| Dale West of TRS (Photo by Jeff Wilson) |
Since the earliest days of the hedge fund industry, relations between managers and their investors have been one-sided — with terms squarely favoring the managers. The best-performing managers cultivated an aura of mystique and exclusivity, creating overwhelming demand for their products. They were able to take money on their own terms, charging whatever they wanted and providing as much, or as little, information about their investments as they liked. Although conditions for clients have gotten better since the 2008–’09 financial crisis, when many hedge fund firms suffered losses and faced redemptions, some investors say there is still a great deal of room for improvement in the manager-investor relationship.
Count Dale West among them. As a senior managing director at the $130 billion Teacher Retirement System of Texas, West heads up the external public markets portfolio, overseeing $40 billion in assets, including $12 billion in hedge funds. He and his colleagues at TRS have joined forces with the Alignment of Interests Association (AOI), a nonprofit organization of professional hedge fund investors that seeks to improve collaboration and communication between managers and investors. AOI’s goals include changing the terms that govern most hedge fund manager–investor agreements, making them more equitable for investors.
The group recently issued a set of principles focused on three areas: economic and liquidity terms; documentation and governance; and transparency, valuation and disclosures. AOI’s proposals to managers include reducing management fee rates as a firm grows, “to account for economies of scale”; using hurdle rates (in which managers charge performance fees only after achieving gains above a specified benchmark) with performance fees to encourage alpha generation; and providing position-level detail to a third-party risk aggregator if an investor requests it.
Before the establishment of AOI, West explains, “there wasn’t an investor-only organization for hedge fund investors that could put out lists of principles and say, ‘These are the things that we think are important when it comes to alignment between asset owners and managers.’ ”
West took an unlikely path to public pension fund management. A native of Hereford, Texas, a small town in the Panhandle, he attended the University of Texas at Austin, then joined the U.S. Foreign Service in 1992. There he worked for the U.S. Information Agency, the government’s public diplomacy arm (since folded into the State Department).
He spent time in both Washington and Bucharest, Romania, where he was director of the American Cultural Center from 1993 to 1996. The center included a library, exhibition space and auditorium for public programming and served as a facility where Romanians could learn about the U.S. During this period West saw the role that the U.S. private sector played in changing Romania, and that piqued his interest in a business career. After returning to the States, he earned an MBA from Stanford University in 1998, then moved back to Europe, spending six years in London working as an analyst for asset manager T. Rowe Price, covering emerging-markets equities and the international telecommunications sector. West next moved to Austin, where he invested his own money before connecting with TRS chief investment officer Thomas Britton Harris IV. He joined TRS in 2008.
At the time, the world was careening toward a calamitous financial crisis. That year three venerable investment banks collapsed, credit markets froze, equity markets around the world plummeted, and the average hedge fund lost 19 percent, according to Chicago-based industry tracker Hedge Fund Research. Many hedge fund firms erected gates, only allowing a certain amount of assets to be withdrawn, or suspended redemptions altogether. In some cases investors learned the hard way that their managers were holding far more illiquid assets than their clients had been led to believe. In other cases investors understood the reasoning behind the managers’ moves but were frustrated with what they felt was a lack of transparency or responsiveness.
For the first time, hedge fund investors began to speak publicly about what they deemed to be the fundamental unfairness of the terms demanded by many of the best and largest hedge funds. One fund-of-funds manager was so irate that she penned a manifesto calling for the formation of a “Hedge Fund Investors United Forum” to “protect against the egregious hedge fund manager” and enact industry reforms. As it turned out, the manager who wrote the letter, Sandra Manzke of Maxam Capital Management, was heavily invested in the Bernard Madoff Ponzi scheme via her firm. (Though a U.S. bankruptcy court approved a settlement returning $98 million to Maxam, Manzke remains a defendant in a lawsuit against a Madoff feeder fund whose board she sat on. The case was dismissed, but the plaintiffs have filed an appeal, which is still pending. Manzke declined to comment.) No other investors picked up the torch from Manzke — at least, not publicly.
But as it happens, AOI was being formed behind the scenes, although the participants had a more collaborative approach in mind. AOI founder Melissa Santaniello was working as a product specialist for fund-of-hedge-funds manager Cadogan Management in 2008. She says the association initially came together as a loosely organized discussion group among her network of professional hedge fund investors, who wanted to share their post-2008 experiences and to talk about internal governance policies and how to educate the boards of their respective organizations about hedge funds.
AOI wasn’t intended to become an official organization, Santaniello says, but what started as a series of informal discussions among 15 to 20 investors quickly turned into regular conference calls and meetings. Santaniello connected with West and TRS through mutual investor contacts in Austin. TRS began participating in AOI’s educational events and eventually became involved with developing the organization’s principles.
Having TRS in its corner was something of a coup for AOI. The pension is widely viewed as one of the most innovative investors of its kind, and its hedge fund portfolio bears this out. For a start, the portfolio’s structure is unique: It’s split into two parts, with one side aiming for noncorrelated returns and the other seeking equitylike returns with reduced volatility. TRS also owns a $250 million, nonvoting equity stake in Westport, Connecticut–based Bridgewater Associates, the world’s largest hedge fund firm — a novel move for a public pension.
West recently spoke with Alpha Managing Editor Amanda Cantrell about AOI’s goals and principles — and why it’s in hedge fund managers’ best interests to comply with the voluntary guidelines.
Alpha: AOI is the first investor-backed association strictly focused on hedge funds. What are you hoping to achieve?
