Most accountants who make it to the very top of their companies cling to a natural inclination to talk spread sheets and statistics.
Not Isaac Souede.
Ask the chairman and chief executive of Permal Asset Management about his favorite investments and he reels off a list of people — Louis Bacon, Bruce Kovner and Stephen Mandel Jr. — rather than the names of funds or sectors. Souede, whose New York–based 200-person firm manages nearly $40 billion in funds of hedge funds, is more psychologist and sociologist than number-cruncher. He makes no bones about the fact that he invests his time — and his clients’ money — in people who run great hedge funds, not just in the funds themselves.
“The best managers are usually ones we have followed for a long time,” Souede says. “They might have spun out funds from other firms or come from the long-only space. If they are in our portfolios, it is likely we have gotten to know them well over a long period of time.”
Souede and Permal’s 40-member investment team study in detail the strategies and styles of their managers, but they also devote an unusual amount of energy to exploring and analyzing their character and temperament. As the Permal CEO explains, the chemistry between managers who run a particular fund is critical: “The partners may get along well when the firm is founded, but performance stress does funny things to people.”
In more than 23 years at Permal, Souede has unearthed dozens of relatively unknown hedge fund managers. Some, like Mandel, the founder of Lone Pine Capital in Greenwich, Connecticut, which now has $18 billion in assets under management, have gone on to hedge fund fame. Others, including Tim Tacchi, senior partner of TT International, a $21 billion London-based firm with $3.7 billion in hedge funds, and Sandy Colen, of Orinda, California–based Apex Capital, which has about $3 billion in hedge funds, have largely managed to stay off most investors’ radar.
Once Permal decides a manager has talent, the firm tends to stick with him or her. Although Permal frequently resizes its positions in the more than 200 funds in which it invests, it rarely exits altogether. So when the partners of Colen’s previous firm, Pacific Equities, of Oakland, California, decided to split up in 1989, Souede didn’t have to think twice about investing with Colen in his new venture. “We knew he was very skilled, so we talked to him and decided to back him,” says Souede. “And we’ve now been with him for nearly 20 years.”
The focus on ferreting out talent — and staying with it — has helped Permal grow from $250 million in assets under management in 1985, the year Souede was hired, to $38 billion as of the end of August. That makes it the fifth-biggest fund-of-hedge-funds manager in the world.
Permal’s people-driven approach has helped the firm weather what has been a tough year for most investors. Despite growing concerns about the health of hedge funds — 2008 is on track to be the worst-performing year since Chicago-based Hedge Fund Research began tracking the industry in 1990 — Permal’s assets expanded during the first six months of this year by $2 billion, reaching $39.2 billion, but (like those of most of the industry) have since fallen.
Investors seem to have few doubts about what drives the firm’s long-term growth. Samuel Rosenberg, New York–based head of equity derivatives sales for French bank Société Générale’s corporate and investment banking group, which invests in Permal funds through its structured products, lauds Souede for “finding the best managers for over 20 years.”
Permal’s returns have handily outperformed the average hedge fund. During the five-year period ended June 30, Permal Investment Holdings, the $7.4 billion flagship multistrategy fund, returned 9.4 percent annually, besting the benchmark HFRI composite funds-of-funds index by almost 2 percentage points. Permal Macro Holdings ($10.7 billion in assets under management) returned 8.9 percent annually, and Permal Fixed Income Holdings, a $10.2 billion fund, returned 8.1 percent a year.
Good investment performance, of course, typically leads to asset growth, as investors flock to funds of funds that outshine the competition. Increasingly, however, size has become paramount to a firm’s prospects. Institutional investors seek investment houses with a depth of resources and the capacity to maintain an edge and provide adequate risk controls. In this time of great volatility, investors value such comfort more than ever: In the second quarter of this year, all of the $9 billion in new capital allocated to funds of hedge funds went to firms with more than $5 billion in assets under management, according to Hedge Fund Research. Those with less than $5 billion suffered net redemptions.
Victor Raskin, chief investment officer at the $5 billion YMCA Retirement Fund in New York, says size had a bearing on his decision to invest $70 million in Permal in August 2006. “They clearly had a lot of experience and deep staff levels,” he explains. “We liked that they could offer a range of specialized funds in one place.”
