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Hedge Fund Monthly

The Case for Levered Fund of Hedge Funds
Pergament Advisors LLC

March 2005

Introduction
Although recent media reports tout the rising popularity of multi-strategy hedge funds, a strong argument can be made for the advantages of investing in a levered fund of hedge funds (FOHF). A levered fund of funds is one that invests money in many hedge funds on behalf of individual and institutional investors using leverage, essentially borrowed money, to achieve double digit returns while mitigating downside deviation.

Today's hedge funds manage the downside better so as to make an optimum degree of leverage a desirable component of a fund of funds investment. It is incumbent on the investor to have knowledge of the underlying leverage and whether there is leverage on top of the leverage, however, and the investor must properly size the managers and the investments. A 5% allocation to a convertible arbitrage fund leveraged six times would not be a wise allocation. However, leveraging a merger arbitrage manager who only utilises 60-70% of cash in the funds may be quite wise. If one is invested with a fund of hedge funds, that entity can hedge some managers with other managers. It has the ability to invest with a long-biased manager because it can hedge out that manager, for example. As with hedge fund investing, investing in a leveraged fund of funds should be done with a long time horizon in mind, as it is difficult to manage for consistent monthly returns.

Clearly, the industry is growing as more and more investors appreciate the benefits a levered fund of funds can offer. Overall, the growth of the fund of funds sector is verified by a UBS study which estimated that overall fund of funds assets grew by more than 46% during 2003 as compared to 31% growth in the single manager hedge funds with which they invest. It also cites a Hedge Fund Research report that shows that 85% of new hedge fund investment is through a fund of funds as compared to less than half in 2000.

The intention of this paper is to address the various structures of levered fund of funds, including fees, liquidity, transparency, capacity, risk management and diversification. In addition, it will review fund structures, analyse a mock portfolio, and review the benefits of levered fund of funds investing. We predict that multi-strategy hedge funds will remain a component of fund of funds, yet will never be a replacement.

I. Advantages of a Levered Fund of Hedge Funds

Because the cost of capital is low it is still a great time to invest in a levered fund of hedge funds. This is due in part to the fact that the interest costs incurred can easily be outweighed by the incremental out-performance generated by the amount of leverage employed.

In recent history, the cost of leveraged premiums has been relatively inexpensive, though in the current cycle of Federal Reserve tightening these costs could increase. This means that a levered fund of hedge funds would need to generate more alpha to cover the cover of capital.

For example, an un-leveraged portfolio returning 1%, in a month, would return 4%, had it been leveraged 4 times. Subtracting the minimal costs of leverage and management fees, it still leaves about 3-1/2% (financing costs are LIBOR +1% to +1.5%).

A second advantage of investing in a levered fund of funds today is their construction, which is typically more diversified than a traditional fund of funds. The largest position is typically 7-9% in a traditional fund of hedge funds versus 4% in a levered fund of funds; this insures protection from directional market movements that might detract from the levered performance results. Levered fund of funds typically have between 40 and 100 underlying funds while a traditional fund of hedge funds may have 20-40 underlying funds.

Thirdly, these funds can deliver returns comparable to the S&P 500 and Nasdaq, with much lower downside deviation.

II. Levered Fund of Funds Structures

Structured products are one way for a fund of hedge funds (FOHF) to leverage the investment portfolio. For example, an investor may buy a call option on the fund's upside returns at a cost that represents a percentage of the total fund investment, thus freeing up assets to invest elsewhere.

There are structures on an estimated $70-90 billion, most of which is on fund of funds, according to UBS. In reality, this number is probably grossly underestimated as RBC (80 billion +), SG Cowen (40 billion+), Lehman, UBP, and others have aggressively entered the marketplace. BNP Paribas has $19 billion invested in structured products, of which 65% is leveraged fund of funds. Another major player, SG Cowen's Lyxor Structured Alternative Investment Funds division, has more than $25 billion assets under management, which represents a substantial portion of Lykor's $56.4 billion total assets under management.

Structured products provide customised solutions to investors' portfolio requirements and take into consideration the level of risk versus return, volatility tolerance and liquidity requirements. Some have principle guarantees. Capital protection can come in many different forms, and the various structures provide different degrees of effectiveness in today's dynamic marketplace. Prior to making an investment in a levered fund of funds it is essential to understand the various ways that these funds are typically structured. Specialised structures also accommodate ERISA accounts and insurance reserves.

Pure, Direct Leverage - a levered fund of funds can increase the amount of capital available for investment into the underlying hedge fund portfolio by accessing a bank lending facility, at two, three or four times leverage of the principal. It would pay an annualised percentage borrow rate on that capital. The investment bank can make a leveraged investment into the fund of funds, and investors can invest through that entity or the bank can provide dollar for dollar matching in the fund.

