse order of importance! Perhaps, CalPERs has discovered something that its existing Asian HFoFs are not currently doing? Surprises are no doubt in store.

This announcement will also provide a psychological boost to Asian institutional investors and their own investment planning. After all, didn't a Chinese bank just make it to being the world's largest IPO at US$19 billion and was massively oversubscribed to boot. The question is how long before they expand beyond market neutral and long short equity on the single manager side and the big global HFoF. And then, aren't we heading back down that familar road of capacity again? Where is it? Will big investors (US, European or Asian) with big appetites ever be satisfied by newer, relatively smaller funds in Asia? My guess is that if they perform as expected "yes". Mahalo.

The End of Japan Long/Short Equity?


"When a person with experience meets a person with money, the person with experience will get the money. And the person with money will get some experience."

Leonard Lauder


In Asia, October mid-month 2006 returns look shaky for Japan Long/Short Equity managers. 25 out of 40 hedge funds reporting to a well-known Swiss bank posted negative returns, while on a YTD basis 32 out of 40 remain very much "under-water"( i.e. drowning). And just how much underwater is a worry as the most popular names are an average of -10% to -25% down.

This is all the more surprising as for most of these high class, experienced players, CY2005 returns came in an average of 15% to 30% on the positive side. As many other researchers (like MS, or Morgan Stanley) have noted, private clients chase returns and this is apparently what happened in terms of net asset flows to Japan over the early part of this year.

That is one big investor "black eye" - whether you are a Swiss institutional investor, family office, Japanese pension or US university endowment. The way that institutional investors view Japan, relative to their other portfolio geographies and opportunities for the remainder of 2006 will be critical in deciding whether we see the beginnings of a net outflow of fund flows heading into 2007. Those decisions are being tabled as I write.

How did so many strong hedge-fund winners now collectively be losers is one of the real questions as yet to be studied and explained by the industry. Simply choppy markets, bad calls, a sudden loss in liquidity, the implosion of small caps, enduring market scandals, bad luck, no trend (meaning uptrend)...these are all of the excuses suddenly seeping out of the mouths of many of these Japan Long/Short managers.

So their old tricks suddenly don't work and there are no hot IPOs to goose monthly returns especially through the end of the quarter. Take a look at gross and net exposure levels and try to understand where performance was generated in 2005 vs. 2006. This must be all too worrying for the average investor in Geneva, Zurich, New York, Chicago or Hong Kong. What happened, what is happening and is it a fundamental shift in how Japan Long/Short Equity is being executed by these practicioners? Of equal interest is the oddity that many of these managers are down about the same amount? And, what about the "hedge" that most of them promised? Were these players ever really hedged or merely levered long?

Finding the underlying reasons IS important. And it is incumbant on an investor to do his/her research and to feel comfortable with it. Why? Because not too long ago Asia (including Japan) was deemed the long-awaited investment opportunity, one to ride out through the Beijing Olympics in 2008 regardless of whatever happens on the Korean penninsula. There were plenty of 15%-20% performers there...and the market is liquid, making it slightly better than other emerging markets.

Many global hedge fund managers have themselves invested resources outside of the U.S. opening and staffing offices in Singapore, Hong Kong, Sydney and Hawaii to be part of what was expected to be a runaway freight-train to Performance Nirvana. They had not done so since the Asian Crisis of 1998. They have even devoted increasing amounts of capital to non-U.S. investment opportunities and in some cases they have incoporated Asia-related strategies and funds into their global operations.

The worry for these hedge funds is now very serious. Aside from taking more inter-month telephone calls and emails from investors (which they typically despise) about what is going on with Japan, the CEOs of these firms will now face the stark reality that as EoY (end of year)performance bonuses are calculated there will be little to nothing to hand out. Like the orphan child in a Dickinsian novel there might not even be a lump of coal.

And without equity in the business, you can expect quite a lot of disappointment, dissatisfication and dissilussionment within their employee ranks. Expect the best performing individuals whether in the front and back offices of some of these big players to move on to greener pastures. Moreover, the freshly minted MBAs armed with expectations of call-option type earning ability, might be "forced-back" into the investment banking ranks for financial security. The cracks might already be appearing.

