A new ruling asset class

Poor performance, market volatility and high-profile investor redemptions have prompted a wave of hedge fund closures and conversions into family offices.

Avenue Capital, Fortress Investment Group, Claren Road and Och-Ziff are just some of the names that have struggled with stuttering hedge funds. The general malaise was reinforced at the close of 2015 when it was reported that Lutetium Capital would close both of its distressed credit hedge funds and return investor cash.

Many of the managers turning away from the sector have found that private equity-style closed-ended vehicles are a better structure for strategies that previously resided in hedge funds. These closures are not just a lesson in structuring but it is the best place to start.

The starkest example of this was the closure of Avenue Capital’s flagship hedge fund in November. It had been cofounded by Marc Lasry and Sonia Gardner in 1995 who went on to expand into private equity and debt. When the closure was announced, the vehicle had been whittled down to just $350 million, a small fraction of the firm’s roughly $12.7 billion in assets under management.

A spokesman for the firm explained the decision in terms of the out-of-date structure: “Approximately $10 billion, or 85 percent, of the capital Avenue manages in the distressed investment space is in long-term investment vehicles with longer lockup provisions generally ranging between five and seven years. The longer lock-up structure represents the principal direction of the firm.”

Sources tell PDI that Lasry has been saying for years that the private equity style is better suited for his distressed investment strategy.

The motivations of other managers who have closed their vehicles to thirdparty capital aren’t as clear cut. Not everyone has publicly blamed the liquidity inherent in hedge funds for their woes or expressed a preference for closed-ended structures. But the liquidity question is key to the decline of some of these vehicles as hedge funds are merely a structure, not a strategy.

Many hedge fund managers gripe about being lumped into one so-called “asset class” or index when there are myriad strategies run by different hedge funds.

That doesn’t change the fact that hedge fund performance has been challenged as judged by both composite indices and strategy indices. The HFRX Global Hedge Fund Index lost 2.34 percent through 21 December 2015 and 0.58 percent in 2014, while several strategy-specific indices have also produced negative or mediocre returns over the last two years.

Some macro strategies have been especially challenged lately. The HFRX macro index lost 0.57 percent through late December 2015 and also showed a loss in 2013 and 2012. It was up 5.24 percent in 2014.

Fortress Investment Group’s macro hedge fund underperformed for some time primarily driven by bad bets on Brazil and currency trades. The firm ultimately shut the vehicle down in October after the vehicle posted a 17.5 percent loss through September. The assets in the hedge fund had dwindled to $1.6 billion, down from $8 billion in 2007.

In contrast, Fortress’s credit business has been thriving. Both Peter Briger, Fortress’s head of credit, and Michael Novogratz, the outgoing head of the macro hedge fund strategy, joined the firm from Goldman Sachs in 2002. Both were popular portfolio managers on Wall Street, but their paths diverged.

Whereas Novogratz had a couple of good performance years, Briger’s credit funds have consistently posted strong results while raking in more and more assets. The firm’s fourth credit opportunities fund raised almost $5 billion in 2015 and the firm closed its first Japanese real estate credit fund at $1.1 billion in the autumn.

Larry Schloss, the former chief investment officer at the New York City pensions who is now a president at Angelo, Gordon, argues that hedge funds still have a role at institutions, though investors need to think carefully about their goals.

“Hedge funds have a place in institutional portfolios as shock absorbers or return seekers. But you have to decide what you’re looking for and how you’re going to measure performance,” he says, suggesting investors choose return and volatility benchmarks meticulously and set a longer time frame for judging performance.

Schloss points out that a large part of the problems plaguing hedge funds is the inevitable liquidity mismatch. “You can’t invest in illiquid securities and advertise them in a fund that offers liquidity. When people want liquidity from illiquid things, prices go down rapidly and it becomes a mess,” Schloss says. “And the markets are relentless and ruthless when it comes to dealing with bad behaviour.”

Schloss also adds that the post-crisis regulatory environment has created a less liquid market in some pockets of the industry. “Leveraged loans and high-yield bonds are less liquid than they were,” he says. “The dealers are not providing inventory or trading capital because capital is expensive. People close to the market get that, the people not close to it don’t. That’s how you get bigger price swings and more volatility.”

A case in point, towards the end of the year, a junk bond sell-off caused several high-yield bond funds to post steep losses. Some of these have shut down, while others implemented gates.

Third Avenue Management barred investors from withdrawing money in its new mutual fund, Third Avenue Focused Credit Fund, in December while it liquidates the vehicle. On the back of the liquidation David Barse, the firm’s chief executive, was ousted. Stone Lion Capital and Lucidus Capital, two junk bond hedge funds, were also reported to be shutting down in December.

Some of Angelo, Gordon’s own hedge funds have struggled lately as well, though the firm has no plans to close any. The firm runs several hedge fund strategies, which have produced returns ranging from minus 6 percent to plus 6 percent. The struggling vehicles were focused on distressed trading, while commercial and residential real estate strategies have been the top performers. Some of the leveraged loan portfolios with more second lien exposure sat in the middle.

