One of the best business lessons David Bailin ever learned came from his father, a jeweler in New York’s Diamond District, who was fond of saying that trust is and ever shall be the coin of the realm. “At the end of the day, the person who buys from you has to trust you,” says Bailin, Bank of America Corp.’s 49-year-old president of alternative investments.
It seems an especially germane rule in the post-2008 investment landscape. Broad losses spurred by the credit crisis began to accumulate across hedge funds last summer and snowballed through autumn, shocking investors who believed they had bought into wealth preservation, at the very least. Then came the unmasking of Bernard Madoff, whose operation apparently wasn’t the hedge fund many thought it was, but rather a black hole that had vaporized billions of dollars invested by funds of hedge funds.
It was a one-two punch that left many investors wondering what to believe. At issue now: “The integrity of their managers, the integrity of their advisers and ultimately their ability to obtain liquidity,” says Bailin, whose job is to shepherd alternative investments for some of BofA’s biggest clients. That entails matching high-net-worth individuals and small institutions with hedge funds, effectively giving them entrée to opportunities that might not otherwise be available. Such a role is more sensitive than ever.
Trust has taken a ferocious hit, and so has the once–$2 trillion hedge fund industry, which has shrunk drastically in the past few months and is probably still shrinking, though Bailin maintains that he sees a new demand for due diligence that will sooner or later help fuel a recovery. “Stay the course,” he wrote in a November paper for clients in which he also said that BofA was sticking with “larger, more experienced institutional managers” who had demonstrated both restraint and success and who “tend to favor less-opportunistic strategies and are less reliant on leverage.”
The bank invests in fewer than 65 hedge funds or funds of funds, all of which must meet rigorous standards (see related story, “A Big Bank’s Smell Test”). BofA won’t disclose the names of the managers with whom it invests, but among the traits they must demonstrate is a proven knack for not losing money, so it isn’t a very big group, especially after last year.
Bailin, who has a staff of 100 and whose job gives him oversight of about $37 billion ($7 billion before BofA absorbed Merrill Lynch & Co.), traces his own knack for business to his youth in Paramus, New Jersey, where he started selling holiday cards door to door when he was 12. Later, he was a bar mitzvah photographer, and before he was 20 he learned the dark art of ticket scalping, lurking outside nearby Giants Stadium to partake in the aftermarket trade in football and concert tickets.
After earning an MBA from Harvard Business School in 1985, Bailin did turns as an executive vice president at two hedge funds, Ellington Management Group and John W. Henry & Co., and in 2006 became head of investments at U.S. Trust Co., the wealth management firm acquired by BofA the following year.
His newest employer seems in no great danger of going anywhere. BofA weathered the 2008 rout of the financial sector far better than most rivals. It is the biggest bank in the U.S. in terms of total assets and is second only to JPMorgan Chase & Co. in market capitalization and deposits. On January 1, BofA completed its purchase of Merrill, sharply expanding its piece of the consumer finance pie (though the deal required a fresh infusion of government capital on top of the $25 billion it had already received). BofA employs about 300,000 people, a number that will decrease as 35,000 announced job cuts are phased in through 2011, and it controls a huge segment of retail banking, counting half of all U.S. households as customers.
The bank is based in Charlotte, North Carolina, but its presence in New York is hard to miss. BofA opened its 54-story Bank of America Tower in midtown last summer, centralizing operations that had been scattered across a half dozen locations in Manhattan. The building is replete with a vast lobby that ties into New York’s subway system and is outfitted with environmentally stylish features such as a system that recycles rainwater for use in toilets.
Bailin has a 19th-floor corner office, where he met with Alpha Senior Editor Karl Cates a few days before Christmas to discuss the state of investor confidence.
Alpha: You just put out a report that estimated the total value of assets run by hedge funds at about $1.7 trillion, down from $2 trillion. Does that number still hold?
Bailin: No, if we’re talking a December 31 number, we would estimate it to be about $1.5 trillion.
And holding?
I would say $1.2 trillion to $1.3 trillion by spring.
Are funds prepared to meet redemption requests?
Most but not all. The ones that aren’t are in one of two circumstances: Either they have created gates or limitations on liquidity or are in the process of going out of business and selling assets. Among the managers we deal with, very few are in the liquidation category.
Are investors rethinking their belief in hedge funds?
