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Jane Buchan Pacific Alternative Asset Management Co. Jane Buchan, co-founder and CEO of Pacific Alternative Asset Management Co., is used to doing things differently. After earning a BA in economics from Yale University in 1986, she began her career at J.P. Morgan Investment Management in New York, where she quickly became the go-to quant in the pioneering capital markets group. She left Wall Street for the West Coast in 1987, becoming director of quantitative analysis and CIO of nondirectional strategies at investment advisory firm Collins Associates in Newport Beach, California. She moved back east to earn a Ph.D. in business economics from Harvard University in 1990, then taught finance at Dartmouth College’s Tuck School of Business before returning to California and Collins, where she stayed until 2000. “I got rapidly thrown into anything that had to do with a number or an equation,” she says. “It was sort of like that commercial, ‘See if Mikey likes it.’ If it had an equation, it was ‘See if she’ll eat it.’ ”
But when Buchan, along with three colleagues — James Berens, William Knight and Judith Posnikoff — created Irvine, California–based PAAMCO in 2000, she dared to be different in a way that would affect the entire hedge fund industry. PAAMCO, which has more than $18 billion in assets under management, was one of the first fund-of-funds firms to offer separately managed accounts to major public institutions. The firm provides more of a consultant role than many funds of funds, relying on data-driven research and early-stage managers to create bespoke hedge fund strategies for clients. PAAMCO focuses on newer, smaller funds to which the firm can add value by taking on some of the operational work managers typically have to do — negotiating fees down in the process. This has given Buchan, 52, a unique perspective on the evolution of the industry.
How did you first get into hedge fund investing?
Buchan: I started at J.P. Morgan, and I worked for a very innovative part of the company that did a lot of new things. Then I moved out to the West Coast for personal reasons and took a job with a small consulting firm [Collins Associates] that had incredibly innovative clients. I was the chief investment officer in charge of nondirectional hedge fund strategies there. When I left, I had several large corporate clients follow me, and that’s how we created PAAMCO.
The hedge fund industry in some ways started on an institutional basis. In the late ‘80s hedge funds were actually managing money for some very large corporate pension plans, but we didn’t think of them as hedge funds. One of the major oil companies was a client of [Collins Associates], and they had Julian Robertson managing their money from the late ‘80s on, but he was just a good stock picker. You didn’t think about him as an asset class or a hedge fund. The firm had always taken a very innovative approach, and as we got more and more into hedge funds, there was a high percentage of them that used derivatives and other quantitative techniques, so that’s how I got into it. As we were putting our clients in these strategies, I got more and more involved with it given my skill set.
Can you talk a little bit about how the hedge fund industry has changed over the years and how PAAMCO has adapted?
Having been involved in the hedge fund industry from the very early days, institutionally one of the things that happened over the years is we’ve hired a lot of great managers and a lot of them have become very, very large. For most of the managers, not all of them but for the preponderance of them, size is the enemy, not a benefit.
When we started, even these high-profile hedge funds were very small. I remember we had money run by Bill Ackman in the ‘90s, when he had Gotham [Partners]. we’ve had money run by a lot of these people who are now big, but we’ve always played in the smaller space.
Our clients are very sophisticated, so our view has always been that the hedge funds that we could really help our clients with are the newer ones. With the bigger ones, given there are a lot of people who cover them and there are a lot of ways to get information about them, our view was we should just have our clients do those directly. So over the years PAAMCO has always played in the smaller, newer manager space, and we have a lot of former managers that are just huge today.
We have a portfolio that includes about 50 managers, so when we take our assets and divide them up, it’s still only a couple hundred million dollars per manager. Most of our managers are less than $1 billion, and what tends to happen is that when they get big, clients will just hire them directly. So We’re always playing in the small-manager group.
How has demand from investors driven portfolio and fee changes in the industry and at PAAMCO?
This is where the fund-of-funds perspective is really helpful. When we had clients in the late ‘80s invested in hedge funds, most of our hedge funds were charging 1 percent, well over half of them had a hurdle rate of return of about 7 percent or 8 percent, and they only collected a 20 percent performance fee above that. They billed very few fees and expenses to the funds. That’s what this industry looked like 30 years ago. One of the things that’s always amazed me over the years is that as more and more money has come in, economic theory would say prices should compress, but if anything, terms have continued to get worse and fees have tended to go up. Ours haven’t because we really negotiate with our managers, but for a lot of investors what became much more important was having the right name rather than looking at the value that was being delivered. One of the huge changes, and it has taken a long time, is that finally people are starting to look at what the value proposition is.
I coauthored a paper for the Journal of Alternative Investments that showed it’s true that better managers tend to charge higher fees. But you can’t take an average manager and have him put his fees up and then improve his performance. Yet there was a lot of that going on. People were running around saying, “The good managers charge more, which is as it should be, but then if I don’t charge a lot, too, people will infer in the marketplace that I’m not a good manager.” It’s very, very similar to what’s gone on with executive compensation. When you talk about CEO compensation, you want an above-average CEO, which makes you say, “I need to pay above average.” So, of course, it keeps going up year after year because nobody wants to say they want to pay at average or slightly below average, because they think that’s a better value. It’s just very counterintuitive.
