NEWS ANALYSIS

4
Hedge Funds Review August 2011 www.hedgefundsreview.com
More competition gives buyers on secondary market better pricing
The average discount as a percentage
of net asset value (NAV) of hedge
funds and funds of hedge funds sold
on the secondary market increased to
63% for the month of July.
This rise in pricing was reflected by
an increasing supply of more widely
held funds that tend to transact at
prices closer to par as well as a gen-
erally improving distribution cycle
from a large number of the more
active secondary funds.
As the secondary market has con-
tinued to mature with a growing
number and range of buyers, general
partners have allowed greater transpar-
ency to underlying assets remaining in
illiquid hedge fundclasses.
FoHFs see limited diversication benets
By Kris Devasabai
Investing in hedge funds can be a
risky business. For this reason it is
logical to assume funds of hedge
funds (FoHFs) should protect them-
selves by diversifying across as many
underlying hedge funds as possible.
However, a recent academic study
led by Stephen Brown, a professor
of finance at New York Universitys
Stern School of Business, chal-
lenges this assumption. A misplaced
emphasis on diversification may be
contributing to performance deg-
radation and increased tail risk in
FoHFs, according to the study.
Brown and his research team ana-
lysed the impact of diversification
on the performance of 3,767 FoHFs
that reported monthly returns and
the number of their underlying
fund holdings to the BarclayHedge
database between January 2000 and
March 2010.
They found the benefits of diver-
sification in terms of reducing
monthly standard deviation tended
to peter out at between 10 and
20 underlying hedge funds while
diversification beyond 25 funds
in most cases led to a significant
reduction in relative performance.
Their analysis also revealed over
diversification across 25 or more
hedge funds actually increased left
tail risk for FoHFs.
One of the studys conclusions
is that diversification has limited
benefits for FoHFs because all hedge
fund strategies are exposed to the
common factor of liquidity risk.
This idea that you can protect
yourself by investing small amounts
of money in many hedge funds,
while comforting, is a myth, said
Brown. We know that all hedge
funds will do rather badly in a big
liquidity crisis. Diversification can
actually concentrate this risk for
aFoHF.
The results of the study indicate
many FoHFs are over-diversified.
Almost half the FOHFs in the Bar-
clayHedge database had over 20
underlying funds the point at
which the risk-reducing benefits of
diversification tend to plateau. More
than a third of FoHFs held more than
25 underlying funds where diver-
sification has a negative impact on
performance and tail risk.
Over-diversification may have
contributed to the high failure rate
among FoHFs during the financial
crisis. The Lipper TASS database
shows that 22% of FoHFs and 30%
of multi-strategy hedge funds failed
when the markets came under tre-
mendous liquidity pressure in 2008
and early 2009, the highest failure
rate of any hedge fundcategory.
This result suggests tail risk expo-
sure is non-diversifiable, at least
when the investor is limited to hedge
fund strategies that are all exposed to
the common factor of liquidity expo-
sure, according to the study.
The study elicited a mixed reaction
from FoHFs.
Eric Attias, chief investment officer
(CIO) at Nexar Capital Group, said
he strongly agreed with the findings.
We think the sweet spot for FoHFs
is 20 names, he said. Having more
than 20 funds does not protect you in
a market shock and it reduces your
performance and Sharpe ratio in the
long term.
Attias was previously CEO of SG
Asset Management (SGAM) in New
York. At SGAM he worked with
the banks global head of hedge
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Jul Jun May Apr Mar Feb Jan Dec Nov Oct Sep Aug
60% 57% 57%
65%
61%
58% 58% 60% 58% 60% 60%
63%
Asset-based lending
Illiquid/distressed
Emerging markets
Legal claims
Private equity
Real estate
Diversied assets
Bank
Funds of funds
Endowment
Family ofce
Pension funds
Private equity
This has generally helped to
improve levels as buyers gain more
pricing comfort and face wider com-
petition for transactions.
