| Nesbitt: Underperformance in a market down 10 or 20 percent signals bad risk management ( Photographs by Stephanie Diani ) |
Managers often complain that consultants and institutional investors are willing to look only at larger well-known names when investing in hedge funds. And funds of funds argue they can deliver more specialized niche strategies to clients. “To some extent, I plead quasiguilty to that,” says Stephen Nesbitt, founder and chief executive of consulting firm Cliffwater. But he hasn’t been impressed with the performance of some specialty funds of funds. “The volatility seems high and the returns seem low,” Nesbitt says. He also contends that investing with larger well-known managers makes more sense for pension fiduciaries, which represent the majority of Cliffwater’s clients. “These are people who are entrusted with other people’s money and pensions, so I do think we feel very comfortable giving a little more weight to the longevity of [the managers’] track record,” Nesbitt says. “If I were building a portfolio for some of my rich Hollywood friends, it would look quite a bit different.” The median hedge fund that his clients invest in has about $2.5 billion in assets, 80 employees and an 11-year track record. Among managers recently hired by the State of Wisconsin Investment Board, which Cliffwater advises, are AQR Capital Management, Bridgewater Associates, Capula Investment Management, Claren Road Asset Management, MKP Capital Management and ValueAct Capital Management. Cliffwater was tapped two years ago to help the $83 billion Wisconsin plan execute its 2 percent allocation to hedge funds.
Most of Cliffwater’s clients hire the firm to help them invest directly in hedge funds for the first time. Nesbitt says the firm provides the pension plans with hands-on research, due diligence and access to top-tier managers. The funds, for their part, have been looking for a more stable capital base ever since the 2008 market crisis, and Nesbitt’s clients fit that bill.
So far, the hedge fund portfolios of Cliffwater’s clients have done well. Though the returns at the Public Employees Retirement Association of New Mexico and the New Jersey Division of Investment, both long-term Cliffwater clients, were down slightly last year, they still outperformed their benchmarks and posted strong annualized returns for the three-year period. The New Jersey and New Mexico portfolios lost 1.36 percent and 2.40 percent, respectively, in 2011, while the InvestHedge Composite index dropped 4.26 percent. For the three-year period ended December 31, New Jersey’s portfolio returned 9.21 percent, while New Mexico PERA’s was up 10.45 percent, compared with a gain of 3.63 percent for the index.
As for funds of funds, Nesbitt says that paying 1 percent management fees is not attractive in a low-return environment. “It’s a high price to pay for convenience,” he says. And those fees, compounded by relatively inferior returns, help explain why many investors have been going direct, usually with a consultant’s help. Cliffwater also advises on other alternative asset classes. Nesbitt used to work with them at Wilshire Associates, where he spent 24 years, starting in 1980, following a two-year stint at Wells Fargo Investment Advisors not long after graduating from the Wharton School at the University of Pennsylvania with an MBA. He decided to launch his own firm to focus on alternatives in 2004, because he and the other consultants that spun out of Wilshire felt that the alternative investment industry was underserved by consultants. “The thing about alternatives is that you have to have your best, most senior people focused on that space,” Nesbitt says. “At a traditional consulting firm, if they want to get into alternatives consulting, they will hire a bunch of junior people and say, go at it. The work product reflects that.”
Cliffwater, which is headquartered in Marina del Rey, about 20 miles west of downtown Los Angeles, and has offices in New York, has been caught up in the regulatory scrutiny involving Level Global Investors and Diamondback Capital Management. Both hedge funds were raided by the FBI in 2010 for insider trading issues, and both had been recommended by Cliffwater. Since then, Level Global has shut down, while Diamondback is still running $2.5 billion. Federal agents are still working through hundreds of open insider trading cases, which makes a consultant’s job more daunting.
With that in mind, Cliffwater organized a regulatory panel of representatives of law firms, prime brokers and hedge fund back-office operations at a recent client conference in New York. “Obviously, this is much more topical,” Nesbitt says.
AR Staff Writer Anastasia Donde recently spoke with Nesbitt about the new regulatory issues facing hedge funds, insider trading concerns and the competition between consultants and funds of funds.
AR: How are you are setting yourself apart from your competitors, now that many funds of funds are offering advisory services?
