| | Isaac Souede: It’s very important in today’s world to be an activist in investing (Photographs by Steve Pyke) |
“Past performance is not an indicator of future results.” This disclaimer appears on marketing documents for most investment strategies. And while this disclaimer may still apply at Permal Asset Management, the fund-of-funds firm hasn’t stopped trying to fine-tune its risk measurement and performance attribution process to better predict what drives performance in Permal’s own portfolios and those of its underlying managers. Following the financial crisis, the firm rolled out CubeRisk, a proprietary quantitative risk measurement system that allows the risk group to work with the asset management group to quickly and easily ferret out the effects of certain managers or securities on a portfolio. “It’s an integrated system that every portfolio manager has on his desk,” says Isaac Souede, chairman and chief executive of Permal Asset Management, “so he can quickly see what’s impacting his portfolio and do substitutions on managers.” The CubeRisk system was designed by Julian Shaw, Permal’s head of risk management, and it applies advanced statistical techniques to estimate portfolio risk. It’s designed to isolate all the different forms of beta a hedge fund is exposed to and instead find the performance that can be attributed to a manager’s skill.
So far, Permal’s strategy has been working; clients and consultants often rate the firm well above some of its fund-of-funds peers. The manager has returned approximately 8% to 10% on an annualized basis for the past five- and seven-year periods in its flagship $5.9 billion Permal Fixed Income Holdings fund, which invests primarily in fixed-income, relative value and macro strategies. This fund also posted considerable gains in the past two years—returning 27.32% in 2009 and 10.39% in 2010. It’s up 3.43% this year through May, according to InvestHedge.
Although Permal lost 18.4% in its flagship fund in 2008 and the firm is still $13 billion short of its $36 billion peak, Souede saw the financial crisis as an opportunity to make improvements. “On the performance side, you can never be pleased to lose money for anybody, but overall, when you think about the art of the possible, we did as well as most,” he says. “But the important thing wasn’t the tribulation or the pain, it was ‘how do you come out better?’ and I pushed this organization very hard to come out a lot better.”
In addition to launching CubeRisk, Souede has been pushing for more separate accounts with managers, in the interest of transparency, liquidity and fee negotiations, as well as working with clients on customized portfolios and launching new esoteric strategies. Permal recently won as much as $450 million from the New York City Comptroller’s Office, which decided to hire Permal as its sole fund-of-funds manager and invest in a customized account. The firm was also one of four funds of funds that won a $100 million mandate in June from the Connecticut Retirement Plans and Trust Funds, which are investing in hedge funds for the first time.
AR staff writer Anastasia Donde recently caught up with the Permal CEO to discuss what’s changed since 2008.
AR: Tell me more about how the CubeRisk system works.
Isaac Souede: It allows the risk group to talk to the asset management group on a continuous basis. A portfolio manager can say, “If I take one hedge fund out and put another one in, what is it doing to my portfolio risk?” It allows you to very quickly predict the performance of your portfolio before the manager numbers even come out. You can also look at deviations from those numbers and figure out why they are this way. It’s factor analysis combined with manager analysis that you can use to see what’s driving performance.
If you go in to see a new manager and they say their performance is coming from XYZ and you run the factor analysis and see that their performance is actually coming from ABC, then there is something you missed there. The system is something that has evolved over the past three years. It’s a part of what the risk team has been doing for a long time, but now it’s much easier. It’s as easy as going to my computer and typing a few things in.
AR: What else are you doing to keep clients happy?
Isaac Souede: As opposed to 20 years ago, when I was chief investment officer of this firm, the industry has evolved quite a bit. It’s much more fragmented. There are far fewer generalists. And our response to that has been to create separately managed accounts with our managers. Part of that is liquidity, part of that is better fee negotiations, and part of it is because it allows us to create more alpha for our clients.
We continue to want to be a firm that goes across a multitude of ways of managing money. If you look at Permal, we have absolute return funds in strategies such as macro and fixed income, and we also have directional funds that are substitutes for equities, and there we’re crossing the entire globe from global strategies to more regional focused. We want to be very broad that way because it keeps you innovative, it keeps you sharp, and it deepens your bench of investment talent.
