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Hedge Funds: Not just a lion at the gate

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Liongate Capital Management, the $7.5bn (€5.6bn) London and New York-based fund of hedge funds, has just celebrated its tenth birthday by selling a 55% stake to Principal Global Investors. That is fitting, because in many ways Liongate pioneered some of the aspects of the funds-of-funds business that today we might describe as ‘institutional’.

With hindsight, it’s clear that 2003 was the twilight of the first era of hedge fund investing, in which family offices allocated capital to talented prop traders, developing into funds of funds as more and more third-party investors came to join. Liongate’s co-founder Jeff Holland, the ex-Deutsche Bank vice president, who sits on the firm’s investment committee and heads business development, describes a ‘velvet rope’ mentality: investors were sold the idea of relationships with managers who had closed to outside money.

“The pitch was that these guys were alpha generators and would perform well in any market environment,” he recalls. “Portfolio construction was rudimentary, based upon balancing allocations between the well-known hedge fund categories: there was little recognition that risk exposures could be shared across different categories, that the main categories disguised a great deal of style diversity or that managers could be categorised in different ways.”

When Holland founded Liongate with Randall Dillard, who had been a managing director at Nomura, this was precisely what they set out to integrate into their investment philosophy. Top-down views are at the heart of a dynamic allocation based upon understanding the effects of changes in the macroeconomic environment on underlying strategies. Liongate’s portfolios are diversified in their exposure to market risks rather than simple hedge fund categories – and they can exclude styles if the firm thinks conditions do not suit them.

“We always impressed upon our clients that there was market beta in hedge funds, that it was important to understand and aggregate it across the portfolio, and that the only way to do that was to have transparency into individual managers,” says Holland. “That was hard to understand for clients who had been trained to think of hedge funds as a separate asset class. Many were not really prepared to respond to it.”

This philosophy naturally led Liongate to adopt propositions (hedge funds have market exposure and transparency is crucial to understand it) and tools (proprietary portfolio risk management technology and managed accounts) that have since become mainstays of institutional hedge fund investing. It also made it an early adopter of another widespread belief: allocating to smaller or medium-sized managers is a good idea.

Most investors like smaller managers because their size has not yet eroded their capacity to generate alpha, or skewed their incentives by creating so much revenue from management fees.

Holland acknowledges these advantages. “The industry is rightly putting more pressure on larger firms to address management fees, because they clearly no longer need them to pay their partners and keep the lights on,” he says. But when it comes to investing with smaller managers, this sort of thing is really just “the icing on the cake”.

“The real reason we go for medium-sized managers is that they tend to be much more focused in their strategy,” he explains.

If your strategy is built on dynamic risk allocation, then it helps if your managers’ risk exposures are relatively stable. In other words, it is not the size of larger managers that is the problem, but rather that larger managers often pursue many different strategies. They may still have excellent skills in some or all of those strategies – and indeed, Liongate has increasingly exploited those skills by carving out specific strategies as managed accounts.

“That’s interesting when clients are thinking about the value proposition of a fund of funds,” Holland argues. “We can leverage our scale in a way that perhaps even large institutional investors allocating direct are unable to.”

This is perhaps today’s most contentious debate in institutional hedge fund investing – the value of funds of funds. While much of the fund-of-funds industry has moved in Liongate’s direction over the past decade, lowering fees as it has done so, many of the investment consultants, fiduciary managers and the go-it-alone pension funds against whom they now compete have implemented somewhat retrograde allocation strategies. Ironically, as funds of funds have institutionalised, some institutions have gone the other way.

“Some consultants are trying to look at mid-sized managers, pushed by clients who want to see less obvious names, but the flows of 2009-10 were almost exclusively into the largest macro funds – the Wintons, BlueCrests and Brevan Howards,” Holland notes. “The consultants’ offering today looks to me an awful lot like the legacy fund-of-funds, where you do due diligence on 40-50 large managers and offer a selection. Feedback from institutions suggests disappointment, but only after 3-5 years do we start to see some returning to fund of funds for advice. The same is true for many of the pension funds that have tried to build in-house teams.”

It is, of course, incumbent upon funds of funds to make the most of this opportunity, which will mean continuing to compete on fees, demonstrating a genuine ability to add value and a willingness to retain the flexibility required to design the bespoke solutions that institutional investors increasingly demand. Despite its clear, self-contained investment philosophy, Liongate has proven its capacity to do these things. Sometimes this has been a case of offering a managed account version of its flagship strategy, or working with an investor that has come to Liongate exclusively for its network of smaller managers. In 2008, the firm launched a commodities fund of funds at the request of a number of clients who were looking for the diversification, inflation-protection and tail-risk hedging properties of a range of long/short approaches to the asset class. On other occasions, the firm’s experience analysing the market risks buried in its managers’ strategies has come into its own for more challenging projects, where investors want the Liongate flagship process tilted slightly to take account of the key risk exposures in their core portfolios.

Finally, of course, there is that partnership with Principal. A giant in US regulated defined contribution retirement solutions, it sees Liongate as the foundation for a credible hedge fund business for that market.

For Liongate, the appeal is obvious. “Our work with Principal is about developing these new distribution channels and the products to go through them,” Holland says. “While we can visit pension funds, sovereign wealth funds, insurance companies and consultants, we simply do not have the business model or scale to construct distribution channels in the regulated space – we needed a partner.”

In 2003, Liongate was at the forefront of the trend to ‘institutionalise’ fund-of-hedge-fund investing. Ten years later, it has survived all the twists and turns and stands ready to enter the world of individual retirement provision. Addressing both of those markets poses investment, product-design and client-relations challenges. But these are challenges that all funds of funds now have to meet if they want to compete.

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