Asset-based lending strategies
increased in supply and transaction
volume throughout July.
A growing supply (and subsequent
demand) for multi-strategy fund side
pockets was also a characteristic of
the market in July.
The side-pockets typically con-
tained private equity and real
estateassets.
A continued trend of private equity
buyers entering the hedge fund sec-
ondary market was also observed
during the month.
Market comment provided by Tullett Prebon (Equities) (www.
tullettprebon.com) which is authorised and regulated by the UK
Financial Services Authority.
We think
the sweet
spot for
FoHFs is 20
names
Eric Attias,
Nexar Capital
Group
HFR0811 004-008 news.indd 4 05/08/2011 15:51
NEWS ANALYSIS
5
www.hedgefundsreview.com Hedge Funds Review August 2011
funds, Ari Assayag, to develop and
launch SGAMs flagship FoHF which
invested in only the 20 best hedge
funds identified by the research
teams across multiplestrategies.
The SGAM FoHF consistently gen-
erated strong alpha and did a better
job of protecting investor capital
than its peers during the financial
crisis, Attias said.
If you limit the portfolio to 20
names, you need a strong process for
identifying the best strategies and
managers. It also forces you to be dis-
ciplined because if you want to add
a name, you have to remove another
one, said Attias.
We think thats the right way to
run a FoHF and were sticking to
those principles at Nexar, he said.
Morten Spenner, CEO of Interna-
tional Asset Management (IAM),
said he also generally agreed with
the findings of the study. IAM
runs conviction-driven portfolios
with holdings numbers between
10-25names.
However, Michael Beattie, CIO
at Tradex Global Advisors, said the
study did not reflect the way he
thinks FoHFs should be managed.
The number of underlying funds in
our portfolio changes significantly
depending on our view of the market
environment and the number of
strategies and managers that we
think can generate an attractive
return at a certain point in time,
hesaid.
Tradex runs concentrated port-
folios of 15 to 20 funds when the
alpha opportunities for hedge funds
are limited and liquidity is a concern.
But if the world is very liquid and
there are a lot of opportunities for
hedge funds, we dont need to put
ourselves in the position of trying to
pick the three best themes and run-
ning it with 20 managers. I would
rather have five or six of the best
themes in the portfolio and run with
40 or 50 managers, said Beattie.
However, for Brown the data
from BarclayHedge did not indicate
that the average FoHF dynamically
adjusted the number of funds in its
portfolio in this way. There was very
little change from one quarter to
another, he said.
There are a number of practical
reasons for FoHFs to limit diversi-
fication, according to Brown. The
most important of these is the cost
of conducting annual due diligence
on hedge funds, estimated between
$12,500 and around $50,000 for each
fund in theportfolio.
Given that due diligence is costly,
the appropriate level of diversifica-
tion for a FoHF is dictated in part by
its assets under management (AUM).
FoHFs that are larger can afford more
diversification, he said, because they
have greater economies of scale.
Brown outlined a simple baseline
LEVEL OF DIVERSIFICATION IN FUNDS OF HEDGE FUNDS (FOHFS)
Number of
underlying funds Number of FoHFs Average AUM ($m) Median AUM ($m)
Percentage that survive
due diligence test
1-2 44 66.31 20.50 32
3-4 18 113.71 15.90 6
5-6 102 257.47 26.36 17
7-8 42 217.02 10.63 24
9-10 71 206.44 19.14 30
11-12 68 46.43 26.60 10
13-14 52 131.61 55.52 13
15-16 95 77.90 25.46 13
17-18 65 131.47 47.00 18
19-20 96 152.41 39.65 15
21-25 161 195.96 71.03 19
26-30 158 325.19 130.29 22
31-40 124 419.84 129.19 20
41-50 74 560.38 108.20 24
51-409 75 571.71 171.00 23
Sources: Brown, Gregoriou and Pascalau (2010), BarclayHedge
test for determining if a FoHF is over
diversified. If the FoHFs annual
management fees divided by the
number of constituent funds does
not exceed $12,500, then it cannot
afford to perform even minimal due
diligence on the funds in its portfolio.