Investors clearly have a higher level of concern about their hedge fund holdings and are asking for more information. They wisely want to know more about what it is that their hedge fund portfolio does.
They’re much more conscious about trade-offs in risk and reward and are seeking more advice today than they were a year ago. The most sophisticated investors will reallocate to hedge funds when assets-under-management levels are at their trough.
Back in April you said, “The level of blowups will continue.” But while most funds have had serious losses, it’s not like the industry has been wiped out just yet.
The hedge fund assets actually lost because of exposure to both private and quasipublic financial institutions were relatively minor. The amount of money hedge funds lost in counterparty exposures to failed financial institutions was also minor because they were very vigilant about counterparty risk. Through August the money that hedge funds had lost in general was not that substantial. Then, in September, October and November, hedge funds lost money the old-fashioned way.
Every market, from plain-vanilla equity to derivatives and certainly across the credit space, lost money. Leverage and illiquidity made it worse. Anyone who had any leverage in that environment had their losses multiplied. So when you look back on the year and ask, “How many firms actually closed during the year due to ‘blowups,’” the answer is, not that many. The difference now is the number of firms that are significantly below their high-water marks and that are shrinking in assets under management.
Speaking of leverage, will it be massively curtailed?
How hedge funds are financed is going to change somewhat — the amount of available leverage to hedge funds has been curtailed. Wall Street is still supporting robust, reputable funds.
Do you still recommend hedge funds as part of a well-balanced portfolio?
Yes. Global macro will be strong. Most long-short strategies will be strong. Merger arbitrage will be strong. Event-driven and credit-related and distressed-assets strategies will be strong. Every time an industry goes through a difficult period, it comes out stronger — if it’s a good business.
How surprised were hedge fund investors at the meltdown in equity markets, the credit crisis, the Madoff scandal and the deepening recession?
Some didn’t realize their holdings could lose so much, even in these difficult markets. So you had a mismatch between expectations and the fact that the hedge fund industry is a risk-taking enterprise. Absolute-return strategies get no forgiveness; the term implies a positive return under all market conditions.
Investors were surprised by the confluence of events and that this confluence so deeply affected alternative investments.The fact is that the withdrawal of leverage and the absence of liquidity in the fixed-income markets represented profound and rapid changes in market conditions. Combined with tremendous volatility, a rapid decline in global economic conditions and a virtual investor panic to gain liquidity at any cost, hedge funds saw a wave of redemptions.
BofA recently restated its standards for picking fund managers. The requirements are daunting.
How much does it take for us to not accept a manager on our platform? The answer is, very little. It doesn’t take much for us to say no.
You even require managers to detail mistakes they’ve made and talk about what they’ve learned from them.
You want to hear what the thought process was before a mistake was made and after, so you can get to know how that manager thinks and deals with negative information.
Among the red flags you raise is “undue growth in assets.” I thought bigger was better?
A manager who grows prudently over time and then demonstrates an ability to manage an increased amount of assets we would consider a normal thing. A manager who grows hugely and doesn’t have the experience managing assets at that level would be, in our mind, a warning sign.
Is it at all plausible that you might have invested money with Madoff?
It is not plausible, because of numerous violations of BofA standards. None of the funds advised by Bank of America Alternative Investment Services had exposure to Madoff.
Your November paper ends with the statement: “Stay the course.”
As with every type of investing, you don’t want to be selling at the very bottom, and you want to have a strong portfolio. And so you look ahead. What is the industry going to look like in, say, 2010? You’re going to have battle-tested fund managers who have lived through the most difficult markets of a lifetime. You’re going to have more resolution about where things are really headed.
There is a need now for more fundamental analysis in every sector of the market than there has ever been before. Today the funds have less competition from Wall Street, too little capital and an extraordinary set of investment opportunities.
Can you envision investing in a start-up fund?
Under very specific circumstances. There are opportunities in the marketplace where you would need a stable pool of capital and an excellent manager, and where it would be best to start from scratch.
That would be in asset-backed securities, in commercial-mortgage-backed securities and in bank debt.
Is big regulatory change coming?
We’ll see a different regulatory scheme, and it will change somewhat the nature of how funds conduct themselves.
What we want is a framework where, when someone looks at it and looks at the industry, they have a high degree of confidence that what’s happening in our industry is efficacious and appropriate and that it is being monitored accurately. The hedge fund industry will want it, just as the investor will want it.
We don’t have that now?
No, we don’t.
