Feet in two camps

When private equity returns plummet, as they have for the last three years, even investors in alternative asset classes need alternatives.

When private equity returns plummet, as they have for the last three years, even investors in alternative asset classes need alternatives. It's no surprise therefore that hedge funds are the fastestgrowing alternative asset class of the last two years: they now represent about $550bn of worldwide-invested assets. Although the asset class saw its first net outflow in two years at the end of 2002 and last year's average returns barely kept pace with modest fixed-income products, the best performing hedge funds still deliver double-digit returns.

Against this backdrop, some alternative asset management firms have taken a variation on their own sales pitches to heart and diversified, running both private equity and hedge fund businesses under one roof. Major alternative asset management houses such as Blackstone, the Carlyle Group and Tudor Investments have embraced both of these asset classes with considerable success. Leading alternative fund of funds managers, such as the Partners Group, or Man Group, the world's largest publicly traded hedge fund business, have also straddled both disciplines. While there are stark differences in their strategies, operations and investor requirements, asset management professionals say firms that are up to the job will do better with a foot in each camp.

Diversification
In today's markets, adopting such a hybrid strategy makes sense for an asset manager, says Christof Grosegger, a spokesman for Man Investments, whose parent company Man Group acquired UK-based private equity fund of funds manager Westport at the end of last year.

“There is a strong aspect of diversification in all this,” he says of the purchase of the $1.7bn Birmingham-based fund of funds boutique. “You can offer an extended range of alternative investment products.”

There is no single model for combining private equity and hedge funds under one roof, but both private equity and hedge fund professionals agree that it's easier to add one side to the other through the acquisition of an already established group, rather than starting from scratch.

At the real height of private equity investing, hedge funds were having a hard time, and now it's the other way around

Westport comes under Man's umbrella as part of a longer term acquisition plan by RMF Investments, the Swiss fund of hedge funds firm purchased by Man a year ago. The price tag was sizeable at $833m, but it let the hedge fund firm branch out into private equity through RMF, which had planned to expand to other areas of alternative investments. “They chose to concentrate on hedge funds in the 1990s, but always kept an eye on private equity,” says Marc Dentand, a former RMF executive now working as a managing partner with Westport's founder John McCrory.

A look at how hedge funds work may explain some of the mutual attraction. Because hedge funds and funds of hedge funds can start small – $10m is often enough to get off the ground – they can run as self-contained operations that generate good returns with low expenses. A manager pursues his strategy and markets his positive percentages. Good track records attract more capital, and hedge fund results are easily described. Also, liquidity is much greater than in private equity. For an alternative asset manager scrambling for market share, these are all attractive qualities.

“For private equity, you need an investment horizon of seven to 10 years, at least,” says Urs Wietlisbach, a principal in the Zug, Switzerland office of Partners Group, a $4.5bn asset manager that is among the world's largest private equity funds of funds, with commitments to more than 100 general partnerships. In 2000, the group also absorbed the hedge funds of funds team of Credit Suisse Asset Management. Hedge funds now account for $500m of Partners' capital under management. The money is run in separate managed accounts, and has proved to be a reliable alternative for laggard fixed-income allocations, with targeted returns of between eight and 12 per cent.

Managing the risks
While private equity funds of funds require managers to have a good sense of their underlying funds' portfolio companies and their performance over the long-term, risk management for funds of hedge funds is a daily exercise. “It's more than just finding [good hedge funds] and getting access. You need to understand what they really do,” Wietlisbach says. “We didn't want to invest in things we didn't understand. We didn't want to be in a Long Term Capital Management or Beacon Hill,” referring to perhaps the most infamous hedge fund collapse of all time, and the latter, a more recent meltdown that has done little to ease public perceptions of hedge funds as risky investments.

Partners Group fund of hedge funds invests in only 18 underlying managers, and risk control is perhaps the most important part of its daily operations. Its quantitative analysis team, which analyses its private equity investments, also models the performances of its hedge funds, explains Wietlisbach. “We want to understand the return sources and the risks managers are taking. We take these control measures every day, and we know about every risk profile from the evening before so we still have time to react.”

For direct management of both hedge funds and private equity, concentration in a specialised investment sector, such as distressed securities, or healthcare, allows both effective risk controls and the chance to tailor investor allocations to maximum benefit.

Kurt von Emster, who heads the $250m BioEquities hedge fund run by MPM Capital, says his firm is in the hedge fund business because of its success in biotech venture investing. MPM started in 1996 primarily as a venture capital manager, raising and closing three funds on a total of $1.72bn. As it raised its $600m BioVentures II fund in 1999 and 2000, management decided to add hedge funds to the mix, and hired von Emster and his investment team away from Franklin Templeton Investments.

The practical results of MPM's “cross investment platform,” as von Emster describes it, allow the firm to tailor its offerings to different investor needs, he says. “You're dealing with two very different investor bases. When you have a major institution, they will have one group that analyses venture capital opportunities, and one that analyses hedge funds. Just because we have both doesn't mean we necessarily appeal to both sides of the same firm.”

Hedge appeal
Right now, that's especially true. Hedge funds have a greater appeal to investors than private equity, which means they have more appeal to asset management firms, says Marcos Camhis, director of business development at Capital Management Advisers, a European alternative asset management firm headquartered in Luxembourg.

CMA has $650m under management, but only $30m is allocated to private equity. The balance is in hedge funds. Camhis explains that CMA, which has expanded aggressively in the last two years with a range of structured products linked to hedge fund returns and customised portfolio offerings, simply needs to bring in capital.

“Given market conditions, we have decided to focus on hedge funds as a growth area for the company,” he says. “Our growth has taken place in the years when private equity has had a lot of trouble. The technology sector bubble burst and general capital market conditions reduced the possibility for exits.” CMA has plans to expand and diversify its private equity offerings, particularly in the secondary market, but right now, private equity sparks little enthusiasm. “Because of the liquidity terms of lots of private equity investments, lots of people may feel that they have lost money and are locked into an investment that doesn't have clear potential for profit,“ he says. “Hedge funds provide more liquidity, though I'd say less transparency. But on a month-tomonth basis they can see where the market is going.”

While hedge funds are the investment flavour currently in favour, asset management firms shouldn't see the two asset classes as mutually exclusive, says Dentand of Westport. “We don't think that private equity will disappear, even though it's having a hard time,” he says. “Institutional investors are still making allocations to private equity – it's just that, unfortunately, the portfolios have become much smaller.”

In the past, Man may have seen private equity as a competing asset class, Dentand says. “In 1999, hedge funds were not at the top of so many investors' agendas,” he says. “At the real height of private equity investing, hedge funds were having a hard time, and now it's the other way around.”

For firms managing the money in both asset classes, that's not such a bad thing, he says. “In terms of diversification, it looks like a very attractive proposition, having these asset classes with different cycles.”