AG’s flagship multi-strategy Super Fund was down by 6.27 percent through December, according to HSBC. The firm is growing a variety of credit products, including mid-market lending, energy credit, CMBS and European distressed, via closed-end private equity style funds. Claren Road Asset Management, in which Carlyle controls a 55 percent stake, has two long/short credit hedge funds focused on the global investment grade and high yield bond markets. The vehicles suffered mounting redemptions with $1.9 billion of investor redemption notices posted over the three months from July to September 2015, almost half of the $4.2 billion in assets under management controlled by the hedge funds, according to Carlyle’s third quarter results.

The hedge funds had posted poor returns for some time, causing a significant drag on Carlyle’s earnings in the third quarter when the firm recorded an impairment of almost $187 million against the value of its stake in the hedge fund manager. Carlyle’s credit unit, global market strategies, also reported patchy that group has been growing its BDC, CLO platform and private closed-end fund businesses. Carlyle declined to comment for this story.

Och-Ziff Capital Management’s flagship hedge funds have also been hit by poor performance and resultant redemptions by investors.

Though the hedge funds have hit a rocky patch, the firm is growing in other ways: new real estate and energy strategies are in the works, it’s launching a business development company, the manager has established credit-focused separate accounts with large institutional investors and is planning to grow its CLO platform.

An Och-Ziff spokesman tells PDI that the firm is still committed to managing hedge funds and many of these initiatives were launched before the hedge funds started underperforming. Och-Ziff was one of the first hedge fund managers to go public in 2007 and sources point out that the listing puts the firm under pressure to continuously grow.

JPMorgan-controlled Highbridge was also originally founded on a successful hedge fund. It is now planning to spin off its private equity-style credit unit, Highbridge Principal Strategies (HPS). HPS was formed in 2007 as part of hedge fund Highbridge Capital. It handles senior loan and mezzanine strategies. The credit unit has grown to be the larger, more dominant part of the business, while the hedge funds have posted weaker numbers and some of the original founders have retired.

Meanwhile, HPS has been scoring big wins from institutional investors, launching new mezzanine, energy and real estate strategies, adding senior staff and growing. The group now handles about $22 billion, while the hedge funds run about $6 billion. The credit group is planning to spin-out via a management buyout while the hedge fund will stay at the JPMorgan parent.

PAST AND FUTURE POPULARITY

The news surrounding hedge funds closures, widespread poor performance, redemptions by CalPERS and other large pension funds have combined to make it much more difficult for hedge funds to raise money.

This contrasts with the huge growth in popularity in recent years of closedended private debt strategies. As PDI reported in 2015, the $90.7 billion raised for private debt strategies in the first nine months of the year outpaced the 12-month total of $84.9 billion raised over the full 12 months of 2014. Fundraising for private debt totalled $102.75 billion for the whole of 2015. This doesn’t mean that it’s a case of investors pivoting into a new ‘fashionable’ investment vehicle. Many hedge fund experts have pointed out that hedge fund strategies have suffered because there are far too many of them and the so-called “alpha” has become diluted.

And that’s a fate that private debt managers searching for a spot on an already crowded bandwagon should be wary of. Kipp deVeer, chief executive of Ares Capital Corporation, says many firms seeking to join the apparent private debt gravy-train know how to pitch to investors.

“There are a lot of industry buzzwords out there and people have figured out what to say, making statements like ‘we originated in-house’” when that might not be true, deVeer said at Bloomberg’s Middle- Market Lending Forum in December. New firms often lay claim to great origination capacity when in reality they are taking slices of transactions sourced by other lenders.

Just as credit selection is essential to the viability of private debt strategies, manager selection will be equally important for LPs investing in these long-term funds. Also speaking at the event, Patrick Adelsbach, head of credit research at consulting firm Aksia, echoed that notion saying limited partners need to be increasingly cautious around backing managers that approach lending like a hot trade.

Hot trades may be what hedge funds thrive on, but it’s not a sustainable way of producing returns within a private debt business. Private debt managers appear to have struck on a better structure in closed-ended funds than their counterparts at credit hedge funds, they will have to be very cautious in order to avoid the other pitfalls that tripped up 2015’s raft of shuttered hedge funds.

How long is a piece of string?
Comparing hedge fund performance to private debt performance isn’t a case of apples for apples. Hedge funds, given their notional liquidity, generally record performance on a monthly or quarterly basis. Meaning when things go badly, investors suffer jolts of pain, whereas for longer-term private debt and equity funds net IRRs are acknowledged to only be a fair measurement of performance towards the end of a fund’s lifecycle.

Some consultants and LPs believe a whole market cycle should be taken into account when seeking to measure hedge fund performance, while others say looking at threeor five-year numbers is the most reasonable approach.

These critics have a point – short-term numbers do not give the full picture. But the fact remains that hedge funds offer liquidity and so must mark-to-market and investors will want to see those numbers.