We’re starting to see a massive shift. I’m surprised it has taken this long for people to say, “No, there may be some really good managers, but even though they may be very good, they’re just not right for me,” and pass on them. We’re just starting to see that.
What do you think is the impetus? Why are people feeling empowered to say no now?
Part of the issue is that when hedge funds were new, it was a lot easier to question whether they were a top-quality fund. I think what has happened is, as hedge funds have become more of a mainstay, people are realizing they are just like any other asset class and any other active investment strategy; there are good ones and bad ones. I think people have gotten a lot more comfortable with the asset class, so they’re much more willing to focus on fees.
I also think that returns are down. Although if you look at the returns relative to other options, it hasn’t been so bad. I was talking with the CIO of a very, very large entity recently and he remarked to me, “Oh Jane, haven’t you heard that zero is the new good return?” In the context of capital markets, I think hedge funds have done well and they’ve kind of done what they’re supposed to do. At least, for our clients that’s what’s happened. But I think people have just gotten a lot more comfortable saying, “No, there’s a limit, and even though someone may be good, it’s just not worth it.”
Do you see the center of power shifting from managers to investors?
Because hedge funds are such active management, I don’t think they are ever going to shift in the way that many other areas of asset management have shifted. There would have to be an overall reset as to the compensation levels that people in asset management want for what they do. I don’t think you’re ever going to see that because there’s active money management in hedge funds. But what I do see for the first time are people walking away from managers. They say the manager is good, they’re not debating the quality of the manager, but the terms are just too onerous. You’re starting to see that particularly with some of the big public pension plans, who are saying they’re willing to spend X percent of alpha on a manager regardless of whether the alpha is generated in private equity, hedge funds or long-only. And once they get over that, they’re using their capital and they need to keep that percentage of the alpha for themselves. You’ve seen a few people do it. I still think people are talking about it, but the number walking away from the good-performing managers is pretty small. You’re seeing it with some of the big macro players where performance has been challenging, and some of the macro managers — because they come out of a different era — have historically charged more than other types of managers. There are still a bunch of them at 3 and 30 — huge fees. And I’ve seen a few people walk away and say that’s just too rich.
At the end of the day, it’s active money management, so you still want to make money.
Does this lead, in your view, to an actual change in the way fees are handled?
I think so, and I think the big change that I’m seeing — and our clients and the people we talk to are very, very large and very, very sophisticated — is discounts for large size. There’s a certain amount of fixed cost available. You have to service clients, you have to take people’s calls, you have to do meetings. Where We’re seeing most of the fee movement is with large allocations where the realization is that managing $300 million or $200 million from a person versus $20 million or $10 million is slightly more work but not 10X. The big changes aren’t overall collapses in fee schedules. It’s giving, frankly, discounts for size.
PAAMCO is dealing with smaller managers, so it is clear that we have more leverage in that space. But those managers also are more labor-intensive. We don’t invest in any commingled funds. We have our own managed accounts, and that requires a solid infrastructure that we have to pay for, and it’s been very beneficial for managers. For example, in 2008 we were able to keep open some managers and some accounts where they were having problems in their commingled funds. But that’s a cost structure for us.
What’s been beneficial for us is that while we’ve had to put more money into operating the business, the fact that We’re doing more than the manager has to do for other accounts has let us negotiate the fees down for those managers because We’re doing more than the manager has to do in other situations. If you look at where the division line is between what we do and what the manager does, we do an awful lot of support for the manager nowadays. Our clients are able to realize large fee savings from that. So while PAAMCO’s fees haven’t really gone down, the whole all-in fees for the client have gone down dramatically. Even when you factor in our fees, it’s still really cost-effective. The way We’re able to get those lower fees is that we do more. We’re the official manager of record.
What are you uniquely able to do for investors as a fund of funds that may be difficult for traditional managers in this environment?
Obviously, our investors are very smart and very sophisticated. Most of them make hedge fund investments directly, or at least they have some influence over what they want their hedge fund portfolio to look like. Our typical client will have big direct allocations themselves, and everybody has a budget constraint. For example, with the big managers, clients can give them a lot of money in their big commingled fund. Small managers are different. At PAAMCO, with our small managers we want all of our risk to be investment risk. We don’t want to take operating risk, so we keep control of the money. That results in a much higher cost for us, but control allows us to have a more aggressive risk profile in terms of the investment risk. Our clients totally understand that because let’s say it costs them X dollars to hire a manager. If he’s a big manager and they can give him a lot of money, that’s fine. But if it’s a small manager, it’s going to cost probably 2X dollars, and then they are only going to give the manager less than half the amount of money. So it’s almost four times as expensive to do it yourself in the small-manager space. That’s where PAAMCO is a much more efficient solution. Plus, we find these managers early and negotiate very preferential terms, and if they invest after us, odds are they can’t get those terms. we’ve had several big clients who invest with us for selected opportunities that make a lot of sense for them.
There are still a few investors out there who don’t look at the total fees, they just look at one part of the fee. We feel very strongly you need to look at your total fee spend and you want to get that to an appropriate place for the value that you feel is being created. •
