The End is Nigh for Smaller Funds of Hedge Funds

For some time there have been questions raised about the sustainability of the business models of funds of hedge funds as a category. There is no doubt that they will continue to exist and that there will be winners as well as losers. But the rising tide of assets in the hedge fund industry is not lifting all the FoF boats. Only this week quoted hedge fund company Man Group reported minor growth in its single manager businesses and minor shrinkage in its multi-manager business (see previous article).

There are solid reasons for the changing composition of the shape of the FoFs sector, mostly related to the source of the whole industry’s net flows, i.e. American investing institutions. A typical example is the Ohio Public Employees Retirement System which had had allocations with FoFs Prisma Capital and K2 Advisors LLC. In the middle of last year the Ohio System hired specialist hedge fund consultant Cliffwater LLC to provide due diligence and manager recommendations to staff on a non-discretionary basis. The existing fund of hedge funds allocations of the Ohio System will remain in place, but from that point on new allocations to hedge funds would go to single managers with consultant input. 

The new “new thing” for state plans starting from scratch in hedge funds is to do as the State of Wisconsin Investment Board has done and go straight to single manager hedge funds without an interim phase of allocating to FoFs. The Wisconsin Investment Board has taken a decision to invest directly in 15-20 single manager hedge funds.The first allocation was to Capula GRV Fund, followed by MKP Credit Fund, Claren Road Credit Fund, Ascend Wilson Fund and BlueCrest’s BlueTrend. The Employees Retirement System of Texas has announced an intention to do the same – direct investment in hedge funds, in their case a 5% allocation amounting to over a billion Dollars phased in over three years.

That is, the marginal flows to the industry are being disintermediated as far as FoFs are concerned, with consultants and advisors taking a bigger role in allocations. This has been great for the business of Albourne Partners and Cliffwater and the like, but what about the funds of hedge fund businesses? How are they getting on?

Fund of Funds In Aggregate

Each year PerTrac, the hedge fund software provider, produces an analysis of the composition and size of the single-manager hedge fund and fund of hedge fund industry. The 2011 study was produced by aggregating investment data from eleven of the world’s largest alternative databases – BarclayCTA, BarclayHedge, CogentHedge, Eurekahedge Hedge Fund, Eurekahedge Fund of Funds,, Hedge Fund Research, MondoAlternative, MorningstarHedge, Tass, and TassCTA. The combined number of investments from these eleven databases was nearly 56,000 entries. Duplicate records for single-manager hedge funds, CTAs and FoFs were removed so that a single record per fund was retained in the study to create a holistic industry list.

According to PerTrac’s data,  the reported AUM of funds of hedge funds were essentially unchanged  y-o-y (+0.23%) at $447bn at the end of 2011. Given the industry had a negative return of between 5 and 8% at the single manager level last year, that implies some positive flows to FoFs in aggregate. Plus, the total number of funds of funds reporting to databases at the end of 2011 was down 4.8% on 2010 at 3,388. That is there were more assets by value overseen by fewer fund of funds managers. Someone in the fund of funds sector was doing a bit better last year!

The answer to  the question “who?” is the largest funds of funds. FoFs that reported managing in excess of $1 billion were the only group to experience a positive growth in fund numbers from 2010 to 2011 as shown in graphic 1 below.
Graphic 1. Number of FoHFs by AUM Size and Percentage Change from 2010 to 2011*
*Figure excludes515 funds in 2010 and 522 funds in 2011 that did not report AUM, source:PerTrac
Taking a look at the different size categories of funds of funds in turn, there is other evidence that  the very biggest funds of hedge funds are getting bigger. The top 10 FoF management companies (as opposed to individual funds, and as covered in the PerTrac study) added assets in 2011, according to InvestHedge data. The ten largest FoF groups managed $227bn at the end of 2011, an increase of 2.6% over the start of that year, and equivalent to 50.7% of the FoF industry’s assets. In addition there were 16 FoF management companies with $10bn of AUM or more at the end of 2010. There were 17 at the end of 2011. So the very large funds of funds groups were slowly growing in aggregate.

The larger funds of hedge fund companies (those managing a billion dollars or more)  have shown stability in assets recently. The InvestHedge Billion Dollar FoF Club managed $622bn of assets between them at the end of 2011, only a tad down on end-2010 levels (-0.7%).
The number of FoFs containing assets of $500m-$1bn shrank last year according to the PerTrac study – there were 5.9% fewer of them by the end of 2011 than at the beginning of the year, but that size category is not where the industry squeeze is most evident. More than one-in-seven of the FOFs sized between a quarter and half a billion dollars in AUM closed down last year. It is in this size band that numbers of funds of hedge funds are shrinking most. 

This has been a long time coming – the demise of the smaller fund of hedge funds was prophesised nearly ten years ago. Very few of the mid-tier FoFs benefited from the growth of the hedge fund industry through institutional flows in the period 2003-2008. But that is not the same as saying the circumstances forced smaller FoFs out of business – they just did not grow much.  

In the period since the Credit Crunch institutional investors have completely dominated the capital inflows to the hedge fund industry. And they go big for their suppliers. HNWI investors were a major source of redemptions in the industry in 2008-9, and there have been few-to-no net flows to the industry from HNWIs in the last two years or so. It was the HNWI that was historically prepared to invest through the smaller fund of hedge fund. So in aggregate the smaller FoF experienced, say, a 35% drop in capital because of redemptions and capital losses in 2008, and little or no recovery in assets since. 

So while 47% of the funds of hedge funds managing $1bn or more experienced positive inflows last year, their smaller bretheren have seen the industry tide of capital go out and not come back again. Most modest-sized FoF managers will be running a business with the same level of income as seen in 2004-5 with the cost structure of 2012. That is not sustainable.
Reaction To Conditions – M&A

Hence the corporate activity in the fund of funds sector. For example, Nexar Capital Group was founded to pursue a roll-up strategy amongst funds of funds, and bought Allianz’s fund of hedge funds business in 2010 and Caledonia Investment’s Ermitage fund of funds business last year. Nexar itself agreed to be bought by UBP at the beginning of March this year. Other FoF takeovers in the last year include William Blair’s acquisition of most of Guidance Capital’s assets under management; Athena Capital Advisors acquired Stonehorse Capital Management; and Cantor Fitzgerald started its planned expansion into hedge funds with the acquisition of Cadogan Management. Other forms of deal seen in the last year, apart from complete takeover, have been merger and stake sale. Evercore Partners bought a large minority stake in ABS Investment Management, the $3.5 billion fund of hedge funds. The  merger between Gorelick Brothers Capital and Access Fund Management may have been defensive as the combined entity  had only $100m under management when the deal was announced.

A dealer in second-hand hedge fund assets said this week that the wind-down of some fund of hedge fund businesses has given his own business a fillip. “I see another 18 months of funds of funds mergers and acquisitions. It is great for me because it throws up holdings in companies and funds to be disposed of – there are a lot of buyers for these sorts of assets out there,” he said.  “But there is a limited window for this activity, and we are in it now.” What has he seen as the driver? “The funds of funds business is dying at the lower level.”

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