Thursday, November 13, 2014

South Carolina Looking at Emerging Managers?

Mark Melin of ValueWalk reports, South Carolina Wants Smaller Hedge Fund Managers:
There has been an ongoing academic debate in the hedge fund industry as to what size fund generates the best performance, large or small hedge funds.  Now South Carolina’s pension system is weighing in on the issue.

The $30 billion pension system is interested in allocating to smaller hedge fund manager to enhance diversification and capture increased returns, state treasurer Curtis Loftis was quoted as saying in a Bloomberg Briefs report by Nathaniel Baker.

Interested hedge fund managers invited at public meetings

Showing a degree of southern hospitality, Loftis invited interested hedge fund managers to come on down and “show up” at public meetings, including the South Carolina Investment Commission meetings. “If I were an emerging manager and I wanted to understand how public pension plans work, I would attend the meetings, shake hands and pass out cards.”

The way the “system works” at many pension plans is that hedge fund consultants who specialize in understanding the often complex strategies screen various funds and then make recommendations to the pension system. Funds typically do not receive access to pension fund management until they have been approved through such a screening process.  Sometimes the more sophisticated consultants diversify a hedge fund portfolio based on market environment exposure and use risk management criteria to make selection decisions.

Loftis loves alternative investments

At the start of the year, the South Carolina pension had nearly $1 billion allocated to 14 investments in “strategic partnership funds” of $1 billion or more but had since “unwound about half,” Loftis was quoted as saying in a speech at the Alternative Asset Summit in Las Vegas last month. “I love alternative investments. I love Wall Street. I don’t mind paying fees,” Loftis was quoted in the report saying in 2013. “But I want returns.”

A key driver for South Carolina is diversification. In 2008 most hedge fund strategies faltered, with a few exceptions in managed futures across the board and some macro strategies.  Loftis was quoted as saying he was “very interested in emerging managers” as a method to achieve diversification and boost returns, he was quoted as saying in the Oct. 28 speech. The pension has already taken steps to address the issue, making “several… investments of $50 million or less the last few of months,” including a commitment of $25 million to $50 million last month to an unidentified small manager, the report noted.  The South Carolina pension system paid hedge funds fees of 1.59 percent last year, according to the report.

Let me first congratulate Curt Loftis for winning a second term as South Carolina's treasurer. Now, let me get into the article above.

Curt is a regular reader of my blog and he knows all about the secret money grab and fast times in Pensionland. The article above is wrong, Curt doesn't blindly "love" alternatives. In fact, South Carolina was about to throw in the towel on them a few years ago and unlike North Carolina, he's not praying for an alternatives miracle.

Curt has has made it his mission to overhaul the investment commission that oversees the state's pension fund but it hasn't been easy:
The last thing you want to tell Curtis Loftis is that he can’t do something.

That’s one mistake the former South Carolina Treasurer made when Loftis was considering a bid against him. “He reminded me that a Republican has never beat an incumbent in a primary election,” Loftis, 54, recalls. The native of Columbia went on in 2010 to become the first South Carolina Republican to oust a sitting Republican, launching a combative primary campaign, then easily winning the general election that fall.

And that was just the beginning of the upsets.

Since he took office more than two years ago, the former businessman has made it his mission to overhaul the state investment commission that oversees the state’s pension fund. The conflict has included Loftis prompting an investigation into South Carolina Retirement System Investment Commission (RSIC) Chairman Reynolds Williams for allegedly steering commission business to his firm, Loftis and Williams using the media to trade insults and a nearly unanimous commission vote to officially censure Loftis (the treasurer, who sits on the commission, was the lone vote against).

Most recently, a lawsuit filed by the commission against Loftis for holding up an investment contract was thrown out by the state supreme court because Loftis had authorized the contract the day before the court hearing, saving the commision from going into default. It won both sides a public scolding: “We don't appreciate trying to referee kids in a sandbox,” Associate Justice Donald Beatty reportedly said at the April hearing.

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After two years of conflict, both sides say they are eager to move on. But at the base of their disagreement is a fundamentally different view on how the $26 billion retirement fund should be performing. Loftis has seized upon what he calls an imbalance between the fees the commission pays (which have ranged between $304 million and $344 million over the last three years) and its rate of return when compared with other sizeable public pension plans. In 2012, for example, the investment fund earned a net $105 million after paying out $304 million in fees. The rate of return that fiscal year ending June 30, 2012, was 0.4 percent after deducting the cost of management fees, according to the fund’s Annual Iinvestment Report (AIR).

When compared with other public pension plans valued at greater than $5 billion, that performance puts South Carolina’s ranking in the 63rd percentile, or in the lowest 40 percent, according to data collected by the investment advisory firm Wilshire Associates and provided to Governing by the treasurer’s office. The Wilshire data includes major plans like CALPERS, CALSTERS, Washington State, Oregon, and Texas Teachers.

Even a good year of returns is all relative for Loftis -- in 2011 the fund earned roughly $4 billion, or a return of 18.3 percent on investment and paid fees of $343.6 million, according to that year's AIR. But compared to other plans, RSIC finished in the 87th percentile that year, or in the lowest 20 percent. (The top returns in 2011 were above 26 percent while the lowest were below 10 percent, according to Wilshire.)

