Co-investments Entering Hedge Fund Arena?

Christine Williamson of Pensions & Investments reports, Co-investing entering new arena: Hedge funds:
Institutional investors increasingly are translating co-investment experience in private equity, real estate, infrastructure and energy funds to their hedge fund portfolios.

Co-investment with hedge fund managers is growing, if a bit slowly, especially with credit and activist equity managers as institutions become more comfortable with an even more direct type of hedge fund investing.

Appetite is growing: 52% overall of investors surveyed by J.P. Morgan Capital Introduction Group for its 2014 Institutional Investors Survey said they were willing to participate in hedge fund co-investments.

A breakdown of respondents showed 74% of endowments and foundations would co-invest with hedge funds, followed by 68% of consultants; pension funds, 60%; family offices, 59%; and insurance companies and hedge funds of funds, both 46%.

Despite this professed interest, the overall pace of pension funds, endowments, foundations and sovereign wealth funds in hedge fund co-investments has been a tad slow, sources said.

“This is a good investment space, but there are a significant percentage of institutional investors that are too boxy to be comfortable with co-investing,” said Stephen L. Nesbitt, CEO of alternative investment consultant Cliffwater LLC, Marina del Rey, Calif.

“You have to be flexible to take advantage of co-investing because it does fall into the cracks between asset classes,” Mr. Nesbitt added.

“The interest level in co-investments is about the same as a year ago, but the difference is that institutional investors had a desire to see co-investment ideas but not to invest,” said Richard d'Albert, principal, co-chief investment officer and portfolio manager at credit specialist hedge fund manager Seer Capital Management LP, New York.

“The credibility factor has risen and now the conversations are turning more often to investment,” Mr. d'Albert said.

Seer Capital has set up co-investment vehicles with a handful of larger clients, Mr. d'Albert said, noting the firm's hedge funds “get first dibs on any of our investment ideas, but sometimes we do run across an outsized opportunity that has great potential, but is too big to accommodate in our funds.”

Seer Capital managed $2.2 billion in structured credit hedge fund approaches as of June 30.

Hedge fund managers offering occasional one-off co-investment opportunities or permanent, dedicated co-investment funds are grouped within event-driven equity and fixed-income approaches, as well as specialists who invest in structured products, lending, mortgage- and asset-backed securities and more esoteric credit investments, such as Iceland bank debt.

In addition to Seer Capital, among those managers attracting institutional investor interest in their co-investment funds are JANA Partners LP, Pine River Capital Management LP, Solus Alternative Asset Management LP, Starboard Value LP and Taconic Capital Advisors LP.

New niche

One reason for the slow buildup in hedge fund co-investment is the relative newness of the niche. Institutions have been co-investing with private equity and real estate managers for more than two decades. But hedge fund managers, for the most part, only shifted to co-investment since the 2008 financial crisis.

Before the crisis, hedge fund managers routinely segregated less liquid assets in separate “side-pocket” funds they ran alongside their flagship commingled funds. The crisis made it extremely difficult to divest those illiquid investments and, rather than sell assets at fire sale prices, hedge fund managers shut redemption gates, locking up investor assets for years.

Mr. Nesbitt said hedge fund managers have begun to recapture the institutional market by repackaging their best, most concentrated investment ideas into vehicles with “much better terms,” including lower fees, lower carry, fees charged only on invested capital and “very attractive performance.”

“Performance comparison of the hedge fund co-investment niche is impossible,” said Jon Hansen, managing director-hedge funds for C/A Capital Management, Boston, the investment outsourcing money management subsidiary of consultant Cambridge Associates LLC.

“There's no way to give a range of returns for hedge fund co-investments because performance is so dependent on unique, individual underlying deals,” Mr. Hansen said.

But the returns of individual co-investments, rarely revealed publicly by hedge fund managers or their large investors, will propel more institutions to seek a place in the investment queue, sources predicted.

“Hedge fund co-investment will evolve from the minority sport that it is today into a defining feature of risk capital markets in the future,” wrote Simon Ruddick, CEO and managing director of alternative investment consultant Albourne Partners Ltd., London, in an e-mail.

