Michael Hennessy, co-founder and managing director of investments at $9 billion Morgan Creek Capital Management, likes to keep an eye on what the hedge fund managers he invests with drive. If one of them suddenly starts tooling around in a brand-new sports car, Hennessy begins to worry. “Red Ferrari syndrome,” as he calls it, implies that the manager might not be paying as much attention to Morgan Creek’s assets as he or she should be.
Anything suggesting inattention, in Hennessy’s view, can only be a bad thing, especially after a year in which there was so little good news for the hedge fund industry. The huge influx of cash into the sector before 2008 helped fuel record growth, and the biggest enablers of the boom were institutional investors who enthusiastically adopted what has come to be termed the endowment model of investing — a strategy best known for encouraging a large, diverse allocation to alternative asset classes like hedge funds. Few have been bigger proponents of the model than Hennessy and Mark Yusko, CIO (and one of the four co-founders) of Morgan Creek, which is based about three miles from the campus of the University of North Carolina in Chapel Hill.
All the rage as recently as a year ago, endowment-style investing has since come under sharp scrutiny. In a research report published in January, Standard & Poor’s noted that investing in alternatives now can “come at a price” that may be unacceptable to some institutional investors:
“Under certain conditions, such as the currently volatile markets, alternative investments are proving difficult to convert into cash.”
Last year was tough on most investors, and those who follow the alternatives-heavy endowment model weren’t spared. Yale University’s endowment — managed by David Swensen, who is generally credited with inventing the approach — lost about 25 percent of its value in the last six months of 2008 to end the year at $17 billion. Massachusetts Institute of Technology’s $8 billion endowment fell by a similar percentage, as did the $4.9 billion endowment of Duke University (where Hennessy was an investment director from 1991 to 1999).
Morgan Creek struggled similarly. Although its Tiger Select Absolute Return fund of hedge funds, now just shy of $1 billion, plummeted 52 percent in 2008 — hurt by leverage and the temporary ban on short-selling, according to investors — the firm’s typical client portfolio was down about 24 percent. This year, by the end of the first quarter, that typical portfolio was up by low single digits, compared with a 10.98 percent drop in the S&P 500 index. Hennessy stands firmly by the classic endowment-investment strategy: “What is the best position to take a portfolio into the future? Is it going back to stocks and bonds only? I don’t think so.”
Investors appear to be sticking with Morgan Creek. Hennessy says withdrawals have been minor. Yusko and Hennessy both say liquidity is not an issue, though some of the firm’s managers have put up gates restricting redemptions. The two men founded Morgan Creek (with Neil Kuyper and Dennis Miner) in 2004 after five years of running the endowment at UNC, where Yusko was chief investment officer and Hennessy was vice president of investment. They gained a reputation for being among the most aggressive allocators to hedge funds and other alternative assets, including private equity and real estate. By the end of the Yusko-Hennessy reign, 84 percent of the UNC endowment was allocated to alternatives, and it had money with more than 200 hedge funds. It had an annualized 9.7 percent return during the time Yusko and Hennessy were running things.
But a falling-out occurred. In 2003, Yusko and Hennessy formed UNC Management Co. under an arrangement, common at large university endowments, that allows money managers to achieve economies of scale (UNC Management Co. aggregated assets of the main UNC endowment and several smaller funds at the university) while reducing public scrutiny of manager salaries, an always controversial topic at public endowments. After a change in the makeup of the board overseeing UNC Management, Yusko lost support for a proposal to run outside money. He quit in June; Hennessy followed five months later.
The partners had the good fortune to start Morgan Creek at the height of a wave of interest in the endowment approach. Another stroke of luck: getting seeding from renowned hedge fund manager Julian Robertson Jr., founder of New York–based Tiger Management Corp., which in the late 1990s had more than $22 billion in assets under management and had developed an almost fanatical following, especially among institutions that were early adopters of alternatives. The Robertson relationship gives Morgan Creek access to the network of Tiger affiliates. As a result, the firm has money with many funds that most investors have until recently found almost impossible to get into, such as Stephen Mandel Jr.’s $13 billion Lone Pine Capital. But there’s no doubt that the relative underperformance last year by some Tiger-related managers hurt Morgan Creek. “Some of the best managers in the world did far worse than the indexes,” Hennessy notes.