Assuming it charges an industry
standard 1% management fee, a
FoHF with 25 underlying funds
would need $31.25 million in AUM
to pass this test. Surprisingly, when
Brown and his team applied this
test to the FoHFs in the Barclay-
Hedge database, only around a
quarterpassed.
Due diligence is a source of alpha
for FoHFs and there is evidence
of increasing returns to informa-
tion. The study found performance
among FoHFs is strongly correlated
to increasing AUM and hence their
ability to perform due diligence
on a large number of hedge funds.
However, even the largest FoHFs
show performance degradation once
they diversify beyond 25 underlying
funds.
As due diligence is costly and
information on hedge funds is diffi-
cult to obtain, Brown argued smaller
hedge funds should specialise and
invest only in the funds for which
they have sufficient information.
This implies smaller FoHFs may
actually capture more alpha if they
were relatively under-diversified.
The performance fee model in the
hedge fund industry also provides
another reason to keep diversifica-
tion within limits. FoHFs must pay
performance fees to underlying
funds that deliver positive returns
irrespective of the performance of
the FoHF as a whole. The higher the
number of funds in a FoHF, the larger
the accumulation of incentive fees,
which becomes a fixed charge pay-
able by the investor whether or not
the FoHF performs poorly.
Finally, the study argues as there is
only limited evidence of hedge fund
performance persistence, having a
large number of hedge fund man-
agers in a FoHF may be counterpro-
ductive. It concluded there are not
enough first-rate hedge fund man-
agers to justify over diversification.
We know
that all
hedge
funds will
do rather
badly
in a big
liquidity
crisis.
Stephen Brown,
Stern School of
Business
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HFR0811 004-008 news.indd 5 05/08/2011 15:51
NEWS ANALYSIS
6
Hedge Funds Review August 2011 www.hedgefundsreview.com
By Madison Marriage
Alpha Strategic, an alternative invest-
ment market (Aim)-listed company,
is offering hedge funds access to oper-
ating capital in exchange for a slice of
fee revenues.
The company has already established
fee-sharing deals with leading hedge
fund groups Winton Capital Manage-
ment and Ikos Asset Management.
The company, founded in 2005 and
listed on the alternative investment
market (AIM), hopes to bring on board
institutional and retail shareholders
attracted to the potential dividends
hedge fund fee payouts could supply.
The cut of the management and
performance fee revenues is a func-
tion of the hedge fund managers total
assets under management (AUM) and
expected performance. In return Alpha
Strategic provides the hedge funds with
cash and shares.
If a manager sells the percentage
equivalent of $1 million of the funds
fee revenue, Alpha Strategic might
offer $4 million of cash and shares. This
capital can be used to facilitate growth
or expansion plans.
Listed hedge funds may also be inter-
ested in the model when they are about
to undergo a liquidity event such as
restructuring the shareholder register.
We can be used as a mechanism to
help [the hedge fund] achieve [a share-
holder exit] efficiently, elegantly and
tax efficiently without them ceding any
other control. Alternatively, the shares
can be reallocated to the next layer of
management, explained Alpha Stra-
tegic CEO Nicola Meaden.
Alpha Strategic already has a number
of institutional shareholders, including
French bank Banque Federative du
Credit Mutuel which has a 3.25% stake.
According to Meaden, such institu-
tions find the Alpha Strategic proposi-
tion compelling as they can increase
their hedge fund exposure without
having to find a new FoHF or increase a
current FoHF investment.
Winton and Ikos both have holdings
in Alpha Strategic Ikos 13.14% and
Winton 3.34%.
Hedge funds tap Alpha Strategic for operating capital
Meaden expects the market capital-
isation to grow rapidly since the addi-
tion of Northill Europe Holdings as a
majority shareholder in May 2011.