Actual versus competitive fees are also an issue that should be considered as part of the fund structure, with Libor +150 being high, Libor +50 optimal and Libor +75 adequate. Investors should also know that fees are built into the manager's management fee and additional fees may apply. Top tier fund of funds managers know what to focus on in order to minimise fees and understand how to traverse these complex legal documents.

Optionality Component - a levered fund of funds may include an optionality component based on a minimum option basket value that must be in place prior to making new investments for a leveraged product. This concept was originally designed to achieve tax deferred preferential treatment, but has evolved to play an increasingly major role in levered fund of funds structures. One reason for this is the fact that options are treated more favorably by the government in some instances, although recent court cases have not been consistent in their outcome, which has led some to believe that their effectiveness is debatable. Some tax opinions are worded more strongly than others.

An additional consideration is the contractual expiration period for additional option purchases. For example, if the expirations are in place for ten years they would be staggered as opposed to alternative contractual structures that include same date expirations. The former structure is more conducive for making investments in longer lock-up managers, including, three-year and five-year funds that have private placements. Some funds offer discounted fees for longer lock- up, yet direct investors may be missing out on these. Funds with a short lock-up may be accompanied by premium fees that represent the price investors must pay to achieve greater liquidity, such as monthly or weekly liquidity.

Warrant Structures - a warrant represents an underlying agreement to buy equity, much like an option. With an option, however, an investor has a timeline or term in place that specifies how long the option must remain in effect whereas a warrant typically does not have a set time limitation. At a levered fund of funds, a warrant is the basis for its structure and can take on various forms, as detailed below. In many instances, these structures have also been awarded tax deferred status by reputable law firms.

Tax-Deferred versus Non Tax-Deferred

Capital gains are an important issue to levered FOHF investors. Those invested in non-taxed, deferred funds are liable for annual capital gains taxes. Oftentimes, they redeem shares and use the proceeds to pay for them on an annual basis. With a tax deferred status fund, however, gains may compound for up to ten years, and then will be assessed taxes at the end. This points to the magic of compounding.

Accretive versus Fixed Strike Structures

Optional ways to structure a deal are employment of an accretive or fixed strike. Accretive strike is a newer method, which differs from the traditional fixed strike method. The accretive strike method means that the fund of funds account would never be assessed interest until the options expire. Though positions could not be liquidated, which allows them to fully compound, the fund of funds could conceivably have to pay millions at the end due to interest on interest.

The fixed strike method differs in that interest is deducted monthly, first from cash, and then from the fund of funds' option basket. Essentially, the fund of funds is constantly delevered and there is an issue with respect to unallocated cash versus used cash. The fund of funds is only assessed interest charges on used or drawn down cash, which is easier from an accounting standpoint and leaves enough cash on the table to pay interest charges.

III. Investor Considerations

Due Diligence & Research

As the hedge fund industry continues to grow both in its size and complexity, investors in a levered fund of funds increasingly appreciate the benefit of working with an experienced team of FOHF research professionals. Since FOHF have access to top managers and understand the ins and out of analysing a hedge fund as a prelude to making an investment, they are well-poised to conduct thorough due diligence investigations. Typically, the due diligence process includes several lengthy visits to the hedge fund's office where all aspects of the business are delved into, including a study of strategy, trading procedures, staffing, infrastructure and technology. Investors benefit from this exposure to and monitoring of a large number of top managers from all hedge fund strategies.

During the due diligence process, the research team should dissect alpha and examine the strategy so as to avoid "closet long shops", and beta mismatching that may come in several forms. Thorough investigation of the manager's skill levels and core competencies should be conducted. Factual information related to external service providers such as the prime broker, auditor and administrator is gathered, and a due diligence questionnaire is completed for each visit.

Increased investor attention has focused on the due diligence process as a result of a 2003 study conducted by Capco, a global financial services industry consultant. The study said that although operational due diligence is an integral part of the due diligence process, it is one of the least monitored of all hedge fund related risks and the root cause of many hedge fund failures.

For instance, some teams believe that it is important to travel to the funds' offshore administrators' sites, which could be located in the Cayman Islands. Effective due diligence must include a thorough investigation of the hedge fund's internal systems and processes, relationships with third party service providers, background checks on key personnel and the integrity of the historical performance numbers.

Another issue facing investors relates to the disparity in valuation techniques employed by hedge funds. Positions may be marked differently, anywhere between the bid and offer price, which means that two funds may have a similar portfolio yet report highly disparate results. The Capco study reported that many of the instances of fraud and misrepresentation involved some form of deception regarding the way the hedge fund valued its assets. As this issue continues to attract attention from the media and investors, it becomes an increasingly important component of the due diligence process.

