By Simon Kerr
One of the best things about the flows into the hedge fund industry coming from American investing institutions is that a good proportion of them are from public bodies. Consequently there is very good transparency about the activities in the hedge fund sector of state pension plans, for example.
Through the annual NACUBO study it is feasible to track quantitative information such as allocations to and returns from hedge funds in aggregate across American college endowments. There can sometimes be good qualitative information about the hedge fund investment programs of college endowments because of the requirement to be publicly accountable. So it is that we can get an insight into the Absolute Return Strategies process at the endowment of the University of California – through the availability of Board papers from the Regents Office.
For a Board Meeting in February this year the hedge fund consultants to the Regents, Albourne Partners, were asked to prepare a memo giving their view of the Manager Selection processes employed in the construction of the UC Absolute Return portfolio, and the competence of the UC Absolute Return Investment Staff. What follows is a lightly edited version of the memo.
The Memo to the Board shows how the investment process for investing in hedge funds evolves at an investing institution. It also gives a real world example of the impact of constraints put on an investment mandate. The limitations of manager size and desired liquidity (ability to deal in the funds) are cited. The Memo reflects the move away from large multi-strategy managers to try to allocate to emerging managers. And manager fees have been negotiated.
Background to Absolute Return Program
Since 2003 the UC endowment has increased its hedge fund allocation from0to 25%. Over time, the mandate has evolved from its initial conservative positioning, with a primary focus on diversification, to a slightly more aggressive and flexible mandate. The guidelines have evolved:
• Fixed strategy targets moved to more appropriate range based constraints. High and low
volatility sub-portfolios were acknowledged in the policy
• Risk contribution was recast in terms of downside risk
• Broader scope for international investments
The UC portfolio initially comprised of some of the largest most well established managers, which exhibited long track records, sizable teams and robust institutional infrastructure. Today the portfolio has become increasingly diversified. It is balanced between large well established firms and smaller groups offering complementary niche strategy exposures, or more aggressive implementations less constrained by market liquidity.
The UC portfolio has grown very significantly with respect to assets and this has placed a challenge with respect to the deployment of capital. The UC portfolio could have been allocated to 20 of the world’s largest most widely held firms with limited risk from an operational perspective. However, we firmly believe that this would, over time, have lead to inferior returns and higher investment risk.
Capacity for UC has been a challenge for several reasons:
• When UC began allocating to hedge funds in 2003, many of its peers had been invested in hedge funds for as much as a decade, if not more. Many had already established allocations of 10, 20 or even 30%. At the time when UC began allocating, a number of widely held high quality hedge funds were not accepting capital which restricted UC’s access.
• A related point is the fact that several of UC Staff’s highest conviction and, in many cases, best performing positions, closed to new investments before UC was able to establish full-sized core holdings.
• UC has been restricted by its guidelines from sizing certain positions to staff’s target levels. This is because of constraints limiting the percentage that UC’s investment can represent of a firm or fund’s assets. UC’s ability to fully capitalize on favorable terms secured by staff is then limited when allocating to new vehicles of established managers and/or funding seasoned teams which have launched new firms.
• UC has been limited in its ability to allocate to less liquid situations because of its
heightened focus on maintaining excess liquidity.
• UC is subject to relatively burdensome FOIA restrictions/obligations which have made
some large well established managers, as well as some smaller lower profile managers
unwilling to accept UC as an investor.
UC Investment Staff:
The team is well balanced with complementary skill sets. For example, team members are experienced in equity, fixed income, credit, structured credit, equity derivative, real estate and private equity investing. As a result, the group is as well placed as any we have seen within a university endowment to evaluate the full array of complex assets that hedge funds are able to invest in. As a result, in the UC portfolio we have seen the UC team act more decisively with respect to allocating opportunistically and strategically to more complex or newer strategies, than many of its peer institutions. That said, we have also seen UC staff unable to allocate enough to certain opportunistic investments due to constraints within guidelines.
UC Staff has implemented several important manager selection decisions over the past 4 years:
• De-emphasis of Multi-Strategy managers
• Diversity of manager AUM, with focus on smaller emerging managers
• Broadened geographical focus
• Increased allocation to Directional (discretionary and systematic macro strategies)
• Increased allocation to Relative Value (opportunistic sub-strategy allocation)
• Increased exposure to opportunistic Event Driven managers (capital structure agnostic,
variable beta, sometimes long biased and/or ability to be active)
These were not always easy decisions to make, for example larger managers can take redemption decisions very personally and exert significant pressure on an investment organization to avoid being redeemed.
Where new strategies have been considered, which bring with them either heightened leverage, market risk or idiosyncratic investment risk, UC Staff has worked creatively with strategic partners to create low cost fund of fund structures to reduce the risk for UC, gain immediate diversification and build experience in the specific strategy. Numerous managers have graduated from these portfolios to the direct UC portfolio over time as staff has built conviction in the strategy exposure and individual funds.
The hedge fund consultant used (Albourne Partners) have been very impressed by the thorough due diligence processes implemented by the UC team.
Over the past several years UC staff has chosen not to invest with a number of managers, where the front office proposition was seemingly very compelling, however non-investment issues raised concerns which warranted caution. For example:
• Transparency is very important to UC Staff and we believe more so than many of UC’s peer organizations. UC requires regular access to the senior investment professionals, comprehensive risk data and counterparty information both in advance of investing and on an on-going basis. Although this has led to some high quality opportunities being passed over, we feel UC staff has acted appropriately with respect to the minimum
transparency standards they have sought to meet and the prudent fiduciary standards they are expected to maintain.
• Operational controls which are in line with industry best practices are sought from every manager with which UC invests. We believe UC Staff have correctly required that all managers retain the services of institutional quality third party administrators and maintain a strong culture of compliance and controls.
• The UC Staff retain significant responsibility for the negotiation of contractual terms with prospective managers, such as fees, liquidity, keyman provisions etc.
In several cases, other endowment investors made significant commitments or were already invested with these same managers, which UC passed on for non-investment reasons. Over the past three years, a number of these managers have significantly outperformed. Without exception, based on our due diligence and the risk tolerance of UC Regents, we believe these decisions were warranted. Furthermore, it is worth noting that we believe UC Staff has maintained good relations with these managers and there are cases where transparency and/or operational improvements were made and UC subsequently invested.
In summary, the UC Investment Staff is believed to be experienced, conscientious, thorough, hard working, smart and capable. They are very clearly mindful of the risk tolerances of the Regents and student body, the fiduciary responsibility that they assume, and the headline risks associated with hedge fund investing.