Hedge funds and private equity move into IR

The fallout from the global financial crisis is forcing many hedge funds and private equity firms to reconsider their approach to investor relations, as wary customers demand more flexibility and transparency. 

Both have typically adopted a ‘take it or leave it’ approach to IR in the past. For years, many hedge funds relied on the mystique of ‘black box’ investment strategies to draw in investors, accepting money on the understanding they would never reveal the secrets of their magic formulas. 

Private equity firms, although often more transparent, tended to rely on illiquid long-term investments, which, by their very nature, required investors to commit money to projects that would be locked in for years. But industry insiders and experts say all this is starting to change.  

‘It used to be that a hedge fund would say, I have a two-year lockup, I’m charging a 2 percent management fee and 20 percent of profit and you’re not going to see any trades. Take it or leave it. Now it’s the complete opposite,’ says Andrew Schneider, managing partner of HedgeCo Networks, a hedge fund services company. 

Today, investors are controlling the relationships and making demands. ‘They want greater transparency, less of a lockup,’ Schneider adds. ‘They basically want to determine the structure of the fund.’ There’s change among private equity firms, too, he says, with many now looking for ‘creative ways to increase liquidity’. 

Taking the lead

‘Managers can no longer let returns sell themselves,’ noted Andrea Gentilini, head of strategic consulting in Barclays Capital’s prime services division, when she issued a report on the matter last year. ‘Today’s investors want more communication, more due diligence and more transparency. Funds that focus on this have clearly been recognized by investors.’ 

Gentilini’s report, ‘Raising the game’, found hedge funds across the industry hiring investor relations and marketing staff – a finding industry insiders and staffers at several outside IR companies confirm. They say it is also happening in private equity. 

For many hedge funds, this is partly because the profile of the typical investor is changing. More and more, institutional investors are providing the bulk of capital – now estimated at around 72 percent – and they are used to a certain level of service, explains Justin Perun, president and founder of Bull and Bear Capital, a Chicago-based business development firm that provides IR and capital raising services to hedge funds. ‘They are used to client services and transparency,’ he adds. ‘They are driving this.’  

The Madoff scandal, the collapse of Lehman Brothers and the general uncertainty of the market have all combined to accelerate the change dramatically. ‘I think it would have happened anyway,’ says Mary Beth Kissane, a principal and practice group leader at Walek & Associates, which is seeing a growing number of institutional investors as clients. ‘But I think it got a real bump.’

Investor worries

Indeed, according to a 2010 survey from hedge fund administrator SEI and the consulting firm Greenwich Associates, such concerns now even outweigh concerns about performance. Institutions overwhelmingly cited poor performance as their top concern in the 2008 survey; by last year, this had dropped to fifth place on their list of worries. And at the top of the list? Lack of transparency and liquidity risk. 

What’s more, these institutions have been acting on their concerns: more than 70 percent of institutional investors say they requested more detailed information from hedge fund managers than they did a year earlier, according to the survey. It notes that institutional investors are increasingly asserting themselves, ‘changing the rules of hedge fund investing as they push managers toward greater transparency, insist on identifying demonstrable sources of alpha, and intensify their focus on operational effectiveness.’ 

‘When we started up our fund, you could be a lot less formal,’ points out John Eckstein, a veteran fund manager who started the Cornerstone Quantitative Investment Group in 1995. ‘People were far less concerned then about who was making the trade, who was entering the trades, who was monitoring risk control and what the risk control regime was. These days, people want to know all of that.’

The response to those demands varies dramatically. Several large hedge funds, including DE Shaw and Renaissance Technologies, remain so secretive they decline to provide information about their level of transparency. But industry insiders who are willing to talk say the response to calls for transparency varies wildly, from providing position sheets for equities to simply being willing to walk investors through the approach for the next 30 days. Usually it comes down to having a dedicated team or an individual who will communicate on a frequent basis with investors. 

