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Daniel SternReservoir Capital GroupThe entrepreneurial spirit runs deep in Daniel Stern. Using a $200,000 investment and a $3 million bank guarantee from Texas’s wealthy Bass brothers, his father, Robert Stern, in 1980 co-founded GTECH Corp., a Rhode Island–based company that created the gaming technology that today powers many of the world’s state and national lotteries. The younger Stern joined the Bass brothers’ investment office in Fort Worth in 1983 after graduating from Harvard College with a BA in economics. There he worked with legendary investor Richard Rainwater and merger arbitrageur Thomas Taylor. Stern, now 55, left the Bass family in 1985 to run movie sets for George Lucas (he worked on one of the Star Wars creator’s few bombs, Howard the Duck), then earned his MBA at Harvard. In 1992 the Ziff family, which had made its fortune in publishing, hired him to set up Ziff Brothers Investments. During his five years as president of Ziff Brothers, Stern helped launch several successful hedge fund firms, including Daniel Och’s Och-Ziff Capital Management Group and Michael Vranos’s Ellington Management Group. He and two colleagues, Craig Huff and Gregg Zeitlin, founded Reservoir Capital Group in 1998, raising $450 million against the backdrop of the Russian financial crisis and the collapse of hedge fund firm Long-Term Capital Management (LTCM). With $6 billion in assets, Reservoir is one of the world’s largest hedge fund seeders, providing start-up capital for managers and investing opportunistically in other businesses.
Why did you decide to leave Ziff Brothers Investments?
Stern: When I started there in 1992, the three Ziff brothers, who are really brilliant, were all in school — one in business school, one in college and one in law school. Five years later they had graduated and were involved in managing the capital, and it’s their money. So we just had a lot of chefs in the kitchen. So with their support I spun off into this new business that I had wanted to start with partners that worked with me at Ziff Brothers — Craig Huff and Gregg Zeitlin. We all left together in 1997. The idea was to basically invest like we had at the Basses and the Ziffs, very opportunistically across the capital structure with long-dated capital, but also seed people in creating new entities, which we have continued to do here at Reservoir.
Are there advantages to starting a business during a crisis?
There are huge advantages because for the people that survive, if you can take risks during the crisis, you then have a tailwind in the early part of your business. So as bad as it is to be challenged in a crisis, if you can live through it and have a tailwind early in the life of your business, it’s a big advantage.
When it comes to seeding, our approach to creating new managers has been investment-focused, as opposed to financial institution–focused — meaning, our goal has not been to build big, profitable hedge funds as financial institutions but to actually make great investments. And the best way to do that is to start something when you’re stepping into a dislocation, so that the risk–reward is really good.
In general, the times in my career when we started hedge funds were all during a crisis — 1991 Resolution Trust Corp. issues, ’94 mortgage meltdown, ’98 LTCM–Russia crisis, 2002 tech meltdown, Enron blowing up. These are all the times when you want to create a firm because you have great investment opportunities in front of you. At the same time, world-class managers cannot access capital because markets are generally frozen.
The dominant factor in seeding, by far, is adverse selection — meaning, the best, most talented people in a normalized market don’t need a seed partner to start. They don’t need your capital. And why would you give a percentage of your revenue or equity away to a partner to start your business if you don’t need to? The best people generally don’t need a seed partner, all things being equal. Therefore the time when it makes sense for both sides to do a seed deal is when there’s a dislocation in the market and even great people have trouble getting capital. At those moments there’s generally something attractive to do on the investing side; the people that are specialists that you may be partnering with see that there’s a really great opportunity. And importantly, they don’t want to wait for the opportunity. In other words, they don’t want to wait for markets to thaw to access the capital because they think the opportunity in front of them is so good. So dislocated markets are, by far, the best time to launch new firms.
Would you give some examples?
I’ll give you two that are easy, but I can give you many. We started Ellington, which is Mike Vranos’s firm, when the mortgage market absolutely blew up in ’94. Kidder Peabody had a dominant place in the mortgage market at the time, and Mike was head of mortgages at Kidder. They had a big market share. Kidder itself blew up, and it was owned by General Electric, and GE liquidated the firm.