She is confident more managers
will join the model, providing all
shareholders with regular dividends
based on a spread of fee revenues
from a range of hedge fund strategies.
Right now the companys market
capitalisation is small at 5 million
($8.2 million), Meaden admitted. As
the market cap grows, I know there
are investors at the institutional and
retail end who find Alpha Strategic
very effective if they wish to have
exposure to hedge fund investment
management, she asserted.
Northill has invested an initial 2.5
million ($4.1 million) in Alpha Stra-
tegic representing a 51% stake in the
company. This should improve Alpha
Strategics ability to strike deals with
hedge funds by providing a substan-
tial treasure chest of cash with which
to do smart transactions.
These transactions or fee revenue
agreements are approved by Alpha
Strategics board which has now
been joined by Jonathan Little, the
founder of Northill. Although Northill
has de jure control of the company,
it has complete faith in its current
management structure and board,
Meadensaid.
With this influx of capital the
smallest deal Alpha Strategic will
complete from now on would be for
$1 million of fee revenue.
Alpha Strategic is looking for top-
tier hedge fund managers within the
top quartile of their respective strate-
gies with integrity of investment
strategy and integrity of business
management, said Meaden.
All managers go through tough
times and have a year or two when
performance is flat, but do they keep
their existing investors or do they all
walk out of the door? she questioned.
Meaden is not interested in com-
petitive fee structures at the hedge
funds themselves. Its all about the
potential for gross revenues, she
explained. Alpha Strategic there-
fore considers fee structures across
the board from 1.5% and 20% to
2.5% and 25% management and
performance fees.
Meaden is positioning the company
as an alternative to FoHFs and Ucits
hedge funds. I want to turn the FoHF
business model on its head for share-
holders and create the ultimate FoHF
proxy, she declared.
There are some excellent FoHFs out
there that do exactly what it says on the
tin: charge fees their clients are happy
paying and they really do add value.
There are an awful lot out there that
dont, she added.
Our objective is to give investors
an alternative. The retail investor gets
treated like an idiot by regulators and it
is incredibly difficult for retail investors
to get exposure to high-quality hedge
fund management investments, con-
cluded Meaden.
Collaborating with Alpha Strategic
is also a way for hedge funds to pro-
vide smaller investors with access to
theindustry.
You could argue Ucits products
enable you to do that, but with the
exception of a couple of strategies I
think many of them are a complete
con for assets from investors who dont
know any better trying to fit a square
peg into a round hole, said Meaden.
Alpha Strategic was originally the
brainchild of the companys chairman,
Colin Barrow. Having been approached
by Barrow, Meaden invested in the
company when it floated on AIM in
September 2005. In October of that
year, she joined the company and
became CEO in 2008.
Both Meaden and Barrow have sub-
stantial experience. Barrow was for-
merly managing director of ED&F Mans
(now Man Group) funds division. He
was also chairman of Sabre Fund Man-
agement from 1996 until 2005.
Meaden was a commodities trader
before setting up Trading Advisors
Selection System in 1990. The com-
pany eventually became Lipper Tass.
She joined Blackstone in May 2001
to set up its hedge fund operations
inEurope.
Our
objective
is to give
investors an
alternative.
Nicola Meaden,
Alpha Strategic
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HFR0811 004-008 news.indd 6 05/08/2011 15:51
NEWS ANALYSIS
7
www.hedgefundsreview.com Hedge Funds Review August 2011
By Madison Marriage
The European Securities and Markets
Authority (Esma) has been given
the task of fine-tuning the European
Unions alternative investment fund
managers (AIFM) directive and over-
seeing the latest changes to Ucits rules.
Esma is consulting with the hedge
fund industry on the AIFM directive and
is seeking feedback on its policy guide-
lines for Ucits exchange traded funds
and structured Ucits.
The authority is expected to provide
the European Commission with its final
recommendations for the implementa-
tion of these rules based on industry
and public feedback by November.
