This publication talks to London-based Sussex Partners, which focuses on the hedge fund sector, about the current scene in the alternative investments space.
As part of this publication’s series of articles examining alternative investments such as private equity, hedge funds, real estate and other areas, it is running a series of interviews with practitioners in the space. Here are comments from Patrick Ghali, managing partner at Sussex Partners, a firm based in London’s Mayfair district. It focuses on hedge funds and funds of hedge funds.
How useful do you consider it to think of “alternative assets” as being at the less liquid end of the spectrum (with venture capital and special situation hedge funds, private equity, etc, at one end, and listed equities at the other)?
We would argue that this is too simplistic. While we see a bifurcation in investor interest, with some focusing exclusively on daily liquidity strategies and others focusing solely on multi-year lock-up strategies, at the extremes, to us alternatives encompass both ends of the spectrum (and anything in between), and both come with their own challenges and benefits. The more liquid end tends to come with more volatility, and sometimes reduced return potential (in return for said liquidity), whereas as the longer lock-up strategies tend to offer less volatility. Some investors equate this with more certainty, and typically a pickup in return (illiquidity premium). However, the longer lock-up strategies often mask volatility and the assets would have to be marked to market in an intervening period; they would likely exhibit significant volatility, be subject to gap risk, and provide a false sense of safety/security. This is why it makes sense for certain strategies to only be accessed through longer lock-up vehicles in order to be able to work through such periods without having to sell at the most inopportune moments.
One also needs to pay special attention to making sure that stated liquidity matches an underlying investment to avoid liquidity mismatches and to make sure that a strategy is given the appropriate length of time to perform. On a separate note, we also think that the term “hedge fund” is somewhat of a misnomer as in many cases strategies are long only and the only “reason” they are classifies as “hedge funds” is because of their charging mechanism (management and performance fee).
In the alternative asset class space that you track, what are the main trends you see (in hedge funds, private equity, VC, real estate, infrastructure, commodities, other)? For example: increased/decreased wealth management interest in certain areas (please give examples); use of specific types of vehicles (listed alternatives, offshore structures), redemption/liquidity requirements, etc?
Given the current environment, we see a marked pick up in the interest from investors, be they institutional or private wealth managers, in finding alternative and non or less correlated sources of return. This is manifested both at the liquid end (daily liquidity hedge funds with little equity exposure for example) and at the longer duration end (lending strategies for example). We saw this increase in interest starting 18 months ago and continuing. The liquid space is mainly dominated by UCITS funds in Europe as well as managed account platforms offered by banks, whereas the less liquid space can be accessed either via onshore of offshore funds.
A big challenge is for accurate reporting about the valuations and performance of alternatives (calculating net asset values, etc). How in your view is the wealth management industry served today in getting such data? There are a few firms out there developing technology, such as FundCount, Private Client Resources, etc. Is there still work to do?
We tend to focus on the more liquid end (daily to quarterly liquidity) and tend to avoid strategies that don’t have an objective price (i.e. model based pricing or non-listed investments are generally avoided) so this is less of an issue for us. We also spend a lot of our operational due diligence on assessing the robustness of a manager’s valuation methodology and processes. For this reason reporting doesn’t tend to be a problem for us.
There is a lot of money going into private capital (private equity, debt, property, infrastructure) and we read comments about the build-up of “dry powder” (uncommitted capital) that is accumulating. Is that a cause for concern? Could yields be squeezed? Has the chase after returns caused some excesses?
We are quite concerned about this and feel that the yields in many cases have been compressed to levels where you are now getting “return free risk” and we tend to avoid such investment opportunities as they make little economic sense. We are also hearing comments from managers trading public markets that deals that couldn’t get done in those public markets because they were too expensive, were subsequently done in private markets at even tighter spreads. Of course, this is very concerning and to us a sign of excess that we want to avoid. We also think that there has been a bevvy of new managers launching in those areas which don’t always have the appropriate pedigree needed to be successful for investors in the long term.