We started doing separate accounts in 1995 but didn’t have great success in getting the managers we wanted to say yes. It’s easier to get the managers you don’t want to say yes. The program really accelerated after 2008, when the negotiating power of Permal versus a manager skewed a little bit because of the crisis and as capital became scarce. We’re now up to 78 separate accounts with managers. That’s about $7 billion of our $23 billion in assets. I want to get it up to a 50-50 split.
In my mind, there are three different styles of separate accounts. The simplest would be pari passu—where the strategy is the same as the manager’s commingled fund, but the benefits we’re getting there are more transparency, better liquidity and at times better fee terms. The second is modified engineering, where it resembles what the manager’s commingled fund is, but it might be more concentrated or it may have more leverage than what the manager typically employs.
The third one is completely different from the commingled fund, where we’ve picked up some ideas that we’re very keen on and that the manager is very professional at, and we focus the separate-account vehicle on only those strategies. Say you’re a fixed-income manager and I want you to focus on mortgages, as an example. It’s very product-engineered, in which case we can live with the volatility within the context of a fund of funds.
But I’ve been very careful about not keeping managers only because they’re in a separate account, which is a human tendency. I get statistics every month showing me the turnover of managers in commingled and separate accounts. And it’s about the same rate.
AR: What types of managers wouldn’t you want to do separate accounts with?
Isaac Souede: Some just won’t do it. But the alpha generation is so powerful that we just wouldn’t say no. It’d be foolish. Some of them you don’t want to put in a separate account because it’s a multistrategy fund that has 40 different trading desks, so to try to recreate the credit lines and the facilities in a separate-account format is prohibited. And then the third is, at times, you want the manager’s money to be in the commingled fund alongside ours, and he can’t disengage enough to put it in a separate account.
AR: How high is your manager turnover rate?
Isaac Souede: It’s very important in today’s world to be an activist in investing, to earn your keep in doing what we do. Alpha is difficult to find, but it’s even harder to retain, so if you look at the Permal manager turnover, it’s about 10% to 15% per year, and it’s about two thirds every five years. That’s one of the things that pleases me when I look at the long-term performance that we generated: It has not been achieved with the same cast of managers, yet the consistency of performance has always been there. Given the turnover rate, there is an opening for 15 to 25 new managers every year.
AR: What is your research process like?
| | |
| Isaac Souede: We look at something like 500 managers per year (Photographs by Steve Pyke) |
Isaac Souede: It’s a very intense process. We look at something like 500 managers per year, and some 150 of those are brand-new. And some of the others are people we’ve had on our radar screen and ones that we follow but haven’t yet decided to invest with. We want to look at as many good ideas or bad ideas, as they may turn out to be, as we can find. At times we’ll focus on a particular area because it’s new to us, so it’ll be more intense. For example, when we began to look at China, we spent two years intensively researching Chinese-related managers. We have heads that are responsible for different strategies. So there is a fixed-income team, a long-short team, a macro team, a China team, a Japan team and an emerging-markets team. And on event-driven they tend to share ideas with the other teams, because you may find a really good idea of event-driven in Brazil that a global equity guy might also want to use. So event-driven kind of goes across the different teams.
When we hire a manager after going through the due diligence process, which involves both qualitative and quantitative analysis and operational and IT due diligence, the manager will end up on the approved list, and then different portfolio managers at Permal can choose this manager.
So you may find a manager in one portfolio or you may find him in two or three portfolios. Once the manager is there, it’s up to the Permal portfolio managers to use him as a tool. You may find one portfolio where a manager is being used in a very defensive way, whereas you may find another portfolio where the manager is being used in a much more offensive and aggressive way.
AR: Are there any strategies you’re particularly interested in now?
Isaac Souede: In the fixed-income space, we’re looking at European distressed. I think the banks of Europe are probably undercapitalized, as opposed to overcapitalized, and might have assets they want to get rid of. So I think there is an opportunity there. We also like postbankruptcy reorganization situations. We’ve added some positions there. It’s a reasonably target-rich environment. It’s more pick-and-shovel.