"Nimbleness and flexibility'

“Hedge fund co-investments embody the nimbleness and flexibility required to give hedge fund managers, and their investors, an essential edge in the ever more competitive quest for alpha. We see hedge fund co-investment as a core component of a larger phenomenon: customized investments,” Mr. Ruddick wrote.

One early example of the type of customization institutional investors are doing with their hedge fund managers is the New Jersey Division of Investment's $300 million investment in February with credit hedge fund manager Solus Alternative Asset Management.

The investment division, based in Trenton, manages investments for the $78.6 billion New Jersey Pension Fund.

Solus' credit mandate specifies flexibility, allowing the firm to invest up to two-thirds of the allocation in its flagship opportunistic event-driven and special situations credit strategy and up to two-thirds in “recovery-like opportunities, including ... high-conviction co-investment opportunities,” according to a report from Christopher McDonough, director of investments, at the Feb. 3 State Investment Council meeting. The council advises the investment division on pension fund management.

Mr. McDonough was unavailable to comment about the division's rationale behind the Solus investment, said Christopher J. Santarelli, a spokesman for the New Jersey Treasury Department, which oversees the Division of Investment.

The Solus investment was not New Jersey's first to a hedge fund co-investment. In May 2013, JANA Partners was awarded $100 million for investment in its flagship Strategic Investments Fund, which invests about 30% of its assets in shareholder activist opportunities. New Jersey also committed $200 million to co-investing with JANA in activist shareholder deals.
It was only a matter of time before co-investments made it into the hedge fund arena. But I share some concerns. First, hedge funds have first dibs on their top ideas and then feed them to pensions co-investing alongside them. And what happens when they exit these positions? Do the pension funds co-investing get an advance warning? How will that impact investors in the co-mingled fund?

Pension funds love complicating things. This push to co-invest with hedge funds is all because they don't have the requisite staff to manage absolute return strategies internally and they want to lower fees hedge funds are charging them.

But if you ask me, U.S. pensions need to improve their governance, improve compensation, hire experts to manage portfolios internally and make better use of publicly available information on what major hedge funds are doing. They can track moves on,, or through my quarterly updates on top funds' activity.

For example, when you see Seth Klarman's Baupost Group owning a 35% stake in Idenix Pharmaceuticals (IDIX), chances are something is up (click on image).

And what happened was Merck bought them out for their Hepatitis C drug, sending shares soaring from $7 to close to $25 (click on image):

This morning, I was checking out shares of Puma Biotechnology (PBYI) soaring 270% in pre-market trading because the company said a clinical trial of its experimental drug blocked the return of breast cancer in women with a type of early-stage disease.

Shares of Puma Biotech took a big hit in Q1with the big unwind and have been falling ever since. But that didn't stop one hedge fund I track closely, Adage Capital Partners, from amassing a 19% stake in the company (click on image):

As you can see, Citadel Advisors, another well known hedge fund I track, also bought positions in Puma Biotechnology. But Adage was the one that made big bucks today, a cool $950 million.

Now, admittedly, these are not the type of co-investments pension funds are looking for (biotech shares are too small and risky for them), but I can show you other examples of well known large cap names too. I just showed you biotech because it's a space I track closely and believe in.

If you have any comments on pensions co-investing with hedge funds, let me know or post them below. Don't get too excited about this "new form" of investing with hedge funds. At the end of the day, overpaid hedge fund managers are looking to gather more assets to manage so they can charge institutions with outrageous fees. That's pretty much it.

Below, Bill Ackman tried to convince investors in a presentation Tuesday that the seller of weight-loss shakes is guilty of fraud. I embedded Bloomberg highlights of his remarks.

Unfortunately for Ackman, he got clobbered yesterday as Herbalife (HLF) shares soared 25% following his "bombshell revelations." He might turn out to be right but some pretty big hedge funds are betting against him, including Soros, Icahn and Perry Capital.

Below, Robert Chapman, Chapman Capital, says he is adding aggressively to Herbalife despite Bill Ackman's criticism of the company. Chapman also  explains why he thinks the stock could hit $150 per share within a year (I would steer clear of Herbalife and let the big boys battle it out).