Looking for alternative advice

Many pension schemes use an investment consultant which can act as a one-stop shop for running their investments.

But in an increasingly sophisticated investment world pension funds now need advice on a wider range of strategies and products than ever before.

"The pension funds we work with in the UK on the private equity side have the greatest admiration for the mainstream consultants," says Christopher Hunter, managing director of Cambridge Associates in London. "But they have realised that generalists aren't equipped to deal with this asset class. We are working increasingly with pension funds in the UK and Europe because we are getting more requests for advice on private equity."

Cambridge Associates offers generalist asset consulting and gives advice on hedge funds, but is best known as a leader in advice on private equity.

Hunter says pension funds are looking at private equity more closely than before. "One reason is that they have more comfort with and understanding of the private equity asset class. They also have more tolerance of illiquidity as their overall allocations become more sophisticated. Because of this, the generalist advisers are increasing their recommended allocations to the asset class to 3-4% of the overall portfolio from 1-2%. But that means the pension funds have to have more understanding and more infrastructure in order to select investments."

For smaller pension funds with a relatively small allocation to private equity, generalist advisers may well recommend a handful of buyout funds, or funds of funds, to cover all the bases, Hunter says.

"But once pension funds wake up to the fact that they are capable of investing in private equity, and can go the specialist route, they tend to look to us," he says. "Having said that, some generalist advisers themselves recommend their clients go to specialist advisers for alternatives, and that often leads to us."

Pension funds can, of course, go it alone. "Some pension schemes hire staff and do their own private equity selection," says Hunter. "But to do that, they must be able to hire the right expertise and that's very difficult."

A specialist adviser can provide a depth of knowledge which generalists would find hard to match, he says. For instance, private equity is extremely labour-intensive because the dispersion of returns from private equity dwarfs anything seen from listed equities.

"For a typical fixed income manager, the difference between the median return and the returns from the better managers in the top quartile is very small," says Hunter. "For equities, the difference is slightly larger. However, in private equity the difference can be as high as 2,000 bps, that's 20%. So you need a robust research staff to sift through investment opportunities."

Cambridge Associates employs 20 people just to look at venture capital, private equity and other alternative investments. "It's a pretty big staff, and is much larger than what you might find elsewhere," says Hunter.

And once the investment has been made, the evaluation process is fairly tortuous. "Private equity is more of a qualitative art, and is limited in transparency," he adds. "Investments are difficult to evaluate and it takes a long time to tell what the outcome is. So you can't necessarily put an asset allocation in place for the pension fund from day one. Most generalist advisers can't work within those
constraints."

Specialist advisers can also build up relationships with fund managers, an all-important asset since this can give access to the better investments.

"Cambridge Associates has been working with alternatives for over 25 years," says Hunter. "So we tend to be the first stop for managers raising money for a fund. The industry is getting more and more sophisticated, and if you can't build relationships, you don't get access to the best funds."

However, he adds that independence is crucial. "Some specialist consultancies advise clients to take the fund of funds route or offer their own fund of funds products on the side. But their clients aren't necessarily looking for that. In any event, it can introduce conflicts of interest if the adviser recommends their own funds."

Hunter says that another reason his company has not taken the funds of funds route is because it does not believe that one size fits all: "So we've taken the advisory route instead."

Cambridge Associates charges a fee that is a percentage of commitments made, but does not charge performance-based fees. The fees for private equity advisory work are higher than those for its own generalist consulting work, but are about 50% lower than those of a fund of funds, according to Hunter. Furthermore, the firm does not charge a carry, which funds of funds often do.

"As more and more pension schemes look at the hedge fund arena, most of them go down the same evolutionary path," says Simon Ruddick, managing director at Albourne Partners, a specialist adviser in the hedge fund market that plans to expand into private equity in the future. "Typically, they look first at funds of funds, then at creating hedge fund portfolios indirectly. So for 99% of people, it has become a two-stage process."

"When traditional consultants are appointed by a pension fund, they tend to be agnostic towards hedge funds and alternatives," says Ruddick. "This is probably because these asset classes still tend to be a relatively small allocations in absolute terms and they are more complicated and risky than conventional assets. So where the client wants to use hedge funds, traditional advisers have chosen to help them pick funds of funds. That is how they achieve economies of scale. They are reluctant to help clients pick portfolios of hedge funds, which is much more difficult."

Ruddick says that advisers do not possess the requisite economies of scale for picking underlying funds, because more research is required. "Hedge fund techniques are constantly evolving and consultants have to make sure they are up to speed," he says. "They have to show expertise and talent over a complete range of diverse strategies. But traditional consultants have problems recruiting staff."

And once recruited, retaining employees is just as difficult. "As soon as these companies start to build up a team, they are vulnerable to the many hedge funds trying to poach their staff," says Ruddick. "All hedge funds and funds of funds want to learn institution-speak to help them pitch ideas to clients. They see traditional consultants as people with a better understanding of that area, and recruit from them. So it's very hard for the consultants to build sufficient economies of scale to advise clients."

He says: "Traditional consultants have therefore been slightly half-hearted in embracing hedge funds. A further brake has been that they could jeopardise their relationship with a client if they put it into a single hedge fund which does badly."

Albourne employs more than 100 staff in 11 offices worldwide. Its 90 clients have a total of $150bn (€114bn) invested in hedge funds. Like Cambridge Associates, the firm is a pure adviser and does not manage fund of funds.

Its services are made up of five components. Due diligence - carried out by a 30-strong team - consists of nine reports on each of 500 funds, which is refreshed continually. Its manager selection team produces detailed research documents on 1,200 funds. The third component is strategy analysis, which appraises the viability of the various hedge fund strategies within the prevailing financial environment.

Albourne also offers risk management and portfolio construction services. The latter involves portfolio transition, because two-thirds of its clients already have well-established hedge fund programmes.

"The volume and depth of our research is difficult for traditional consultants to replicate," says Ruddick. And he says there is a further snag - what he calls a Catch-22 situation. "In mainstream investing, many consultants carry so much power that asset managers live in fear of them," he says. "But hedge fund managers don't see consultants in that way. In order to get good access to information from the hedge fund managers, it helps if you have clients who have invested with them, or who are about to invest. But to get an investment mandate from a pension fund, you have to show that you've already done the research."

Like Cambridge Associates, Albourne benefits from its years of experience. "Many hedge funds like to say they are closed," Ruddick says. "But it actually depends who wants to put in the money. They will only open for the best investors. We also find that funds are also willing to give preferential access to our clients because once they have submitted themselves to our due diligence process accessing further investors via us involves zero marginal aggravation."

Despite of these obstacles, interest in hedge funds from pension funds is growing rapidly, Ruddick says. "The great drive is peer group confidence," he says. "There is a lot of co-operation between investors. And as more and more institutions go direct, it works pretty well. The key issue is confidence in the due diligence."

Furthermore, Ruddick says that Albourne can sell information cheaper than it would cost clients to do it themselves, because it is being used by 90 clients.

He adds: "In the past, pension schemes sometimes have paid a lot to funds of funds to act as a kind of reputation risk buffer. Nowadays, direct investing, topped up by credible specialist advice and due diligence, is proving to be a viable and cost-effective alternative."