The AIFM rules have provoked con-
troversy since the first draft was pub-
lished in April 2009. The furore about
the directive has never been fully stilled
and questions remain over whether the
proposed passporting regime for Euro-
pean hedge fund managers is feasible.
Esma has also been given the task of
supervising Europes credit rating agen-
cies as well as introducing harmonised
guidelines on automated trading by the
end of 2011.
Recent statements from Esmas
chairman, Steven Maijoor, and the
European Commissioner for internal
market and services, Michel Barnier,
suggested Esma will lean towards rec-
ommending tighter regulation of the
European financial services industry
ingeneral.
We need more, not less, European
supervision in the internal market,
Barnier declared at the official inaugu-
ration of Esma in early July.
Maijoor reiterated this fervour for
increased oversight following the release
of an Esma consultation paper later in
July. The paper proposed guidelines for
automated trading platforms and invest-
ment companies, which would have a
major impact on high frequency traders.
A common interpretation of the
existing requirements in Mifid [mar-
kets in financial instruments directive]
will ensure that safeguards in relation
to electronic trading systems will be
applied in a homogenous manner and
that increased competition in a highly
automated trading environment will
not lead to an uneven playing field,
hesaid.
However, there are lingering con-
cerns over the regulators capacity to
create coherent policy in such a short
time frame and with limited resources.
Staff and budgets are an issue, Sharon
Bowles, chair of the economic and
monetary affairs committee, conceded
during Esmas inauguration.
The important job of Esma must not
be impeded by starving it of the neces-
sary resources and this is a matter to
which we will have to return. Resources
must match tasks, Bowles warned.
Esmas limited capacity was also
underlined by its chair, Maijoor. It is
clear that Esma has many tasks and
responsibilities, and the number of tasks
will increase in the future. Today, only
50 people are working for Esma. This is
clearly very challenging, he admitted.
Despite its limited resources, Barnier
called on Esma to take on further
responsibility by becoming the super-
visor for trade repositories and over
the counter (OTC) derivatives. He also
wants the European Parliament and
Council to enable Esma to enforce
short-selling restrictions in excep-
tionalsituations.
On top of these tasks, Esma is cur-
rently charged with establishing a com-
mittee on financial innovation. Working
with the European Banking Authority
and the European Insurance and
Occupational Pensions Authority, the
committee aims to create more consist-
ency across sectoral financial products
andservices.
The committee will carry out research,
including data collection from national
regulatory authorities and analysis of
trends, with a view to keeping track of
financial innovation by monitoring new
and existing financial activities.
Esma may also implement a system
for issuing investor alerts or consumer
warnings relating to specific product
types, selling practices or activities in
addition to any outright bans that it
puts in place.
Advising and deciding on such
significant pieces of regulation while
carrying a workload that seems to be
increasing by the week begs the ques-
tion whether Esma has bitten off more
than it canchew.
Esma exes its muscles
Steven Maijoor,
chair, Esma
www.mamotcv.com
Mamo TCV Advocates
Palazzo Pietro Stiges,
90 Strait Street
Valletta VLT 1436, Malta
T: (356) 2123 2271 / 2123 1345
F: (356) 2124 4291 / 2123 1298
E: financialservices@mamotcv.com
Committed
to excellence
Mamo TCV Advocates is a tier-one law firm in Malta with
a strong international practice and actively involved in
all areas of commercial law, with a particular focus on
financial services and structuring and on-going advice
to investment funds.
Read more online
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HFR0811 004-008 news.indd 7 05/08/2011 15:51
NEWS ANALYSIS
8
Hedge Funds Review August 2011 www.hedgefundsreview.com
Soros, Singer and succession planning
By Kris Devasabai
George Soros surprised the hedge fund
industry in July when he announced
he was closing the Quantum Fund and
returning money to outside investors.
