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| Girish Reddy, Prisma Capital Partners: It was very difficult to hide in 2011 (Photographs by Axel Dupeux) |
Many institutional investors have been flocking to larger, well-established hedge fund managers and investing in them directly. But Prisma Capital Partners, a fund-of-funds group in New York that has been investing with smaller managers since its 2004 founding, takes a more nuanced approach to fund size, and that has helped it buck the trend. The firm often scouts for smaller managers that are nimbler than their larger counterparts and even gives some of them capital on day one, though Prisma doesn’t seed new managers. Girish Reddy, managing partner and founder of the firm, says his portfolios are now more heavily skewed than they once were toward larger ($1 billion and above) managers, but he points out that Prisma helped many of these managers get their start.
Prisma was a day-one investor in JAT Capital Management and an early-stage investor in Discovery Capital Management, as well as a European market-neutral fund that has recently grown to more than $1 billion. In hindsight, investing early in JAT was a shrewd move, as John Thaler’s tech start-up was one of the better-performing managers last year, gaining 17.2 percent while the AR Composite Index was down 0.47 percent.
But Prisma is careful not to let such performance lead to unwieldly asset levels, as it has withdrawn capital from some managers that the firm thought were adversely affected by significant asset spikes. “We’ve exited lots of managers because they’ve become too large. But we’ve also stayed with a couple where we feel that the strategy allows them to continue to benefit from the size,” says Reddy.
Some of the managers Prisma exited when they got too large were equity- and event-related firms. These included Paulson & Co., which Prisma withdrew from in 2009, and Harbinger Capital Partners, which the fund of funds exited in 2007 and 2008. The moves proved to be timely, as both Harbinger and Paulson posted steep losses last year.
Still, Reddy says there are some strategies where growth can be a good thing, and Prisma will often stick with those: “This is particularly the case in distressed and macro, where I think size can sometimes be your friend.” Prisma invests with some very large distressed managers whose size allows them “to have a seat at the table of restructuring and lead the credit committees,” Reddy explains.
But size is, of course, not the only thing Prisma looks at when investing in managers. It also focuses on specialty strategies and the ability to customize funds with managers. So far, Prisma’s interest in specialists and newer managers has worked with clients. The firm has won mandates from several large U.S. pension funds over the past year, including the Ohio Public Employees Retirement System, the Kentucky Retirement Systems and the Connecticut Retirement Plans and Trust Funds — even as other institutions have been bypassing funds of funds to invest directly in hedge funds.
Although Prisma itself is much smaller than some of its competitors, the firm has been able to compete and win money alongside such behemoths as Blackstone Alternative Asset Management, which now has north of $40 billion in assets. Prisma manages about $7.5 billion, though that is $2.2 billion more than what it managed at the beginning of last year. The firm’s flagship Prisma Spectrum Fund lost 2.41 percent in 2011, according to the InvestHedge database, while the InvestHedge Global Multi Strategy USD index was down 3.92 percent. Prisma’s fund gained 7.41 percent in 2010 and 18.03 percent in 2009.
AR Staff Writer Anastasia Donde recently caught up with Reddy to talk about his work with managers and clients, as well as his views on the market environment.
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| Reddy: I think some managers’ risk timing wasn’t very good |
AR: What do you make of 2011? Was there any silver lining? Reddy: Two thousand eleven was among the more challenging years we’ve faced. It was marked by uncertainty in public policy. Central banks around the world were not coordinating. The U.S. was much more benign and helpful to the markets, while the European Central Bank raised rates in the first quarter. The Asian central banks were going through their own inflationary fears, so there was no coordinated effort to solve global problems.
These forces made it very difficult for investors because we believe the worst environment for hedge funds is policy uncertainty, which was compounded during 2011 by extraordinary market volatility. These forces also make it difficult for fundamentally oriented managers to perform well. Having said that, I think some managers’ risk timing wasn’t very good. Many of them reduced risk after July or August and missed the fourth-quarter rally, though there continue to be managers that do well despite the market environment.