Doors only ajar

John McGillian, who opened a firm called Symmetry Global Advisors in January 2009, says many managers remain reluctant to show their position, especially if they are shorting a stock. However, McGillian produces a monthly report that allows his clients to see his position if they want to, and offers monthly redemptions with five days’ notice – something he is able to do because he trades in highly liquid currencies and futures, among other things. 

‘The biggest negative reaction to 2008 came from the fact that investors were not only losing money, but were also unable to get out whatever money they had left. And that’s because so many hedge fund managers had invested in illiquid assets,’ McGillian says. ‘Now people are much more conscious of liquidity and transparency, and much more demanding of both.’

Eckstein, who issued monthly reports from the start and was known to write out equations for some clients on a whiteboard in his conference room, says the benefits of being open with clients easily outweigh the negatives. ‘You’re always going to have periods of bad performance,’ he points out. ‘The question is how you handle it. The more information you provide for clients, the more patient they will be. If you don’t explain your strategy, the only thing the investor can do is look at your performance. And that’s not a great position to be in because everybody is going to lose money sometimes.’

Kissane agrees. ‘Hedge funds used to buy a Rolodex and go golfing with people,’ she says. But demand for outside IR services from hedge funds and private equity firms has increased significantly in recent months. ‘I think they now realize that, if you have the wrong investors, you have a real problem,’ Kissane continues. ‘It’s about setting and managing investor expectations. If you have investors who don’t understand what they bought and people start running for the exits, you have a problem.’ 

Traditional values

Increasingly, funds are asking for the kind of IR expected of a traditional public company. They are taking the time to produce professional investor letters that will connect the dots and talk about performance and strategy. 

More funds are holding annual meetings and conducting regular conference calls. They are producing investor decks and relying on IR professionals to focus their message and presentation, and to handle follow-up questions. ‘Both private equity firms and hedge funds are now focused on being far more transparent for investors,’ Kissane says. ‘They have often done so in an ad hoc way but their investors are now demanding more transparency, and our clients are eager to meet that demand and make it part of their selling proposition.’

Still, there are signs of rising tensions between certain private equity funds and some of their investors. Recently, a trade group representing 215 private equity investors controlling more than $1 tn in private equity assets released a 17-page document laying out best practices for private equity firms and calling for significant changes in the field. The document, from the Institutional Limited Partners Association, proposed increased disclosure, greater investor oversight and lower management fees.

Representatives from leading private equity firms, such as Blackstone, Kohlberg Kravis & Roberts and the Carlyle Group, did not return calls seeking comment on increased investor demands and IR. According to the Wall Street Journal, however, while ‘no one is complaining out loud, at least three large private equity firms have retained outside counsel to examine potential anti-trust issues’, and may accuse the customers of ‘collusion’ and price fixing. ‘The gloves are finally coming off,’ the article notes, but it adds that new private funds at Blackstone and Goldman Sachs have cut their fees.  

The liquidity problem

Some firms are taking steps to address concerns over liquidity, which more than 50 percent of the private equity investors surveyed by SEI ranked as their top concern, above poor performance. Schneider has been consulting with a number of private equity firms and says the industry is using several creative approaches to meet investor concerns. 

Some are offering in-kind distributions: if a fund manager invests in 10 residential houses with the intention of flipping them, for instance, he might offer one of the houses to an investor faced with a liquidity event that forces that investor to cash out of the fund.Such options were not often available in the pre-bust days. ‘Most of these investors are savvy enough or have the relationships where they can liquidate to a third party,’ Schneider says. 

Another creative solution is to use ‘side pocket accounting’ and allow investors to enter and exit funds at different times by weighing the value of their capital based on how close a project is to completion, Schneider adds. If the private equity firm has invested in the construction of a casino, for instance, those who put money in initially would have a larger stake in the project than those who invest the same amount of money into the project when it is just a few years away from completion. 

‘Private equity funds try to raise all the money at the start and then close the fund,’ says Schneider. ‘That is not happening right now. Nobody is raising $100 mn and then closing the fund; that is why they have been coming to me. They need to find creative solutions to increase liquidity.’