West: We want to be part of the institutionalization of the hedge fund industry. We want to educate new hedge fund investors — and new hedge funds, for that matter — as to the important areas of alignment between managers and hedge fund firms. Ultimately, we’d like to see some of the terms that the industry operates under be more institutional and a little bit more mature in terms of alignment of interests. Hedge funds’ documents reflect their history as private partnerships, with minimal documentation, very flexible investments and few restrictions with regard to asset classes and strategies. And as asset classes have become more institutional, in some cases the documents haven’t caught up.
We want to keep that investment freedom but include some appropriate protections for investors and a structure that promotes good alignment of interests between investors and the managers. We’re going to continue to contribute to educating LPs [limited partners] and continue exchanging ideas, both on the principles but also on innovation in terms of fees and terms. We’d like to monitor how terms are changing in the industry over time. Those are two of the ongoing goals, and I’m sure that the principles will go through revisions over time as well.
Many of the principles focus on fees, which are something of a sore spot for some investors right now, as well as a contentious political issue. What is a fair fee for hedge funds to charge?
Fees are just one area of focus for AOI. In fact, there’s nothing in the principles about the absolute level of fees, because ultimately pricing is going to be the result of a market negotiation.
But we believe that for a given level of fees, there’s a way to structure an investment so that there’s better alignment of outcomes between the manager and the asset owner. Things like using performance rather than asset-based fees and taking into account appropriate hurdle rates.
How common are hurdle rates?
They’re still relatively rare in the hedge fund world, but we’re hearing and seeing more of them in the marketplace.
Many of the AOI principles make a lot of sense on paper but are not widely practiced in the industry. Why aren’t they, and how likely is it that managers will start implementing some of these suggestions?
I don’t think there’s anything on the list that is very far outside of market practice. A lot of these things are basic truth and justice. There’s not really any way somebody could oppose them, especially a lot of the governance principles — things like fund insiders having the same liquidity terms as LPs, and LPs being notified when insiders withdraw material amounts of their investment. There’s not really anybody who can reasonably object to that kind of thing.
Many managers haven’t taken it upon themselves to do things like this, particularly with respect to fees, because they haven’t had to. Is that changing as hedge fund performance continues to disappoint, at least at the aggregate level?
Some firms are going to be in a stronger market position. But certainly, firms that have either had disappointing performance or that are just new firms, new spin-outs or start-ups are in a position where they can implement some of these principles from the start, which will be good for them and their investors.
We definitely want to move the industry. Another one of the goals of AOI is to analyze trends in the hedge fund terms and measure that through collecting data from our members about where our hedge fund terms are going. That’s definitely a goal to improve things.
What about management fees? They seem to have become profit generators for some firms, which was not the original intent of such fees. Where does AOI see room for improvement?
Hedge funds are behind the rest of the asset management industry in passing along economies of scale to customers and in charging management fees that don’t scale down for fund and strategy assets. I’d definitely agree that realized performance fees should be the main source of profits for hedge fund firms and hedge fund managers. And I think that’s a case where incentives are really well aligned with the LPs.
Let’s talk about governance, another area of focus for the principles. How does AOI think hedge fund boards can improve?
Some of the ideas behind it are, first of all, let’s just have clear and consistent governance rules and clear expectations for what is the standard of care and fiduciary duties. And disclosure: A lot of directors are on a lot of boards, so just disclosure about board members’ additional responsibilities and their skills and experience that qualify them for the role.
We haven’t had very much experience with practical problems in hedge fund governance. It’s more the theoretical problem of recognizing fiduciary standards and recognizing that boards represent the investors of the fund and not the management company, and making sure that the legal structure is in place to reflect that. It’s more of a theoretical danger than a practical danger for us, although I’m sure other institutions have different stories to tell.
The principles also tackle transparency. But hasn’t that already come a long way since the financial crisis?
That’s something I’ve seen even in the short time I’ve been in the industry: improvement in terms of managers’ willingness to report to third-party risk aggregators and to give us the level of transparency we need to monitor the risks that could be important at the portfolio level. Things like liquidity, leverage and concentration that, again, are important at our portfolio level. And we’ve seen a sea change in willingness compared to, say, pre-2008.
What other kinds of transparency are you looking for?
Significant changes at the firm level in terms of ownership or personnel, regulatory action, key-person departures — those are things that should be disclosed to all investors in a timely manner. And for key-person departures and also changes in investment strategies, investors should have exit rights without penalty even if other LPs approve those changes. Things like a clear and transparent valuation policy and use of third-party valuation — that’s another form of transparency that’s inherent in the principles.
What incentives do managers have to implement these changes?
Look, we believe that hedge fund firms do want to get alignment with their LPs. Managers are starting to become more receptive to ideas such as performance fees that are calculated over a longer time period instead of being paid yearly, especially in cases where the manager asks for a multiyear investment commitment.
The success of moving the market on these terms is really going to come down to individual negotiations between LPs and their GPs [general partners]. So that’s something we do at TRS every time we make a hedge fund investment.
In terms of what AOI can do, we can start the conversation. Because we sometimes get the argument from the firms’ outside counsel, even on issues of basic fairness, that “nobody else is asking for this.” So the hedge fund principles are a way to eliminate that line of argument and say, “Well, a lot of this is common sense.” And yes, LPs as a group want these principles respected. So you at least take that initial argument off the table.
How would the AOI principles be helpful for a small public pension plan just getting into hedge funds?
A lot of the principles, outside of just straight-up pricing, are things that don’t necessarily cost the manager any money. They’re the right thing to do. They’re common sense. So a manager can get their docs right by embracing a lot of these principles, and that benefits every LP in the fund, whether they’re brand-new, small, whatever. There is definitely a benefit to all investors from some of the principles.
