Alternative Managers
Alternative managers are hedge funds and private equity funds. Because there are special issues associated with such managers, I've added a few paragraphs about working with each.
Working with Hedge Funds
Prophesy as much as you like, but always hedge.
—Oliver Wendell Holmes
As Gertrude Stein might say, a manager is a manager is a manager. But a hedge fund manager is a manager only more so—a manager on steroids, if you will. The earlier precautions about managers in general go for hedge fund managers, but they are all even more critical. Long-only managers can underperform, sometimes substantially, but they rarely blow up and lose all an investor's capital. Hedge funds do this quite regularly.
The fundamental concern about hedge funds is that the assets managed by hedge fund managers are not held in custody in the usual sense of the word. Custody issues are discussed in Chapter 22, but in brief, when an investor engages a long-only manager, the manager never actually gains control of the investor's cash or securities. Cash and securities remain in the hands of a bank or brokerage firm that is acting as the asset custodian for the investor. The portfolio manager has, in reality or in effect, a limited power of attorney to direct the investments in the account. The manager can cause the account to sell GE and buy Microsoft. But the GE stock doesn't leave the custodian's hands until the proceeds from its sale arrive, and the funds required to buy Microsoft don't leave the custodian's hands until the Microsoft stock arrives. (All this occurs electronically, of course, and is subject to the prevailing settlement rules.)
But when an investor engages a hedge fund manager, the cash and securities are held in accounts controlled by the hedge fund, not the investor. Typically, the cash and securities are held by a so-called “prime broker” for the hedge fund. But whereas in a traditional custody arrangement the investor is the custodian's client, in a prime brokerage arrangement the hedge fund is the broker's customer. The prime broker's loyalties—to say nothing of his lucrative business dealings—lie exclusively with the hedge fund. If the hedge fund manager wakes up some morning with a hankering to go to Brazil, he can simply wire all the funds in the hedge fund account to his private account in Sao Paulo and hop on the next plane. (He or she will have more trouble passing through security at Kennedy Airport than stealing our money.) The same is true if the manager wakes up in the morning with a hankering to buy his girlfriend a new Jaguar or to bet the house shorting an obscure tech stock whose price is about to go through the roof.
In short, when looking for a hedge fund manager to engage, we will want to keep in mind all the challenges discussed previously about long-only managers, then perhaps square them. And after we have finished all that diligence, we will want to add a whole new level of inquiry, namely thorough background checks (civil and criminal) on the principals in each hedge fund we are considering. Background checks won't necessarily identify hedge fund managers who will turn out to be incompetent or foolish, but they will identify managers who have checkered pasts and who are therefore exponentially more likely to keep checkering away—this time with our money.
When we pick a lousy traditional manager, the worst that usually happens is he underperforms and we replace him with someone better. But the downside with a hedge fund can be much worse. Hedge funds can simply underperform, of course, but hedge funds can also blow up as a result of poor risk controls or fraud. There are a few examples of advisory firms being destroyed by their association with hedge fund blowups, and many firms have been seriously crippled by client defection, litigation, and general reputational damage.
If you are going to work with individual hedge funds—and client pressure to do so is intense—you will simply have to devote some very serious research to the task. Especially on the ODD side—operational due diligence—many firms will find that it is more economical to outsource ODD to a specialist firm.
Even so, it's important to supervise the specialist and to understand what it is they are doing and why. After all, if you have a blowup or fraud in the clients' portfolios, blaming the specialist won't get you very far with your clients.
Working with Private Equity Funds
Private equity, broadly speaking, encompasses venture capital, management or leveraged buyouts, mezzanine financings,9 and various kinds of illiquid distressed investing. These strategies can be executed directly, by investing in individual deals; indirectly, by investing in venture, buyout, or mezzanine limited partnerships (which then invest in direct deals); or very indirectly, by investing in funds of funds that invest in limited partnerships which then invest in direct deals.
The main consideration associated with PE managers is that investing with a PE fund is like getting married. Like it or not, you are largely stuck with the manager from the date you commit to the fund until the final underlying investment has been liquidated or sold. This can easily add up to a 15-year relationship, especially when investing in a fund of funds.
Because of the long lockup, the importance of up-front diligence can't be emphasized enough. Although it's not impossible to exit a PE fund, except in extraordinary circumstances the cost of getting out is likely to be higher than the cost of staying in.
When our clients commit to a PE fund or fund of funds, all the capital isn't called down immediately. Instead, the manager will call the funds as it finds opportunities to invest it. Our clients are therefore faced with a dilemma: They have committed their capital to a PE fund and are legally obligated to live up to that commitment. (The penalties for failing to meet a capital call are draconian.) Yet, the PE manager takes no responsibility for the fact that our capital won't be called down for some time—usually, a period of three or four years. If we calculated PE returns on the full commitment amount from the date of the commitment to the date the fund terminates, our PE returns would look very much worse than the manager's reported results.
So the question arises: Where should committed-but-uncalled capital be invested? Many investors, not wanting to be caught short, keep that capital in a money market fund or some similar low-risk investment. But this creates a very serious opportunity cost for our clients. Money market fund returns are very low, typically equaling about the rate of inflation. PE returns (we hope) are very high. But when we blend the low returns the clients get on their money market funds with the high returns they get on their PE funds, the drag of the former on the latter will be substantial.
Instead, advisors should recommend that investors keep most of their committed-but-uncalled capital in equities—or at least spread across the entire portfolio—perhaps moving the funds to a short-term bond fund as the likely date of a capital call approaches. Over the long term, this strategy will reduce the overall return on our clients' committed PE capital, but not by nearly as much as if we kept their total commitment in cash.