Looking across portfolios, I’d say the most interesting thing about 2011 was that the short book, which was a detractor from performance for many years, did really well. To some extent poor business models and high valuations did get punished, but managers were able to make good returns or alpha from the short book.
Besides that, credit had a hard time and so did the mortgage market because of technical selling, not because of fundamentals. It was very difficult to hide in 2011. There were no standout winners.
AR: Are your portfolios more heavily skewed to any particular strategies right now?
Reddy: We tend to be global and believe that we are much more broadly diversified than most funds of funds. So we are invested in all sectors. But we do take advantage of dislocations and put quite a bit of importance on strategy allocation.
So where do we stand today? We think that economic growth globally will be okay and that it will be led by the U.S. and Asia. We also believe that China will not have a hard landing, and that while Europe may be weak, global growth collectively should be all right, without fears of inflation or of recession. So with that in mind, we like credit-related strategies, where the spreads have widened dramatically. Low growth and low inflation are the ideal environment for credit.
Structured credit, mortgage credit and high-yield credit in the U.S. look attractive to us. Distressed credit in Asia also looks attractive because a lot of European banks are selling their Asian exposure first to clean up their balance sheets. As a result, there are some interesting opportunities there.
Equities in Asia look particularly attractive because central banks are becoming much more friendly — always a good sign for the equity markets. We believe that the two-year bear markets have created extraordinary value. Consequently, credit in the U.S. and Asia, equities in the U.S. and Asia, and macro managers who can take advantage of this uncertainty are really the areas of focus for us at this point.
AR: Do you already have exposure in these areas?
Reddy: We do, and we’re looking to add more in Asia. The only place that we’re cautious about now is Europe, where the valuations look attractive but policy uncertainty is still a big question mark. That makes timing more difficult, and the risk-reward less compelling to us.
AR: What are your managers doing about the European situation?
Reddy: A lot of U.S. credit managers are building out teams there, the consensus being that European banks need to deleverage and shrink their balance sheets. We feel this trend is in its early stage, however, and because the ECB has now become much more friendly, the need by banks to unload assets is less imminent. We are seeing a lot more [such] activity in Asia by European banks because they feel that’s not their core market, and so they’re much more willing to reduce their exposure there.
As for Europe, there is still a cloud of policy uncertainty there, and many of our managers continue to be a little more conservative. The valuations look very attractive, however, so people are starting to think about investing now.
AR: How many managers do you have in your flagship strategy?
Reddy: Our flagship product has an onshore and offshore version, and we collectively have $2 billion in those funds. Each of those funds has 35 to 40 managers, cutting across eight substrategies. It’s a relatively concentrated portfolio, and the managers all tend to be specialists. We prefer the specialist model where we know exactly what the opportunity set is, and where managers are playing in a very defined sandbox and not able to move around.
We feel strongly that we should be doing the strategy allocation ourselves, so our two key drivers are early-stage and specialist managers. For example, we have an event manager whose focus is on opportunities in Canada only. We have had a structured-credit manager who focuses on interest-only investments. We now see interesting opportunities developing on both the agency and nonagency fronts of mortgage-backed securities. We really want to identify what the dislocated opportunity is and find the best manager in that particular space, so most of our portfolios are a collection of specialists. We believe that this approach also creates a highly risk-diversified portfolio that avoids crowded trades.
AR: Tell me about some of your work with clients.
Reddy: Seventy percent of our business is in customized portfolios. These could include a very concentrated five-to-ten-manager portfolio, which some of our larger clients have asked us to do for them as a proxy for a direct portfolio. They feel it has the benefits of a direct portfolio, with the added advantage of allowing us to do strategy shifts, whereas if they invested directly it would be a much longer process.
The customization can range from a very concentrated portfolio to a very strategic portfolio where we have equity, credit and macro mandates. We are seeing a lot more customization in terms of sectors and concentration levels.
