‘Adjacency’, or the art of step-by-step
It is tempting, just because it is so good at it, to think of the $11bn (€7.8bn) London-based hedge fund manager CQS as a credit specialist. But founder Michael Hintze is keen to emphasise its broader strengths. "We are a big hedge fund, but we do more than simply provide absolute returns in credit," he says. "Nowadays we are a global multi-strategy, multi-asset management firm providing hedge fund, long only and bespoke solutions for clients."
The fact that CQS's first fund, launched in 2000, was Convertible and Quantitative Strategies (now running more than $800m), pushes the point home. "Convertibles requires an understanding of all sorts of areas, from derivatives to equities to credit," Hintze explains. "From there we pretty quickly built credit, asset-backed and multi-strategy capabilities. All of the development has been what I refer to as ‘adjacent': the starting point for anything new is making ourselves smarter in the things that we are already doing."
But ‘adjacency', as well as describing organic growth in strategies, also describes an increasing diversification of strategies. The benefit of this (which underpins the concept of the Diversified fund that we will turn to later) was most evident when market conditions turned against the firm's Capital Structure Arbitrage fund. By 2007 CQS and its clients recognised that this portfolio had run its natural course, but this was offset by the ongoing success of the original convertible arbitrage strategy, and also by the addition of Directional Opportunities in 2005 (the mutli-strategy fund managed by Hintze himself, now with $1.3bn under management), the ABS fund in 2006 (see this month's ‘Investing in structured credit' section), the multi-asset Asia fund in 2007, and three European CLOs through 2006-07. Since 2009 the firm has added a Distressed fund and a Credit Long Short strategy (which has already reached $170m and earned a place on Schroders' exclusive ‘GAIA' alternatives platform).
This range of strategies not only provides some diversification of performance within the firm, but also necessitated the building of an infrastructure that can now support the ‘bespoke' service Hintze mentions. He sees CQS resting on three pillars - the research capability, the operational infrastructure and client relations - and recognises the links between them.
"We've got a number of convertible portfolios out there, but they all feed off of the same research function and can all be monitored by our systems," he observes. "I was initially concerned about offering 20 flavours of vanilla, but the infrastructure allows us to do it and that means the marketing team has much greater flexibility to meet clients' needs. We can accommodate the client who wants a very short notice period for redemption, for example, by cutting the portfolio in a certain way and having absolute confidence that our operational platform will meet their needs."
The changing shape of institutional allocation to hedge funds has been transforming the importance of these capabilities. Through 2007 Hintze noticed pension fund principals increasingly turning up to meetings alongside their fund-of-fund agents. Then some began to ditch the middle men altogether.
"We'd spent a lot of time and resources making our risk reports state-of-the-art, but we realised we needed a real human interface, too," says Hintze. "This was about the financial crisis to some extent, but we were in a transition anyway: they'd tried off-the-shelf for a while, now they were thinking bespoke."
Today, over $1.5bn of CQS's AUM is in bespoke solutions or ‘Funds of One', the fruit of a lot of time spent in dialogue with investors and global and specialist consultants around the possibilities of convertibles, ABS and multi-strategy. A proactive rather than ‘build it and they will come' approach is not new to CQS - Directional Opportunities resulted from a reverse enquiry - but this was on a different scale.
Particularly successful was work done with one leading global consultant to develop Convertible Opportunities, the pension fund-friendly long-only convertibles strategy launched in June 2009. It raised almost $250m in six months, and now CQS manages well over $600m in long-only convertibles.
"A lot of investors sensed value in the global convertibles market after 2008, but also knew it paid to have a ‘jungle guide' there," says Diversified fund portfolio manager Peter Warren. "They wanted to position themselves for that value without recreating the issues that led to that value in the first place."
Warren describes a quid pro quo: the consultants recognised CQS's long success with the asset class; CQS recognised the consultants' insights into how a product might be structured for long-term, real money investors. Convertibles had been plagued by hot-money outflows, for example, so CQS demanded 60 days' redemption notice precisely to attract investors who would be willing to commingle.
"It was also clear that these were not shoot-the-lights-out investors, so the portfolio has a pretty defensive investment-grade bias and targets returns of 8% per annum with low volatility," Warren adds. CQS want investors to see convertibles as a useful strategic asset (and CQS as a long-term partner) rather than a tactical deep-value bet.
"The collapse in option delta temporarily made convertibles a cheap corporate credit market, which helped pension funds take the decision," says Warren. "But then they see outperformance relative to corporate bonds as equities rally - and that's a good position from which to start the dialogue about engaging for the longer-term."
It is at that point that strategies can begin to attract big money. The ABS fund has a remarkable track record stretching back almost five years, for example, but it has grown by $600m to $1.6bn in 2011 alone. From a pre-crisis peak of $9.5bn, the firm's overall AUM fell to $6.5bn in January 2010 (all redemptions having been met without recourse to gates), but has since soared to over $11bn. The plan is to reach $15bn over the next 18 months.
"We are mindful that we need to focus on generating returns for our investors," says Hintze. "Having said that, we have a number of funds that have further capacity. The converts strategy is still under-invested, just because convertibles generally are under-invested: that could be a $2.5bn portfolio. The Asia fund has converts at its core but in reality it is multi-strategy and we could have another $2bn in that product, as we could in Credit Long Short. The Distressed fund, at $60m, we'd like to see running $1bn."
This growth will be managed carefully. January saw CQS soft-close Directional Opportunities, even though it could conceivably take a lot more of the money that still clamours for access. In June the directors of the ABS fund announced their intention to soft-close it at $2bn (despite a view that opportunities remain abundant) and actively manage monthly inflows so that institutions presently undertaking due diligence have the opportunity to complete that process.
This desire to see as many investors get a share of the CQS alpha as possible (rather than zeroing-in on a few heavyweight ‘gold standard' clients) is indicative. Recognising that many will not want individual strategies, the firm is keen to nurture its Diversified fund, a multi-strategy in-house fund of funds. It is a compelling way for investors to benefit from the very low correlations between the firm's strategies in much the same way that CQS itself does, which since inception in March 2007 has achieved its target annual return of 10%-plus with less than 10% volatility (finishing 2008 down just 7%). One reason for soft-closing Directional Opportunities and ABS was to reserve capacity for Diversified, says Warren. "We can envisage that fund becoming a key franchise for us with institutional investors."
But not just institutions. About 25% of the fund's $450m AUM comes from a London-listed vehicle - another diversifying source of capital. And, perhaps most important, 16% comes from CQS' staff, as Diversified is the main vehicle for investment of deferred compensation at the firm.
Considered diversification of strategies and client base, high-alpha strategies, alignment and engagement with clients (it is a founder member of the Hedge Fund Standards Board): CQS represents something of a model of what the twenty-first century institutional hedge fund business might look like.