As investors, one should have to monitor closely the remuneration of "key" individuals to assess such brain-drain flight risk. As investors you whould want to see the most valuable employees get well-paid. Investors should also go back and re-read the fine print of their fund documentation to find out when they can get out of their respective hedge fund losers, and at what cost! Those decisions are coming. Trust me, Japan Long/Short Equity is no longer a sure thing if you think you can get 15% net of fees with low risk.

There is also talk that some institutional investors are looking to modify their investment philosophy from investing purely for absolute return (which doesn't make sense if you are down 20%) to one in which you focus on modified high-water marks and relative benchmarks.

Expect investors to switch investments into cheaper, beta-chasing benchmarks such as ETFs that reflect more on the upside. The result might not be a continued asset growth in Japan/Asian hedge fund markets at a 20-30% CAGR but rather a tailing-off with investors focusing on revised environment in which Long/Short Equity hedge funds have grown more correlated to the markets; where investors become more fee conscious and take that into their investment decision; and, where for some pension/institutional managers more focused quantitative specialists gain AUM (assets under management) such as the State Streets, GSAMs and BGIs, and other enterprising Japan Equity Market Neutral managers can expect to make a killing if their product produces alpha and is scalable.

There is another dimension too. What about the myriad of Asian and Japan-focused fund of hedge funds, numbering well over 100 globally. Armed with their glossy marketing docs that boasted uncorrelated performance and great returns a couple of years ago, they too have been bloodied. Returns are generally down. These players can expect to lose AUM very soon, as most of them have made fundamental flaws in portfolio construction that has not accounted quickly enough to the spectre of rapid correlation among so-called different managers.

Rather than thinking "big-big" (investing in big hedge fund names) there is probably more diversification going "small-big", that it a selection of small managers mixed with big ones chasing different deals and arbitage opportunities. Moreover, a prominent hedge fund manager and former colleague of Soros once said: everyone knows that the first 4 years of a manager's exisitence is his most profitable. That is the time when he needs capital and ironically it is the time he will not goet it from institutional investors. Of course, this implies another set of different risks for the investor. Chances are they are still likely to be better than the 2006 Japan Long/Short Equity benchmark of being down 15-20%!

Consider the well-known Japanese broker who set up a Japan Long/Short Equity fund of funds product a couple of years ago. There were approx. 8-10 different managers. Unfortunately, the correlations of those products have probably converged . The portfolio was built at a time when the long side of virtually every Japan portfolio was heading upwards. Hedge funds were uncorrelated de rigeur.

Today, that portfolio is almost surely flat on its face, especially among the firm's senior management who put down approximatley US$50 million to seed it while it built up a track record. Its outside investors are probably pulling back their commitments as they have done with many of the firm's other sponsored hedge fund products. Earlier this year perhaps sensing the pressure its chief strategist moved on to another firm. So, the wheels keep on turning but the question still remains for investors and managers: what is to become of Japan Long/Short Equity? Quite a lot I think.
Maholo.

Hedge Fund "Hotels" in Asia

" Each problem has hidden in it an opportunity so powerful that it literally dwarfs the problem. The greatest success stories were created by people who recognized a problem and turned it into an opportunity."

Joseph Sugarman

A broad overview. The concept of the hedge fund hotel was initiated in the late 1970s by the then little known broker, Furman Selz. It started out as office space on 237 Park Avenue in Manhattan, N.Y. in what was then known as the Pan Am Building (located directly over Grand Central Station). This took the form of space sub-leasing, the provision of electronic trading screens (later known as Bloomberg terminals), dealing room back office facilities, plants and even lunch on Fridays! Why? Because the small broker realized that by effectively nuturing some of its trading clients it could establish a quid pro quo of brokerage commissions for this "hotel" support.

This was the origin of prime brokerage and a developing realization that business could be built organically with the then blossoming hedge fund client (typically an ex-mutual fund guy with a few coins and penchant for entrepreneurialism).

Back to Furman Selz. With the financial industry consolidating in 2001 there began the ING-Furman Selz fund of hedge fund (FoHF) initiative. Not only could you access some of the hotel fund managers but in a portfolio format - great for the institutional investor and even greater for the promoter given the opportunity to generate additional fee income on the product marketing side. In the meantime the bigger players, like Merrill Lynch also jumped into the fray and started the first overseas PB operation under the umbrella of Merrill Lynch Intl Bank in the late 1980s.