Since few individual investors have the expertise and resources required to perform effective operational due diligence on a fund, the potential for loss is greater if one does not work with an experienced levered fund of funds manager.

A less tangible benefit of working through a levered FOHF, however, is greater access to the intelligence that is gathered from industry peers on a daily basis. Wall Street is relatively incestuous, and those who work at leading fund of funds tend to be well-connected and knowledgeable. As analysts and portfolio managers move from one hedge fund to another, and as new funds open and close, this knowledge is parlayed through the fund of funds grapevine. While this is not meant to advocate a reliance on hearsay, it is advantageous in that intelligence and rumours provide valuable insights into areas that may require additional study. In addition, because the FOHF research team sees so many managers, it is cognizant of their idiosyncrasies, non-verbal messages and other subjective areas that should impact the investment decision-making process. The subjective value of working with a fund of funds should not be discounted.

Diversification

Increased returns and decreased risk are among the important benefits of including a diversified fund of hedge funds in an investment portfolio. This is, in part, because of the fund of funds' understanding of market activity, what works in various environments and how best to correlate investment decisions with respect to market dynamics. While a FOHF's investment decisions will focus on strategy related issues, individual investors may fall into the trap of chasing past performers that may not necessarily be tomorrow's strong performing funds.

Instead, a fund of hedge funds will strive to maintain an all-weather portfolio, inclusive of many strategies, many asset classes and exposure to various inefficient global markets while mitigating the drawdowns through rigorous portfolio testing. Because the fund of funds can dial up and down the investment spectrum, it may elect to patiently await strategies to come back into favour, if it so desires and elects to do so. This may be a wise move, for example, with Commodity Trading Advisors (CTAs) that perform over long periods of time. A fund of funds will increase its exposure when it foresees enduring market trends and decrease exposure after any prolonged stretch of solid performance in advance of trend reversals and choppy trading environments.

Liquidity

Liquidity and lock-ups, the notice period required for investors to redeem funds, represent important issues in an era where the trend seems to be one of increasingly longer lock-ups. Requiring investors to hold their investment in the fund for a longer time period can be advantageous. Fund of funds have the ability to wait patiently for their managers' investment thesis to evolve. This time period is never clearly defined, however, and can take as short as one night or longer than one month to a year. Fund of hedge funds have the ability to negotiate shorter lock-up provisions due to their buying power when establishing new relationships.

Levered fund of hedge funds typically have more liquidity in the underlying managers than individual investors. Additionally, a fund of hedge funds can stagger its redemption terms by buying shares over the course of many months or quarters.

Transparency

Transparency, the investor's ability to monitor positions in the invested funds to generate risk analysis and track potential style drift, is another key area of concern for the fund of hedge funds investor. Investors must insist on the level of intelligent transparency with which they are comfortable. If they are a fund of funds investor, they likely will have the ability to meet with the team to learn more about the underlying funds and their positions. It is important, however, to realise that a levered fund of funds is put together by professionals who are working diligently to achieve solid, risk-adjusted returns over the course of a business cycle. Investing in a levered fund of funds, as with a hedge fund, is a long-term investment and requires a level of trust in the portfolio manager and his team. The headline stories about hedge fund blow-ups, although rare, are good in that they encourage investors to talk with their fund of funds, who already employ ongoing monitoring, about potential red herrings such as fraud and mismarked positions.

Because the fund of hedge funds has a relationship with industry service providers such as fund administrators, accountants and prime brokers, it will have the added ability to gather intelligence about the activities of hedge fund managers that are not publicised, nor communicated outside of a face-to-face meeting.

Access & Capacity

A levered fund of funds can accommodate larger allocations from pension funds by easily adding to each or several of the underlying hedge fund managers. Access to top managers is the result of the fund of fund's experience with hedge funds with which it has invested in the past or with which it has considered an ongoing investment relationship. Since many top funds are closed to new investors, the issue of access is an important benefit of investing with a fund of hedge funds.

An additional consideration is whether the fund of hedge funds is personally invested in each of the hedge funds. Investors should ask that question since those who "eat their own cooking" are increasingly likely to insist on hedge fund best practices with respect to valuation, operational risk and other key areas.

Anonymity

One benefit of fund of funds investing, which may or may not be important to all investors, is the ability to be an anonymous investor. Often, the end hedge fund may not even have access to the list of fund of funds investors. Therefore, when anonymity is preferable, it is possible to fly below the radar screen and even to dodge investment minimums while dialling up and down in leverage several times within a quarter.