Souede predicts that a supergroup of fund-of-funds firms will break out of the pack and attract the vast majority of assets allocated to the industry. He says the depth of experience within Permal, allied with its formal processes and infrastructure, will make it one of the founding members of this supergroup. Souede has set for his firm an ambitious target of 20 percent asset growth a year in its quest to continue to pull away from medium-size funds. Performance will contribute half of this anticipated growth, he estimates; net inflows will account for the rest. This would make Permal a $94.5 billion firm in five years’ time.
One way Souede hopes to achieve his bold ambitions is by developing new strategies and themes within Permal’s fund-of-funds offerings. The firm started investing in Indian hedge funds last year, and in November it plans to launch the Silk Road Fund in Africa and the Middle East. A China fund is in the wings for next year.
Permal is also into visibility. Its staff works in some of the most high-profile buildings in the world. Its new offices in London are leased for £140 ($245) per square foot. And Permal has improved its branding through Legg Mason, the $923 billion, Baltimore-based mutual fund manager that bought a majority stake in the firm in 2005 but allows it to operate mostly independently of the parent company. Still, Permal’s success hinges chiefly on being able to maintain market-beating returns, a sure challenge in the short term, at least, as market uncertainty is testing hedge funds across the spectrum. Many credit-based funds have been savaged. Volatility in the equity markets has hurt long-short funds, and prime brokers have withdrawn support just when hedge funds need it most. If ever there was a time for funds of hedge funds to prove they are worth their extra layer of fees, this is it.
But performance across the sector has been disappointing of late: The average fund of hedge funds was down 6.48 percent this year through August 31, according to HFR. Permal did better: Although the value of Permal Investment Holdings fell by 10.9 percent, Permal Fixed Income Holdings was off by just 3.4 percent and Permal Macro Holdings was down 0.2 percent. Permal’s historical growth rate suggests its target is achievable (since Souede’s arrival in 1985, the firm’s compounded growth rate is 24 percent). But hedge fund investors have short memories, and few will tolerate mediocre performance for long — pedigree notwithstanding. Permal was born in 1973 as the wealth management arm of Worms & Cie, a holding company controlled by the magnificently wealthy Worms family of Paris. When the closely linked Banque Worms was nationalized by president François Mitterrand’s government in the 1980s, the group was severely weakened; in 1997 it merged with Ifil, an industrial and investment vehicle controlled by Italy’s Agnelli family, of Fiat fame. Today the founders’ influence is gone: There are no family members at the firm, and Souede is by far its longest-serving employee. His path to the top began when he qualified as an accountant in New York State and worked for several companies before serving as chief financial officer through the 1980s at Merrimack, New Hampshire–based Chemical Fabrics Corp., now known as Chemfab. From there he joined Permal, which in the mid-1980s invested in an eclectic array of strategies that weren’t very well arranged. “Funds of hedge funds were a real cottage industry then,” Souede recalls. “It was all a little haphazard.”
With James Hodge, the firm’s chief investment officer and a former director of cost accounting for the New York Stock Exchange, Souede developed systems and controls to open the funds to third-party investors and to build up the asset base. By 1989, Permal had invested with 20 managers — including future Alpha Hedge Fund Hall of Fame members Julian Robertson Jr., George Soros and Michael Steinhardt. The wheels Souede put into motion then have carried Permal far: Today the firm has offices in the Bahamas, Boston, Dubai, Hong Kong, London, New York, Paris, Singapore and Tokyo. It has 21 funds and invests with 215 managers.
Permal promotes a three-pronged approach to running customers’ money: manager selection; portfolio construction and asset management; and risk management.
The firm has a long record of finding, researching and investing in talented managers, usually early in their careers, and then riding their coattails for years on end. Lone Pine’s Mandel is a prime example. Several members of the Permal investment team knew him as a young Goldman, Sachs & Co. consumer retail analyst and followed his fortunes as an analyst in Robertson’s stable of funds at Tiger Management Corp. When Mandel set out on his own in 1997, Permal was among his first investors. Mandel’s deep understanding of stocks and his ability to properly time his short-selling led to annualized compound growth of 36 percent in Lone Pine’s first 11 years. Permal was also an early investor in TT International, run by Tacchi, a former investment director with Fidelity International in London. TT’s European long-short equity fund distinguished itself by posting 20 percent average returns in 2001 and 2002, when the markets were falling. “He kept up this performance even as the market changed,” Souede says. “That is the ultimate test — to be good in all markets.”