“If we were number one in returns and in fees I’d love it,” Loftis says. “But you have to pay fees commensurate with what you’re getting. What we’re paying for is a Rolls Royce. And we’re driving off in a [Ford] Pinto.”

But that’s not how the commission sees it.

“What I’d encourage everyone to stop and think about … we’re not thinking about putting ourselves in a horse race with other public pension peers,” says Hershel Harper, the commission’s Chief Investment Officer. “We look at what it is in relation to our expected return of 7.5 percent [over the long term], and what are the risks we are comfortable taking.”

Although Loftis has lamented that the fund’s investment in hedge funds or other “alternative investments” generate the higher fees, Harper noted that the underperforming investments in 2012 were generally in the traditional asset classes, not the alternative ones. Still, in January of this year (2013), the investment commission did something it hadn’t done before: it attached an addendum to its 2012 AIR that provided a second summary letter to the original November 2012 report. The addendum gave the investment fund’s totals for the 2012 calendar year -- a far rosier picture (an 11.5 percent rate of return, in fact) than the fiscal year stats.

A spokesman for the commission said the January letter was attached to give lawmakers and the public a more up-to-date summary of the fund and that the decision to do so was made after it became clear that the final six months of 2012 were financially far better than the first half of the year. The spokesman, Danny Varat, added that he imagined such updates for timeliness would also occur in the coming years.

On fees, Harper warns that it is misleading to compare RSIC’s fees with other public pension plans because there are no uniform guidelines for reporting fees. For example, he said, the commission includes auditor expenses in its fees and other plans don't. “We feel we cast possibly the broadest net in capturing every fee out there,” he said.

Some public pension plans elsewhere are taking a stab at lowering management fees. This spring, the $10.5 billion Orange County Employees’ Retirement System (OCERS) approved a plan that would bundle pension fund assets together in an effort to be able to negotiate lower management fees (a kind of pension fund collective bargaining). The plan was projected to spend $52 million this year in fees, according to media reports.

Loftis’ recent announcement he will seek a second term in 2014 has quelled for now any musings that his pot stirring is part of a larger effort to run for governor. “When I lay my head down at night, I don’t think about that rickety old mansion on Charles Street,” he says. “I can’t stop what I’ve started [here].”

But if there is an understanding to be reached between the South Carolina treasurer and the commission he serves on, neither side has found it. At the last commission meeting in April, the commission's vice chairman threatened to resign on May 31 if the relationship with Loftis was not resolved, adding “there is little or no common ground between” the two sides.

The investment commission’s Chief Operating Officer, Darry Oliver, says he doesn’t think the commission “gets enough credit” for the improvements it has made in recent years such as establishing an internal audit and compliance function. The commission also plans on more transparency in reporting, including more frequent updates on the investment fund’s statistics. The feud with Loftis, Oliver says, is detracting from that. “My view is that the negative publicity isn’t good for anyone -- it’s not good for the commission, it’s not good for the treasurer, it’s not good for the stakeholders.”

But Loftis, who says he initially planned on handing over his commission seat to a staff member but felt compelled to stay on, dismisses that notion. “This is high finance,” he says. “When they say things like, ‘People won’t want to do business with us,’ that’s pure silliness.”
I'm glad Curt didn't hand over his seat and think he's on the right track bringing light to the excessive fees South Carolina's pension fund is doling out. The guy who said there is no uniform reporting guidelines in fees is partially right but there should be, especially in alternatives like private equity where many state funds are getting bullied into remaining mum on fees and terms.

As far as focusing on emerging managers, there too, I think he's on the right track. Smaller hedge funds have withered but the irony is they typically outdo their elite rivals. Why? Because their focus is primarily on performance, not asset gathering (2% management fee really kicks in when managing billions, just ask Ray Dalio, Bill Ackman and other oversized hedge fund egos that now figure among the richest Americans).

Are there pitfalls to investing in smaller funds? You bet there are and I warn Curt and others taking this approach not be be penny-wise and pound-foolish. There are a bunch of charlatans in Hedgeland that know how to talk up their game but they're pure cons. And many smaller hedge funds stink, just like most of their larger rivals. There is also the big issue of scalability, which most smaller players don't offer or are not set up for.

I'm not a fan of funds of funds but when it comes to identifying and selecting emerging managers, you need to be cautious and find true alpha generators that will offer you a lot more than just performance (knowledge leverage is critical!). Talking to Tom Hill at Blackstone or Jane Buchan at Paamco is a very good idea but make sure you get the terms and fees right when dealing with funds of funds.

Having said this, nothing precludes Curt and others at South Carolina's pension fund from meeting individual managers and I've got a couple of exceptionally talented merging managers to introduce them to.

Below, David Rubenstein, co-founder and co-chief executive officer of Carlyle Group LP, talks about losses sustained by Claren Road Asset Management LLC, the hedge fund firm majority-owned by Carlyle. Rubenstein, speaking with Erik Schatzker on Bloomberg Television's "Market Makers," also discusses market valuations and Carlyle's investment strategy and growth outlook.

And billionaire John Paulson posted a 14 percent loss in his firm’s event-driven hedge fund during October, adding to declines this year, two people with knowledge of the matter said. Betty Liu reports on “Movers & Shakers” on “In The Loop.” Paulson and many others got burned by taking wrong-way bets on AbbVie Inc.’s failed merger with Shire Plc

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