Soros said new regulations requiring
hedge funds to register with the Secu-
rities and Exchange Commission
(SEC), introduced as part of the Dodd-
Frank financial reforms, were the main
reason behind his decision.
Soros Fund Management has effec-
tively been operating as a family office
since 2000 when it stopped accepting
new money from external investors.
Rather than register with the SEC,
Soros opted to return around $1 billion
to external clients and focus exclu-
sively on investing his personal wealth
and that of its founder and his family.
Soros joins a growing list of hedge
fund legends that have decided to
shutter the businesses they built from
scratch rather than engineer a plan for
succession or institutionalisation.
Stanley Druckenmiller, who man-
aged the Quantum Fund in the 1990s
before stepping down to run Duquesne
Capital Management, activist icon Carl
Icahn and Tiger cub Chris Shumway
have all decided to step away
from their hedge funds in the past
12months.
The closure of top funds has
investors wondering whether other
hedge funds can survive their
foundersdeparture.
Investors are asking questions
about succession planning and
wanting more transparency on what
happens if the founder retires or gets
hit by a bus, said Myron Kaplan,
founding partner of law firm Klein-
berg, Kaplan, Wolff & Cohen.
Kaplans firm is legal counsel to
Elliott Management Corporation,
which recently took the unusual step
of creating a formal succession plan
outlining how the $17 billion hedge
fund business would be managed in
the event of founder and CEO Paul
Singers departure.
Elliott has established a board of
directors that will assume control
of the management company and
make key decisions, including having
the power to appoint a future CEO
if necessary.
The board of directors is the latest
element of a plan that has evolved
over years. A decade ago Elliott estab-
lished a management committee of
senior people from the investment,
risk and operations teams to oversee
the business.
Its key employees are large investors
in Elliots funds and they also have an
equity stake in the management com-
pany alongside Singer. Last October,
Jon Pollack was promoted to co-chief
investment officer, a role he shares
withSinger.
Whats a little different about
Elliott is that it is putting in place
the mechanisms and organisational
changes to create a lasting institution
while the founder is still 100% active,
said Kaplan, who sits on the board
of directors.
That is the right approach in my
view because getting a succession plan
in place is a process and not something
that can be done overnight. You have
to get the right management structure
in place, ensure the long-term incen-
tives and interests of key employees
are aligned with the business and
create an ownership model that can
include and survive the founder,
saidKaplan.
A handful of hedge fund founders
have successfully transitioned owner-
ship of their business to employees,
while others have opted to sell the
management company or part of it
to a larger financial institution. This
strategy has produced mixed results.
JP Morgans acquisition of Highbridge
Capital Management, with co-founder
Glenn Dubin remaining at the helm as
CEO, is generally seen an example of a
modelsuccession.
However, Morgan Stanleys acquisi-
tion of FrontPoint Partners in 2006
appeared shaky from the outset. Its
founders started leaving soon after the
transaction closed. Earlier this year
Morgan Stanley sold FrontPoint back
to its management team.
Despite the varied outcomes, these
types of transactions are expected to
become more common as hedge fund
founders look to realise equity value in
their businesses and create a platform
for succession. York Capital Manage-
ment founder and CEO James Dinan
sold a 30% stake to Credit Suisse last
September, while Izzy Englander is
reported to be in talks to sell a minority
stake in Millennium Management to
the private equity company Founda-
tion Capital Partners.
At a panel discussion at the Salt
conference earlier this year, Dinan
said York had been working on a suc-
cession plan for five years. He said a
current executive at York would likely
take over as CEO when he decided to
step down.
While hedge fund founders appear
to be giving more serious thought
to succession planning than before,
there are likely to be more casual-
ties than survivors as a generation of
hedge fund managers who made their
names in the 1980s and 1990s near
the end of their careers. For many
finding a way for their funds to carry
on after they exit the industry may be
the most impressive trade they ever
pull off.
Closing shop:
George Soros
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HFR0811 004-008 news.indd 8 05/08/2011 15:51