Permal’s best performer by far last year was New York–based Paulson & Co. Permal executives met John Paulson, the firm’s founder, in the summer of 2006 and liked his proposal to short the subprime mortgage market. In January 2007, Permal invested in three Paulson funds — including a new credit fund set up expressly to profit from the bursting of the credit bubble — which returned from 130 percent to 650 percent last year.
The firm typically replaces only ten to 25 managers each year out of the 215 on its approved list, yet finding the next Mandel or Paulson entails analysis of the entire universe of hedge funds. Many are passed over for being too small or too illiquid; ultimately, the possibilities are narrowed down to about 400 each year. Permal analysts then benchmark each firm against its peers, visit hedge fund offices and talk to staff members to get an inside view. Souede says face-to-face interviews are priceless: “Some managers tell us they are bottom-up stock pickers. But when we ask them about certain stocks, we sometimes find we know more than them.”
Other managers, Souede says, have been so meticulously coached that their presentations can be hard to tell apart. Permal analysts frequently ask such managers to explain their business in simple terms and to clearly state what kind of edge they have and what their strongest convictions are. The final-cut debate on each fund is led by what the firm calls a “champion” of that particular fund, usually an analyst who has studied it inside-out.
The second piece of the Permal process — portfolio construction and asset management — is run by a four-member investment committee (Souede, Hodge, deputy CIO Robert Kaplan and executive vice president Judy Tchou). Souede believes in top-down analysis — deciding on an investment strategy in advance of selecting a mix of hedge funds. “In the early days the hedge funds themselves took you to the next opportunity,” he says. “Today funds of hedge funds need flair, and they need to add value themselves.”
Permal put this concept into motion in 2003, when it predicted a multiyear bull market in natural resources but could find few managers to exploit the opportunity. Its solution was to call some of the best managers it knew and ask them to trade natural resources — among them, Hong Kong–based Lloyd George Management, a hedge fund firm specializing in Asian assets. Permal is pushing the idea even further now, undertaking more of what it calls “product engineering” to find high-tech-focused funds, which Souede predicts will outperform in the long term.
The third prong of Permal’s investment approach — risk management and monitoring — is run by the firm’s quant group in London under the supervision of Julian Shaw, a former head of risk management at Barclays Capital. The group makes a particular effort to hunt down cases of autocorrelation — where returns are suspiciously smooth month to month — believing that it is a major predictor of potential drawdowns.
Risk is also explored in broader business terms. In 1990, Permal hired chief operating officer Thomas DeLitto from defense contractor Condec Corp. at a time when few hedge fund firms had COOs. DeLitto’s team sets up new vehicles, administers funds, deals with regulation and compliance and runs Permal’s training program, which has seen senior staff turnover reduced to nil over the past couple of years. The development of such an infrastructure — more reminiscent of a traditional asset management company than a hedge fund firm — has made an impression on the biggest investors: Institutions now represent 25 percent of Permal’s assets, up from 1 percent in 2000.
Souede’s process may not seem remarkable, as many fund-of-funds firms boast similar approaches. But it is one thing to espouse something and another to implement it. “The whole industry says it can do manager selection and combine it with asset allocation,” notes Jeremy Rowlands, chief executive of London-based Caliburn Capital Partners, which manages $1 billion in funds-of-hedge-funds assets. “But very few actually can.”
Successful as it has been over the years, Permal’s methodology is under extreme pressure these days. Much of the hedge fund industry is losing money, and Permal is now focused mostly on protecting capital. The firm made sweeping changes in the composition of its funds at the start of the year, in anticipation of turmoil to come. It trimmed its commodities allocation to 13 percent from 20 percent over concerns about short-term headwinds. Within that allocation, Permal increased its position in precious metals and lowered its exposure to energy. The long-short equity manager allocation was rebalanced to reduce the net long bias. In addition, Permal’s long-biased strategies were refocused into higher-growth regions like the Middle East, where liquidity has been rising.