Nesbitt: We positioned ourselves as the ones that help fiduciaries not only understand hedge funds but understand how they fit within the total portfolio, how they integrate within the total asset allocation and how to implement a direct hedge fund portfolio. What we’ve always believed is that funds of funds, while they offer some convenience, are suboptimal for large fund sponsors. They tend to overdiversify and overcharge. We saw this play out in private equity. Funds of funds used to be part of the private equity landscape, but among the large institutional investors, it was not demonstrated to be a significant value added. Most of the people who are successful in private equity go direct.
However, funds of funds are adapting to a more hybrid model and saying, “put the money in our funds of funds and we’ll help you invest directly as well,” and that has also happened in private equity, so I think that’s something we’ll see more of. I think the fund-of-funds people are very smart and very knowledgeable; they just have to change their model a little bit, so there will be that competition.
And generally on the direct hedge fund consulting side, we see two competitors, and I think they do a very good job as well. Their models are closer to ours. We try to differentiate ourselves in that we don’t want to be the Morningstar of hedge funds. We are not interested in everybody who calls themselves a hedge fund. We try to stay focused. We want to turn every stone, but we don’t want to spend too much time on hedge funds that we would give low ratings to.
AR: How does your ratings system work?
Nesbitt: We rate all managers we meet with an A, B, C grade and below. We’ve rated 1,500 or so hedge fund managers. It’s the A’s and B’s that we are interested in, and there are about 500 of those. When a potential client asks us how many hedge funds we follow, I generally say 500. Those are the A’s and B’s. Those that we recommend are just the A’s. And the A’s are about 90. We concentrate our research on the A’s, though we continue to meet with the A’s and B’s. The A’s are the ones we will be following very closely.
AR: How do managers get on your A list??
Nesbitt: We look at the quality of the organization, the people, the platform and the process, and ask whether it’s differentiated; can it produce alpha? Have they executed on it in the past, and has it been successful? And we look at terms: Do they have investor terms that are friendly? Do we think the majority of the alpha will be distributed to the limited partners and not the general partner? And we look at liquidity and transparency: Do we have the liquidity and transparency that institutions expect is consistent with the underlying securities and investment process?
AR: What are some of the reasons you might recommend terminating a manager?
Nesbitt: It depends. In 2008, we had some termination recommendations primarily because of performance, but more so, it was disappointment with the absence of risk controls. Every time the market goes down 10 or 20 percent and a hedge fund underperforms, that’s an immediate signal that they have a problem in terms of risk management. After all, that’s what a hedge fund is partly for. And then personnel issues are probably the most common other factor. Ownership has not been as big a factor as I thought it would be. When Och-Ziff Capital Management did an initial public offering, we were very concerned, but they’ve done as well post-IPO as they did pre-IPO. We’ve seen a lot of hedge funds be bought up by private equity firms and others, and we haven’t seen any significant change.
AR: Do your clients ever consider smaller managers or spin-outs?
Nesbitt: I think that will happen more and more. Our clients have been making their first investments in hedge funds. They are fiduciaries, so they are generally risk averse. Our portfolios reflect the more secure, lower risk end of the hedge fund industry. Just like in other alternative asset classes, and even traditional asset classes, as these allocations get larger, capital will flow to newer firms. I believe that the optimal hedge fund size is about $500 million to $2.5 billion. It’s not $25 billion.
AR: How much do your clients invest in hedge funds, on average?
Nesbitt: Generally, the range is from 3 to 30 percent. The average is around 15 percent. From our point of view, 5 percent is the minimum. Hedge funds are like private equity: It’s a higher-cost, higher-risk investment. If you are going to use it, it probably should be at a significant level. That said, most of our clients will start small and then build up. We have a client who is close to 30 percent, but they started at 3 percent. In alternatives, most public funds start small and then build up.
AR: Pensions seem to put more money in hedge funds when they invest directly rather than through a fund of funds. Do you think that means it’s more risky to invest directly?
Nesbitt: I think there are two types of risk. There is headline risk, and as we learned from Madoff and some other blowups, it doesn’t matter how small the allocation is, the investor is still likely to make it onto the front page of the business news. Size doesn’t seem to matter when it comes to headline risk. The other risk is: If you are more concentrated, do you have greater exposure to losses? I don’t think so. In my experience, in looking at programs that are in funds of funds and are highly diversified, they tend to have more blowups because they are invested in more funds, so there is more probability for a problem. If a problem happens, it’s more likely that it’s going to be in your portfolio, so the incidence of loss is higher, while the magnitude is smaller.