To close the loop. Eventually firms started to pull back from the office leasing business as they found that the expenses they provided to the hedge funds kept on rising exponentially. They could hardly make the manager pick-up the tab. Typically though, 90% of managers that left the confines of the "hotel" continued to do business with their "prime". In addition, this period saw significant reductions in the cost of technology and telecom rates making it easier for a manager to set out on his own.

Today the hedge fund industry is pretty much the leading money maker for IBs and brokers on "The Street" throwing off US$6.5 BLN in revenues in 2004 and comprising roughly 40% of total equity trading revenues. With US$1.325 TLN in industry capital managed by approx. 8,500 funds (single managers and FoHFs) it is big business and likely to get even bigger - albeit below what had been a 15-20% AUM CAGR in the late 1990s and early 2000s.

Of additional interest is the current make-up of the PB participants. Roughly 60% of global prime brokerage business is dominated by three houses - Morgan Stanley (MS), Goldman Sachs (GS) and Bear Stearns (BS). Each has a "hold" on a different hedge fund industry niche. Morgan Stanley is strongest in servicing offshore funds especially out of Europe and Asia via their Hong Kong office; GS is strong in U.S. onshore product, new jumbo managers (usually former GS prop traders) as well as in Japan, where they hold a well-attended "meat-market" event showcasing emerging Japan managers each November at the Four Seasons Hotel in Tokyo; while BS is strongest in relative-value strategy funds like convertible arbitrage, fixed income with a focus on U.S. managers.

Why Back To the Future with hedge fund hotels? Its simple really. Hedge fund hotels can be a profitable entre for a growing prime brokerage business operation. Not really an already established one but a mega-IB wannabe. Your customers are effectively home-grown and assuming you have effective due diligence (which is often times very suspect given the natural conflict of interest to get the business regardless of how the alpha is generated). The up-and-coming PB hotel owner can even serve the capital introduction platform. The latter is the PBs attempt to showcase favorable managers to their best institutional clients.

But the conflicts can make the relationship between manager and PB a little tense, particularly if the fund AUM takes off and the manager expands products and fund offerings to other more potentially specialized PB platforms. What happens then? I guess it is better to have 20% of some business than 100% of nothing! So the battle of negotiating power between PB and fund manager is an ongoing one of struggle as each attempts to protect their valuable "margin" on the hedge fund value chain. And today, the Asian hedge fund value chain is very valuable indeed.

In 2006 there are an estimated 100 such hedge fund hotels, mostly in the U.S. on the east coast but also in many others cities like Chicago, Boston, San Francisco etc. They are even sprouting overseas in places as far afield as London, Geneva, Paris, Hong Kong, Singapore and Tokyo - in short, to wherever the hedge fund "bug" (or "locusts" for all you German speakers out there) has bitten and taken hold. Which is one reason why the hotel business model has arrived in Asia.

This brings us to Hawaii. Rather than "Why?" one might pose the question "Why not?" Why not anywhere for that matter? Really. The truth is that for a particular region it sometimes makes sense with the right mix of trading talent to exploit whatever natural advantages might exist. Twinning time zones in the U.S. and Tokyo suggests that there might be particular advantages for a hedge fund manager wanting to be closer to Asia and desrious of a U.S. lifestyle for his family. So why not Hawaii? Maybe because the big IBs are not there.

Interestingly, the growth rate experienced in hedge fund industry AUM (if they can be believed from the various"authorities" that exist) has actually started to slow down in the U.S. and to a lesser extent Europe since 2002/03. Only in Asia (specifically Japan) and from an arguably lower starting point has the growth rate been an impressive 30-35% every six months (since the Nikkei low in May 2003). This has not gone unnoticed by many big PBs ramping up their operations in Hong Kong, Singapore, Tokyo and Sydney. There is probably one being set up in Shanghai as I write!

What this all means is that competition for the Asian hedge fund manager coin is certainly going to heat up. And more competition means a trend towards commoditization and lower brokerage commission fees. That is great for hedge fund managers and potentially investors. Which is why the issue of conflict of interests in some of these ventures is particularly interesting and conveniently overlooked.

Remember, the Asian hedge fund industry is moving from about 4-6% of total hedge fund AUM (or a speck in the ocean) in 2005 to potentially 15% by 2011 (a pretty big lake). That makes Asia a particularly appetizing piece in the developing hedge fund industry pie. Mahalo.