More drastic changes had occurred earlier. At an investment committee meeting in late 2006, Souede argued forcefully for a radical restructuring of the firm’s portfolios. “The world was becoming a lot less liquid in general,” he recounts, “so we decided to purge any manager in the structured-credit or asset-backed space, particularly if they were highly levered.” Peloton Partners, the $4 billion London-based hedge fund investing primarily in asset-backed securities, was one of several hedge fund firms that were let go — to the disappointment of its executives, who called Omar Kodmani, the London-based Permal director who monitors distribution and oversees international investment activity, a year later to ask Permal to reconsider.
“They told me that they had just won a hedge fund industry award and that we must feel silly for not getting back in because their performance had been so good,” Kodmani recounts, conceding that Permal missed out on Peloton’s astonishing return — almost 87 percent — on its asset-backed-securities fund in 2007. But early this year, Peloton collapsed and Permal avoided one of the largest hedge fund failures ever. The decision to bail out early — and to stay out — was in keeping with the importance Souede puts on liquidity.
In practice this means that Permal’s portfolios typically invest roughly two thirds of their assets in long-short and macro funds, about one fifth in fixed-income strategies and some 15 percent in event-driven strategies. Permal rarely invests in funds with leverage of more than 100 percent. And discretionary investments are preferred over quantitative strategies. Of the $10 billion Permal manages in its macro funds, for instance, 42 percent is discretionary — run by hedge fund managers themselves — and 36 percent is systematic, run on quant strategies modeled by computers. The balance is split between two niches: natural resources and relative value.
In volatile markets like these, the emphasis shifts even further to human intervention in the funds and away from quantitative measures, which are notoriously unreliable when economic cycles are at tipping points. So to make sure funds meet Permal standards, the firm has begun to “scrub” each of its manager files quarterly. Analysts are asked to review funds they have not examined before, looking at performance, style drift, organizational changes, personnel turnover, assets under management and changes in liquidity terms, fees and governance. The goal is to demonstrate a consistency that helps persuade institutional investors that this is a firm to be trusted, even if short-term performance is occasionally off.
To some extent, Permal is pinning its hopes for continued expansion on Kodmani, who arrived from Scudder Investments in 2000, and Lawrence Salameno, who also joined the firm in 2000, from Merrill Lynch & Co. Before 2000, Permal’s sales were made almost entirely through the global-distribution platform run by Merrill Lynch (which is being bought by Bank of America Corp.). This meant it was competing for shelf space alongside dozens of other money managers and funds. Kodmani, who had previously developed Scudder’s international mutual fund business, set about building a
direct-sales capability in Europe for Permal. His approach was simple: He made a list of 20 banks, then knocked on their doors. Prudential Securities signed on quickly, and other banks followed. Recognizing the potential for direct sales, Permal gave Kodmani a free hand.
The plan was spectacularly successful. In 2000, 90 percent of Permal’s sales came through Merrill Lynch; now just 30 percent do. Future markets include the U.S., where Permal has little direct distribution. In January the firm hired Joshua Levine, former head of BlackRock’s Latin American institutional unit, to jump-start that effort, and in September, Huey Richardson from Merrill Lynch’s equities securities lending desk joined the push. Permal will also focus more on the Middle East and Asia, which it sees as the greatest growth regions. But rivals are circling the same markets. Sophia Brickell, an investment director at London-based, $25 billion fund of funds GAM, says volatility is helping her firm raise assets in Asia: “In Hong Kong and Singapore, there is a feeling that hedge funds are risky products, so funds of hedge funds — with their risk diversification and access to a spread of the best managers — are more attractive than single-manager investments.”
For the moment, though, even the largest funds of hedge funds are focused on surviving the turmoil. The hope at Permal is that its chief executive’s knack for finding high-performance hedge fund managers will stay intact and that the firm can maintain its sense of when to get out of something, as it did more than a decade ago with a certain big name.
“We saw a marked degradation of risk-adjusted returns from Soros in 1995–1996,” Souede says. “We had no hesitation in exiting.”