Hedge funds have had mixed results in recent years and their traditional 2 and 20 (annual management fee, performance fee) per cent fee models have become squeezed. Do you see further fee compression?
This very much depends. Managers that are offering a “me-too product” with middling returns have no choice but to compete on price, and their value add is clearly questionable as is their survival. Managers that either specialise in a niche, or have very limited capacity (or both), or operate in a very expensive and time intensive segment of the market and/or are able to consistently provide very attractive risk adjusted net of fee returns are still able to command a premium and will continue to be able to do so in our opinion.
When accessing hedge funds, do you prefer to go directly to a specific manager of a strategy or still prefer a fund-of-funds/multi-manager approach where the manager/fund selection role is outsourced?
This very much depends on the strategy, and the client mandate. Some clients are not able to invest in single managers, and for some strategies we want diversification and wouldn’t be comfortable to only invest in one manager, and so prefer either a fund of funds or a portfolio of funds in the same strategy. Not all FoFs are the same, and there are many that provide excellent returns in specific niches where the result is better net of fee risk adjusted returns than for example provided by the equivalent single manager index but with added diversification. In such an instance, an FoF that can deliver this is clearly the better option than a single manager as it allows us to diversify away idiosyncratic manager risks. In other cases, we don’t see the need for this diversification and prefer to have exposure to single managers.
How much has the squeeze on yields for listed equities and other conventional asset classes encouraged a shift to alternatives?
This is certainly one of the drivers, as is the desire for less corelated returns. This is especially a factor after so many years of a bull market.
There is a sort of wealth management quest for the “Holy Grail” of uncorrelated returns, encouraging interest in ideas such as life settlement funds, liability finance, not to mention traditional areas such as gold and diamonds. What is your take on whether such uncorrelated returns are ever really possible?
We think that you can create portfolios of lesser correlated managers/strategies/assets that should be able to protect some capital on the downside. However, this has to be caveated by the fact that even those may not necessarily make money in certain types of crisis but should protect capital better than traditional portfolios of long only stocks and bonds. In many cases, correlations of assets converge to 1 during a crisis and it can be very hard to fully offset this. Some of the strategies you mention above are not truly uncorrelated but rather have hidden gap risk due to the fact that they are hiding behind their illiquidity.
If you had to sell them in a real crisis, where there is no market liquidity, it would be likely that you would not be able to get a good bid on them either (as was certainly the case in 2008 when people who really needed liquidity had to accept very steep discounts to liquidate these types of investments). The aim should be to minimise drawdowns in such periods in order to then be able to recover more quickly, and get back to compounding positive returns over a long period of time. Large drawdowns, and permanent loss of capital, are the biggest risks to wealth preservation and wealth generation, and the aim should be to minimise those risks.
Has the 2008 financial crisis and its aftermath radically changed how you think of alternative assets, or just added to the data that you take into account about these areas?
Anybody who has lived through 2008 will have been deeply affected by this period and will have hopefully learned some valuable lessons. Operational considerations are certainly even more important today, as is the risk embedded in illiquid strategies and the false sense of security they may provide. Many investors had significant holdings of illiquid investments pre 2008 and had to learn the hard way that they were not nearly as stable as their pre-crisis track records lead many to believe once global liquidity dried up. We can see many parallels between the current chase for these illiquid investments and what happened pre 2008, and so are very hesitant and sceptical when analysing these types of investments. Avoiding liquidity mismatches has certainly become an even bigger focus of our due diligence process, as have valuation policies.
Are there other points you want to make?
We strongly believe that hedge funds have a place in investors portfolios and will continue to exist. We also expect there to be more of a conversion between traditional and alternative managers over time. Investors we speak to seem to spend more time today than they did in the past in trying to understand what role they want their hedge fund allocation to play not just on a stand-alone basis, but in a portfolio context, and we think that investors are also more realistic today in terms of their expectations for these funds.
Further, we feel that investors have also understood that hedge fund investments require specific expertise and are no longer something you can do on the side but requires dedicated expertise and resources to do it properly.