So you had a huge crisis in the mortgage market, and Mike was in the middle of it. And we — this was now at Ziff Brothers in ’94 — teamed up with Mike and went in and actually talked to GE about buying the bulk of their mortgage derivatives book at a time when everyone was very, very fearful of that market. We felt the securities were really well priced, and in fact it turned out to be that way. We made a lot of money early. And as in any new firm, if you can have great momentum coming out of the gates, it’s incredibly helpful.
Another example would be Anchorage [Capital], which is a firm we started in 2003 at Reservoir with Kevin Ulrich and Tony Davis, two senior guys in the distressed area at Goldman Sachs. It was a very bad time for the distressed market, coming off of all the defaults at Enron and the energy bankruptcies. So it may be a struggle for a little while, and you can’t raise as much capital, but you have great things to do with the money and you have good returns early, and that tailwind kind of helps.
What was the relationship between hedge fund managers and investors like in the ’80s, when you worked for the Bass family?
I sometimes tell our young people that start here that they can’t even imagine how different it was. Hedge funds were a cottage industry; it was really tiny. When I went to go work for what was effectively a hedge fund right out of college and described what it was that I was going to do — buying stocks but shorting things as well — the vast majority of people said to me, “Are you sure that’s legal?” Most of the people at hedge funds, personality-wise, weren’t mainstream. They were unusual thinkers operating in a rogue corner of the world — not rogue in a negative sense, but they were kind of unusual, independent thinkers.
There were very few hedge funds and only a few firms on the Street that were very active using their balance sheet: Goldman Sachs and Salomon Brothers and a few others. So the investors in hedge funds were mostly family capital and a few institutions. It was primarily private individuals that put money in hedge funds because institutions didn’t understand them.
And in fact, obviously, that’s the legend of Jack Meyer and David Swensen at Harvard and Yale. They were innovative and ahead of the curve on a number of things. One of them was hedge funds. They were an investor in hedge funds — in Yale’s case very early on. And Harvard Management actually ran hedge fund strategies internally.
So the relationship was very personal back then because it was primarily the money of private individuals and they knew the investment managers directly. The next-earliest adopters were other endowments and foundations, and then eventually came the bigger institutions in the late ’90s and early into the 2000s. The business has gotten increasingly institutionalized as it has scaled.
Has the business lost something as it has become institutional?
Yes, but I don’t think it’s different than any other industry when it evolves from its founders and early entrepreneurs and the very inventive people who are early players to something more institutional. You lose something and you gain something. You’ve gained much more transparency and clarity on what people are doing; there’s far less secrecy generally. And you’ve probably lost some of the really independent-thinking people who were early players. But listen, the competitive landscape is the biggest difference. You’ve gone from a small number of hedge funds to 8,000 or 10,000.
Has it become harder to generate superior risk-adjusted returns?
Well, the markets would tell you that. I mean, it has been harder. That’s a fact, particularly this past year, which has been a really difficult period. Sitting here today in August of ’16, the 12-month returns are especially disappointing for hedge funds relative to their asset classes. Yeah, we can have a long conversation about what the drivers of that are, but for sure one of the drivers is increased competition.
With so many hedge funds today, has the quality of the talent been watered down?
It’s kind of easy to say that, obviously. The math is the math. If you went and said, “Let me pick the five best investors in the world,” they’d be a different group than the 10,000 best investors in the world. So by definition there’s some watering down.
On the other hand, there were a lot of people in the early days that operated on their gut and were very good at it, of course, and were very entrepreneurial but didn’t have the depth of knowledge of some of the people that are in the business today. That’s a trade-off. You’ve traded entrepreneurialism for scale, and on the other hand you’ve gained: There’s much more professional management of the risks in hedge funds today than there was 30 years ago.
Risk management certainly has become a big focus for both managers and investors.
Yeah. Well, the business has become large-scale and institutionalized. So every subject we could hit — disclosure, valuation, risk management — everything has become more professional. And obviously, that’s good.