Risk Management

Fund of hedge fund investors benefit from the additional layer of risk management that the fund of hedge fund provides to its investors. Overall, the goal of a risk management programme is to avoid losses so as to minimise the need to recover from these losses. Because the fund of hedge funds insists on strong due diligence and strives for an optimum level of transparency, the investor also benefits from the fund of hedge funds' ability to fend off complacent or greedy hedge fund managers. They know which funds are aggressive and performance-driven as opposed to too cautious and management-fee driven.

Investors should be aware that position transparency in a limited partnership is provided with a one- to three-month range delay; however, if an investor is in a managed account, real time transparency is offered, allowing the investor to see every trade and real time position with no time delay. This provides keen insights into fund activity. Due diligence teams at the leading prime brokers provide leverage for these managed accounts, thus providing an additional investor benefit. Additionally, they may reserve the right to prohibit certain types of investments or outsized positions.

IV. Fund Size Considerations

Studies have proven that single strategy funds that enjoy exceptional success often achieve diminishing returns as they reach a certain high asset level. With that in mind, consider that a levered fund of funds can move in and out so as to stick with the best performing managers. This may differ for individual investors who tend to become complacent, miss annual liquidity deadlines, and therefore end up invested for another year even when not thrilled about the fund's performance. We predict that additional attention will be focused in the near future on issues that relate to fund size, including the marginalisation of merger arbitrage strategies, the fact that too many smart managers are spread too thin, and the existence of an increasingly high level of industry collusion with respect to fund positions.

V. Fees & Cost of Financing

Increased institutional participation in the levered fund of funds space means increased scrutiny of fee structures. Indeed, pension funds must know what they are paying and are not eager to tolerate excessiveness. As an example, consider a $25 miilion investment leveraged 4X to $100 million with fees of 1% of the management fee and a 10% performance fee. Do I know if I am paying fees on the equity amount or the notional value of the fund? Some fee structures are 2% and 10%; some have performance hurdles and high water marks while others do not. New fee structures enable a manager to earn a performance fee while recovering from his drawdown. There is a myriad of structures. Investors in a fund of funds benefit from its ability to negotiate fee structures and its knowledge of competitive pricing. Another valuable benefit is the fact that a fund of funds is likely to have access to the best possible legal team that monitors fee structures and costs with the goal of protecting the fund of fund's investors.

VI. Mock Portfolio Analysis

As a conceptual example, consider the performance of an investment in a fund of hedge funds equally leveraged three times and invested in the following strategies: global macro, equity hedge, merger arbitrage, fixed income arbitrage, convertible arbitrage, equity hedge and event-driven.

Back testing the portfolio over a ten-year period results in compelling performance statistics. It shows an annualised return for the leveraged FOHF of 22.95% compared to 7.81% for the S&P, and significantly lower volatility. Management fees of 1% and performance fees of 15% were incorporated into the calculations, along with a cost of capital of 2.65% and three times leverage. The downside deviation of the mock portfolio was 6.04%, versus 11.62% for that of the S&P 500. The portfolio was not rebalanced for this exercise

 
FOHF Leveraged 3X
S&P
Annualised Return
22.95%
7.81%
% of Profitable Months
74%
62%
Average Negative Month
-1.76%
-4.08%
Annualised Deviation
10.67%
16.19%
Sharpe Ratio = 1.73

VII. Core Benefits of a Levered Fund of Funds

Successful levered fund of funds are those with the following 10 attributes as an integral part of their investment strategy:

1. Understand the importance of being wary of style drift and avoid hedge funds that have the tendency to stray from core competencies

2. Have a global presence and the ability to seek specialists around the world

3. Realise that the best hedge fund managers with which to invest indeed may be the mavericks who are not willing to join someone else's firm

4. While nearly every hedge fund manager will tell you that their strategy is ideal for the current environment, a fund of funds and its underlying managers should possess a macro view as opposed to being solely focused on their fundamental bottom-up approach

5. Monitor portfolio strategy tilting and how that function operates in different environments where it is easier to gear up or down

6. Track the competition and know what other fund of funds are doing in terms of asset growth and avoidance of content marginal managers

7. Remember past failures, people and structures and, more importantly, know who failed and why so as not to repeat mistakes

8. Do not give up on a strategy based on the activities of one incident such as a well-publicised blow-up

9. Actively seek knowledge of new types of securities, regulatory developments, fund structures and risk management procedures

10. Intelligence regarding industry personnel means a fund of funds is often the first to know when key people leave, who is important at the fund, and who the main idea generators are at each hedge fund, i.e. knowledge of the grapevine and a sense for the intangibles

In conclusion, we predict that the success stories in 2005 will be the levered fund of funds that are cognizant of the need to control fees, realise the need for some level of risk in order to achieve good returns, and stand diversified and attentive to all positions. Those who do their homework and learn what they need to know to debunk the myths are well-poised for success as levered fund of hedge funds investors.



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