AR: Cliffwater and other consulting firms had some exposure to Diamondback and Level Global. Has your due diligence process changed at all because of this?
Nesbitt: We always tweak our process for events such as this. I always say to our operations due diligence people: You want to be ahead of the wave. But insider trading is a very difficult thing to anticipate. Once it happens, our operational due diligence people try to vet all of our existing hedge funds for their use of third-party research firms and ask whether they are using them. Have they used them before? Are they operating in sectors that appear vulnerable to this type of activity? They try to research if we have exposure to any of that and what our downside is.
AR: How did your clients react to the insider trading issues and their exposure to some of these hedge funds?
Nesbitt: What we are expected to do is be on top of the issues when they arise and keep our clients informed and make recommendations as to redemptions and so forth based on our analysis. Insider trading is not new. I think clients were disappointed, but they weren’t completely caught off guard. It’s not like the Lehman collapse or MF Global. It’s not unimaginable. It’s not something people view as “we are going to suffer serious losses.” There have been some accusations and convictions from insider trading. I don’t want to say it’s not important. But I think the FBI brought a new dimension to this. I don’t remember any other time that the FBI showed up at a client’s investment manager. That brought a new level of concern. And the other thing is the uncertainty about how widespread it is. It just takes a while to work through the system. You wish you could get closure and move on. Today when we recommend an equity long-short fund, we’re always asking how vulnerable this fund is to being swept up.
AR: If you are putting client money in the large well-known managers, can’t most pension funds get access to these on their own?
Nesbitt: What we’ve tried to do is construct a client base of long-term, tax-exempt investors. We try not to have any fickle clients. We focus on clients who will represent stable capital, and that’s one thing hedge funds want, which funds of funds and European investors have not been able to provide.
Can they do it on their own? Probably. And we’d welcome them to try. We’ve had clients decide to do that and say, “Hey, Cliffwater, we love you, but we want to do this on our own,” which I really respect. That’s the potential endgame. It’s really the clients that make us different. And this is true on the private equity side as well. We don’t have any fund-of-funds or investment bank clients; we are not on anybody’s platform. And I tell those difficult-to-access GPs that our clients are reliable investors; as long as you are true to your word, they will be your long-term investors.
AR: Are you working on any new projects?
Nesbitt: Toward the end of last year, we introduced a risk analysis and management system where clients can put together portfolios and measure risk for different purposes: whether it’s absolute return or an equity substitute or a fixed-income substitute. They can run that through a program without actually investing. They can pick from a long list of hedge funds, load it into a portfolio, assign weights and do risk analysis. It will also show which funds are more or less attractive, not just from a portfolio point of view but from a risk view. So if you have 20 managers and you want to add one more, it can show you which manager provides the best diversification.
AR: Are there any hedge fund or alternatives strategies you are particularly interested in right now?
Nesbitt: I think the new new thing is opportunistic investing. These are what I call one-time funds that are sourced from hedge funds and from private equity managers. It’s where they see a unique opportunity that may be short-term and narrow. It may not even be a single fund, it may just be a trade. I’m very interested in providing a platform so that clients can invest in those types of opportunities in an expeditious but fully vetted form.
AR: What do you enjoy about working with hedge funds on the research side and public funds on the client service side?
Nesbitt: Hedge funds have been adding value and alpha, and unlike many other alternatives, there is instant gratification. If you are doing private equity, it will take you five years to get money in the ground and produce profits. With hedge funds, you make a decision today, and at the end of the month you can be invested. Public funds are very process oriented, and they generally take their fiduciary responsibility quite seriously.
AR: Doesn’t this also mean that they take a long time to implement investment ideas?
Nesbitt: Not necessarily. The classic vetting process in long-only was the beauty contest: do an RFP, go through a three-to-six-month process, interview managers, select finalists, etc. Generally, in alternatives that doesn’t work. So trustees and staff have implemented a streamlined process, and even fast-track cases, where if a decision needs to be made in a couple of weeks, they can accommodate that. Some of that involves ceding the manager selection responsibilities to staff. That’s a reflection not only of the need to move quicker but also of the quality of staff. AR