| Girish Reddy, KKR Prisma |
Girish Reddy, Gavyn Davies and Thomas Healey started the fund-of-hedge-funds firm Prisma Capital Partners in 2004 with a plan to do nothing less than overhaul the definition of a fund of funds. The three co-founders had worked together at Goldman Sachs in London — Reddy as head of equity derivatives for Europe, Davies as chief economist and Healey as head of North American pension business — and had observed that the pension fund portfolio managers they served were becoming more interested in funds of funds, at the time largely a tool for wealthy individuals wanting to get into hedge funds. They also believed a fund of funds should offer customized portfolios, lower fees than those an investor would pay to a single-manager fund, stringent risk analysis and complete transparency. The model didn’t rake in capital immediately, but after 2008 everything changed. Prisma was able to meet redemptions, and the flexible structure of bespoke portfolios was reassuring to investors at a time when many were reconsidering funds of funds and going directly to single-manager funds. In October 2012 the private equity firm KKR & Co. acquired Prisma, and the New York–based KKR Prisma is now No. 16 in the Alpha Fund of Funds 50 ranking of the largest such firms, with assets of $10.1 billion. More than 90 percent of the assets come from institutions, and approximately 60 percent of Prisma’s assets are in customized portfolios. The portfolio managers gravitate to emerging fund managers, partly because as early-stage investors they can negotiate lower fees than the traditional 2 and 20. Prisma clients typically pay management fees of 1.6 to 1.8 percent and performance fees of about 16.8 percent, with no additional cut for the fund of funds. Reddy, the founder and chair of KKR Prisma’s investment committee, spoke with Alpha about the best ways for a fund of funds to thrive in the future.
Q. What makes an institution with sophisticated portfolio managers invest with a fund of funds rather than picking their own single-manager funds?
A. I think hedge funds are becoming a more complicated game. And investors want to have a one-stop shop. They really don’t have the resources to deal with multiple organizations.
Q. At Prisma’s current asset size, you could be a conduit into some of the multibillion-dollar funds that are closed to most new investors. So why are you investing mostly with smaller emerging managers?
A. Our research has found that fund managers in an early stage tend to generate more returns through their own investment skill than through market beta. They tend to be more risk-controlled and focused on individual opportunity than larger, more established managers. So we like them because of the alpha returns but also because they’re focused on their core areas of competence. Most institutional clients are not comfortable investing in early-stage managers, but our due diligence at examining the portfolio, risk and operations gives them the comfort level they need. Most clients don’t have the resources do the level of due diligence that we perform.
Q. How big do the funds have to be before you’ll invest? And what do you see as the biggest risks when you’re going with newly launched funds?
A. We like to see assets of at least $150 million to $200 million to become a partner. We do run the risk that sometimes with emerging funds the talent pool doesn’t get enough traction to attract enough assets. If we see that happening, then we redeem. We rarely see emerging funds blow up, but there is a widespread risk of the managers not gaining traction.
Q. What strategies do you like now?
A. Last year was all about price-earnings expansion. Now we think it is both earnings and corporate restructurings that will be driving the prices. We think event-driven strategies look very attractive because corporates are balance-sheet rich, and hedge funds thrive on identifying undervalued companies that are likely to be taken over. We lean more toward equities than fixed income. In fact, interest rates are at such a low level that we find forward-looking returns unexciting.
Q. You’ve said your holdings sometimes produce returns that come from earnings that tie into the movement of the markets, or beta, but it’s a good kind of beta. What is good beta?
A. In our client letters we go into details about where the returns are coming from, and clients get concerned when they see equity holdings that are producing returns with the characteristics of beta rather than alpha. In many cases, however, there is a form of good beta that comes with a lot of alpha. I call it idiosyncratic beta, and I always say it’s like HDL — the good cholesterol that reduces your risk of heart disease. Idiosyncratic beta isn’t performance that you can replicate by buying an ETF that tracks the market. It’s unique to each situation.
Say, for example, our distressed-credit manager buys the debt of a financial holding company going through bankruptcy. While a bankrupt company is restructuring, it tends to show a high correlation to the equity market, so the returns look like equity beta. But when it is restructured, typically it will be listed on the exchange again. Then, with a new capital structure, it might produce extraordinary results generating unique alpha. That can also happen with equity of a company in a special situation, such as an activist target. It has beta, but as the company responds to activist demand and restructures, it creates a lot of value for the investor. Those are good examples of idiosyncratic beta.