We’re also now able to customize funds at the hedge fund level, where we identify either a specific opportunity or the manager’s specific strength and create a portfolio that will leverage that particular asset. For example, we took an Asian credit manager and had them restructure a fund for us that invested slightly more in liquid securities and slightly less in illiquid ones, since we thought that was the more attractive strategy. In structured credit, where we have historically gone with multiple strategies, we are asking some managers to run only agency or nonagency [interest-only] portfolios.
These are examples where we asked managers to build portfolios for us that would be a good combination of market opportunity and manager strength. And in the process we’ve also been able to negotiate better fees for our clients. Indeed, I think the industry is moving away from the standard multimanager, multistrategy model. The larger institutions in particular are asking for that kind of customization.
AR: Is that why we’re seeing other institutions going the direct route?
Reddy: No. This large plan wanted to go with a concentrated portfolio of eight to ten specialist managers through us, so that we could actively shift the portfolio on their behalf to reflect our strategy views. I think the plans that are going direct are doing the opposite. They tend to go with large multistrategy managers with a “buy and hold” approach.
AR: Are managers usually willing to customize their portfolios?
Reddy: Not all of them. But we tend to invest with early-stage, younger managers and specialists, so that gives us a little more flexibility. That’s harder, of course, if you’re dealing with a very large and successful macro manager, for example. But we’ve done customization at times in the macro space as well as in credit. We’re in the process of doing more of those funds where we identified specific opportunities and then found managers to create separate funds for us.
AR: What are you seeing lately in terms of new launches and spin-outs?
Reddy: I think people from both successful hedge funds and prop desks are spinning out. Goldman is probably the biggest example of that, but you see spin-outs elsewhere, as well. That’s actually good for our clients because we get to see much more talent. We’re then able to team up with people at an early stage of their careers, help them design their infrastructure and identify specific opportunities with them.
AR: You tend to invest more with the smaller managers and some start-ups. How do you vet them?
Reddy: Since our inception we have always had a three-pronged due diligence approach: portfolio, risk and operations. All three groups independently visit the manager, and each has veto power. Because we invest with early-stage managers, I think these three parts are important, and have historically kept us away from frauds and blowups.
About 15 percent of managers don’t meet our risk, infrastructure or operational standards, which means we won’t invest with them. In some cases we work with managers to help them meet those standards before we invest with them.
AR: What are some examples of red flags?
Reddy: On the operational side, it’s infrastructure and independence of the people in the trading allocation and cash management groups. It might also be process and methodology of valuation of illiquid securities. On the risk side, I’d say it’s about leverage, funding and asset-liability mismatch.
AR: Are there any new portfolios that you’ve built for clients or products that you’ve launched recently?
Reddy: Yes. In the fourth quarter we launched a tactical trading macro product, where a client seeded us to start the product because they felt that we’ve had very strong performance in that area. That’s an example of a client asking us to build a portfolio that was a core competence of ours but a weakness of theirs. Many funds of funds and clients are underweight in that particular space, so we’re quite excited about those kinds of customized mandates.
We also launched a very concentrated portfolio for a large European client. We’re seeing varying levels of risk appetite, and our portfolio construction tools allow us to build these kinds of portfolios.
AR: Are there any areas that you’re exiting or reducing exposure to right now?
Reddy: We see event-driven strategies as being slightly less attractive for the next 12 months as a result of tepid growth and market uncertainty. I think there should be some interesting opportunities on the capital structure side, however, and we have some exposure there.
AR: The performance of hedge funds overall hasn’t been that great lately. What would you say is the justification for investing in them?
Reddy: I think investors are looking at these portfolios as longer-term, stable parts of their overall portfolios.
AR: What are your expectations for 2012?
Reddy: The first six months should bode well for risky assets, given the liquidity injection into the system by central banks. Both ECB and Asian central banks are aligned with the Fed.
It’s harder to say what these banks will do over the second half. The fiscal austerity programs could become strong headwinds. Right now, however, we think that the liquidity injection into the systems is a stronger tailwind. AR