The firm invests in more than 200 hedge funds (plus more than 100 funds in other asset classes like private equity). They run the gamut from the obscure, like Barcelona-based $300 million-in-assets Pyrenees Investments, which invests in emerging markets, to the well known, like $29 billion Paulson & Co. in New York. More retiring than Yusko and not nearly as widely known, Hennessy, 52, has nonetheless been just as important in the growth of Morgan Creek. And he’s no sucker for a red Ferrari. He drives a Honda CR-V (having given his 1992 Volvo to his then-16-year-old daughter two-and-a-half years ago). He spoke recently with Alpha Staff Writer Imogen Rose-Smith about the endowment model and the future of alternative investing.
Alpha: How do you define endowment-style investing?
Hennessy: What it is not is just assembling a portfolio that is merely heavy on alternatives. It is a disciplined application of a long-term investment strategy that strives to achieve defined objectives, generally to meet one’s real spending needs — “real” meaning after inflation. Say 5 percent is a typical endowment spending rate and long-term inflation is 3 percent; to achieve your goal you probably want to shoot for 9 percent nominal returns over a long time horizon. This entails a relatively aggressive asset allocation, but one that is highly diversified. It is also highly tactical.
As the endowment approach took off after 2000, did investors really understand it?
Some did, too many did not. This is very difficult to do well, and it is also costly. Some investors didn’t understand what they were doing, some didn’t allocate sufficient resources to the task. Some made both of these big mistakes.
What’s a simple way of stating the benefit of adding a diverse group of alternatives to a portfolio?
Instead of golfing with just a driver and a putter, now you’ve got 15 clubs in your bag.
But those 15 seemed to be the same club last year.
You’re right, we had the biggest crisis in anyone’s working history and, literally, all correlations went to one. That was the case for nine weeks — nine weeks really accounted for the bulk of what happened last year. Some of the best assets out there performed the worst during that period.
There was no preparing for that?
The only thing that would have withstood that kind of market was either an all-cash portfolio — and that’s a portfolio that would have done poorly for decades before and would do poorly for decades going forward — or some guy who made a one-time lucky market-timing bet. There’s not one person out there who consistently times the markets right. That’s not a viable strategy.
Did Morgan Creek make mistakes?
We’re really good at picking talent and at portfolio construction. But you have to have some reliable tail insurance. We thought we had it by being short credit and short financials, the highest conviction trades I think we’ve had. But that wasn’t reliable enough. We didn’t imagine that the government would ban short-selling.
When do you stay with a manager who’s done badly?
If a guy has had a really bad year but his long-term track record is good, you ask yourself, “Has he lost it? Has he gotten too big? Has he gotten red-Ferrari syndrome or golf syndrome or trophy-wife syndrome” — or whatever you want to call it — “Richer than God? Is he really driven anymore?” In the final analysis you really don’t know. Sometimes maybe it’s as simple as baseball — some of the greatest players fall into slumps, and maybe that’s the best time to give them some more money. Likewise, when they’re knocking it out of the park, maybe that’s the time to trim back.
At some point a player’s career comes to an end.
There’s a life cycle for managers. Does he still have a lot of pride and ego invested, still have a true sense of loyalty to his partners and investors? Is this still truly his passion? If so, he’s probably still got it. But arrogance is one indicator that something is wrong. If you see arrogance building up, that is a warning sign. Confidence, yes; arrogance, no.
Do you think endowments should be more closely run by their governing committees?
I think it has been proven that guys who meet quarterly or even monthly — they just can’t do it. This is hard, complex work, so you need a lot of resources and good people fully engaged on a daily basis.
You’ve raised a distressed-asset fund. Isn’t that already a pretty crowded trade?
There will be rolling opportunities including convertible debt, bank debt, the alphabet soup of carefully chosen tranches of select collateralized debt obligations, collateralized loan obligations, asset-backed securities, residential-mortgage-backed securities, high yield, classic corporate debt and an entire financial sector that’s distressed. While it is true that there is much capital amassed to pounce on distressed opportunities, the size of the opportunity is still far greater.
What’s the best investment strategy going forward?
A lot of that phenomenon of correlation going to one last year was related to the crisis, because there was just massive and instant panic and deleveraging. Although that’s probably not over, you look at this year so far, and the outperformance by hedge funds is massive. In the first quarter hedge funds were flat to up compared to the markets’ being down. Three months doesn’t a jury decision make, but I don’t think the hedge fund model or the endowment model is broken.