As a broad long-term play, I like the idea of long-short investing in a place like China. I also like that in Japan right now. I think event-driven investing, if you’re patient, is a very good place to be. So these are the areas where additions have been focused.
AR: What do you look for in managers?
Isaac Souede: The things you can’t ignore are enthusiasm, professionalism, thoroughness, determination and dedication. We can get into the tactical aspects of how someone manages, but if you don’t find these characteristics in an individual, that’s a problem for us. It’s a very difficult business, and it’s a very humbling business, and if you don’t find those characteristics, you can’t prosper for the long term.
When I started here 25 years ago, it was much more of a business of generalists, and now it’s much more of a business of specialists, which, from our perspective, has really changed what we do if we want to earn our keep and earn our fees. You’ve got to be much more activist. You’ve got to look at opportunities and make sure they’re properly representative of the portfolios you’re trying to build, because no one else is going to take you there.
As an example, in 2003 I had a very strong view that China natural resources was going to be a very good strategy to be in. But at the time there were very few natural resource managers because the last bull market for natural resources ended in 1981. So we had to really go out and build those skill sets for two to four years because it was very hollow out there. But, of course, now there are a lot of natural resource managers. That’s the main thing that’s changed. It’s a much more specific industry than it used to be. And what clients look for is much more specific.
AR: How do you vet funds that are relatively new?
Isaac Souede: The first thing we are going to want is a separate account. I’d feel much better about the operational side, because then we control the accounting, the custodial relationship, et cetera. So that’s the first discussion. If you’re picking the manager in a high-risk area such as China, it’s not even a discussion.
The other thing you want to see is pedigree, and this more often can be found in second- or third- generation managers. We made a very successful health care investment with a manager about three years ago, where we got a separate account and a fee discount. In this case we knew the manager and his performance very well from the firm he was coming from. The only doubts we had were: Can he be a good businessman? Can he be a good CEO of a firm? And we alleviated all those doubts by a separate account.
AR: Have you had exposure to any of the recent frauds or blowups?
Isaac Souede: We’ve avoided them. It’s really all about very extensive quantitative and qualitative due diligence. If you don’t understand the investment or if it’s too good to be true, then just skip it. Or if you are that anxious to do it because you think it’s going to be a great investment, then go into a separate account and monitor the portfolio constantly. And I think most of the blowups that we missed were really 75% common sense and 25% quantitative work. And the only real way to protect yourself, beyond all the due diligence you do and all the intelligence you have, is to diversify.
AR: You’re still about $13 billion below your 2008 peak assets. Where did most of your redemptions come from?
Isaac Souede: Most redemptions came from people who were on leverage with us and the banks pulled all of their lines. That’s reason one. The other reason was structures that were created around us, unbeknownst to us, by financial institutions which collapsed those structures. The others came from clients that needed liquidity—those were mostly ultra-high-net-worth.
But if you take out the leverage and those financial structures, we’re definitely approaching our peak. And we’re absolutely at our peak on the institutional side. Our institutional business is about 40% right now and high-net-worth is 60%. I think we will go to 50-50 in the next six months and that would be a sweet spot. I’d want to stay there.
AR: Were you able to get your money back from managers to meet redemption requests?
Isaac Souede: We didn’t have to gate or side pocket. As a firm we have a philosophy on being invested in very liquid structures. The only thing we did was to temporarily go from a 20-day redemption notice to a 90-day redemption notice.
AR: Have you had much push-back from institutional clients on fees?
Isaac Souede: I think with very large institutional clients, there is obviously a discussion on fees and comfort levels on fees, so I’d say there is a predilection at the moment to have more fees paid to us on an incentive basis. There are many more fixed-plus- incentive formulas that we’ve entered into, which we’re very comfortable with because we’re confident in our ability to perform as we have for the past 10 years in our major strategies of 8% to 10% per year. And if we do that, we’re getting the fee that we think we deserve, and if we don’t do that, we probably don’t deserve that fee.
So that’s really the main thing I’ve seen change. There is more of a weight on the incentive side of the fee formula, but if we perform at 8% to 10% per year, we’ll end up earning what we’ve earned traditionally.