But some of the losses you have from this institutionalization is what we talked about earlier. You just have some of the really independent thinkers driven out of the business. You’ve obviously seen a number of big hedge fund legends make enough money and retire and go run their own family money. I think part of that is because as family offices they can have a broader palette to invest and more latitude in the way to invest, including the ability to do nothing. For example, it’s hard in today’s world to actually have a lot of cash in your portfolio. There are managers that are known for it, like Seth Klarman and others who have such a stellar record and are so well regarded that investors allow it. But by and large, the structure around what managers are allowed to do for their investors has narrowed. And you’ve lost some of that bandwidth, I think, for a lot of the industry.
How has this affected your seeding business?
What I’ve described to you so far is really the environment pre-2008. Postcrisis the environment’s changed pretty dramatically. Some of that’s good, and some of that’s bad. There was a thesis by a lot of investors and allocators that the Volcker rule was going to trigger a once-in-a-generation migration of talent from the sell side to the buy side, and that you had to be a part of it. And so a lot of seed capital was raised. There were only two or three major pools of capital in seeding, but a lot of money was in the market. Most of it was based on this thesis of the migration of talent from Volcker. And that migration hasn’t really materialized, and I think that people are disappointed in the returns of the two biggest seeders. I shouldn’t speak for others, but our returns from this vintage — and I think Blackstone’s — are muted, and I think that you didn’t see that migration of talent from the Street.
Then with all the increasing scrutiny on the business post-’08 — appropriately — it’s gotten harder to start a hedge fund. So some of the terms between seeders and managers have actually gotten more favorable for the seeder. But I would argue overall that the probability of success — I mean for the individually seeded firm — has actually gone down. At the same time, the barriers to entry and the minimum efficient scale to start a hedge fund have gone up. Seeders in some ways are needed more.
So it’s a balancing act. Some part of seeding has gotten easier, and some of it’s gotten more difficult. I would say, on balance, it’s gotten more difficult because the most important thing is the probability of success of any individual fund. And I think having that probability of success go down, which it has demonstrably across the board, is the biggest issue.
Has the balance of power shifted from hedge fund managers to investors?
Obviously, there’s been a lot of talk about fees and alignment of interest, and I think that’s appropriate. Like any maturing industry, the relationship with the customer changes over time, and that makes sense. I also think that we’re in an environment with well north of $10 trillion of sovereign debt trading at negative interest rates that no one anticipated. So you have an environment that obviously has been very hard for allocators to adjust to. It’s also been very, very hard for hedge fund managers to adjust to. And the returns have shown how difficult it is to navigate if you’re trying to be active. And I think it’s been hard to try to recalibrate what the right relationship is between a hedge fund manager and an investor when you have effectively zero interest rates. Is a 200-point basis fee off the top the right model?
And so, yeah, I think that relationship is being redefined as we speak. And I think with our managers and those I see, that dialogue is taking place and there’s a lot of people complaining. But it is expected on a journey where an industry has gotten this big and this mature, and the environment is so unusual that people have to reassess and ask what’s the right balance between the customers and the providers. I think that’s happening now. You see that in all kinds of deals with a smart allocator such as a Texas Teachers. The other way to reassess is to say, “I just don’t like it and I’m out,” which is what CalPERS did. That will prove to be a mistake, in my view, because hedge funds do create alpha over time and are an important part of institutional portfolios. Obviously, I’m biased, but I do believe that. On the other side you have many institutions that are just trying to be part of the process of figuring out what the right balance is in their relationships with managers.
Where is the balance right now?
You’re looking for an answer on one side or the other. There’s no simple answer. It’s too fluid. I think there are managers that are so sought after and have limited capacity that there’s still no balance. They name their price, and the market’s there to take that price. And there are managers at the other end of that spectrum, and there’s everything in between. So you have a dynamic process where people are resetting. Basically, you’re in a resetting process to try to figure out what the right balance is economically between the two when you’re living in an environment like this. •
