Top institutional investors have long been able to structure "best ideas" side-pockets or managed accounts with their managers to gain additional exposure to a handful of top positions. And sometimes these arrangements come along with higher performance fees, but perhaps reduced management fees (as they are really extensions of positions already being "managed" in the main fund). It was a way for a manager to leverage a high-conviction idea in a manner that didn't go against either the letter or spirit of its fund documents, while providing a super-sophisticated, risk-tolerant investor the opportunity for incremental alpha. And for that, they're willing to pay. This all makes a lot of sense, and has made sense for a long, long time.
But what of these new best-ideas funds? It seems to me that they open a Pandora's Box of potential problems, substantially out-of-line with the messaging around the benefits of such funds. I can think of a few off the top of my head:
Inherent conflict with the native fund. If a best-ideas fund is an offshoot of an existing fund (call it the "native fund"), and if it is going to have sufficient mass to warrant it being a separate fund, won't a substantial scaling up of a subset of the native fund's positions dampen returns for the native fund? Won't this make it harder for the native fund to exit its positions in the shares held by the best ideas fund, either because:
1. The SEC will aggregate the holdings of the native and best ideas funds for ownership purposes, potentially subjecting the native fund to onerous restrictions it would have avoided absent the best ideas fund; or
2. The sheer size of the combined funds positions is large relative to daily average trading volume, potentially adversely imacting returns for both funds? Are share sales allocated pro rata by capital? First in first out? It is a hard question.
Now, to be fair, there are situations where a native fund/best ideas fund could benefit the owners of both. Consider David Tepper and Appaloosa with Delphi (see earlier post): he effectively called in $2 billion of capital from existing investors in order to have a stronger hand during the Delphi reorganization. This could have been done as part of a best ideas fund or a side pocket, which would have had beneficial effects for both native fund and best idea fund owners. But I see these types of situations as being more the exception than the rule. But that's just my perception.
Dilution of returns. One of the great things about best ideas in side pockets or in managed accounts is that they augment a strategy, they aren't in and of themselves a strategy. If a fund raises money explicitly for this purpose, you know what will happen - they will get too big in these high-value, high-alpha potential positions and get in their own way, squashing alpha generation. And this is bad. Part of the phenomenon of the institutionalization of the hedge fund business is that large firms are now building less volatile, less high-returning (and less alpha generating) portfolios, increasingly looking like virtual fund-of-funds from a risk/return perspective. Why? Because this is what a lot of institutions want who simply are seeking exposure to the hedge fund asset class. Nothing too racy, nothing to complicated. Then there are those more sophisticated institutions who are frustrated by this dumbing-down of the business, actively pursuing alpha through willingess to accept incremental volatility and concentration risk. These are for whom best ideas accounts are designed. By "fundifying" the best ideas strategy, however, you can be sure that alpha will be drained away from these ideas in short order.
I do want to raise the caveat that "concentrated" funds are not subject to the same issues I've raised above. If a manager establishes a fund, with the charter of holding 5-10 positions, that's great. Investors know what they're getting. The manager knows what their job is. All is clear. This is very different than having a fund, setting up another fund where a subset of the original fund's positions are cherry-picked and sized up in the new fund. This is what leads to dilution of returns and potential conflicts of interest. This stinks.
Yet another way to generate fees. Readers know I am a supporter of, an investor in and a former employee of hedge funds. But I am deeply concerned by this development, as it smacks of packaging/re-branding and not of true value creation. In fact, I'd argue that this will ultimately be value destroying, particularly for those who have participated in best ideas strategies before but who now will simply be riders on a much-more-crowded bus. Some strategies are just not designed to get big, i.e., certain ultra-high frequency statistical arbitrage strategies. If you could be happy running $50 million and generating super-attractive risk-adjusted returns all would be fine, but no, you want to build a hedge fund of scale, create a legacy, etc., which causes you to alter your strategy and tinker with your models in ways that undermine the original (and successful) incarnation. And this is a shame. Does this sound like the best ideas fund concept? I think so.
And this is, I'm afraid, the likely path of the best ideas hedge funds, which seem like a logical new product but will eventually collapse under its own weight. Time will tell but I am highly cynical. Sorry.
Given the rush of assets into alternative assets in general and hedge funds in particular, it is very seductive to develop new ways to gather more assets to build scale and, yes, generate incremental money for the principals when it may not make long-term financial sense for the LPs. I am not suggesting that this is some kind of conscious conspiracy on the part of fund managers to separate institutions from their money for "new" ideas: in fact, I am 100% certain that many institutions are approaching managers with precisely this best ideas fund idea. What I am suggesting is that a disciplined, long-term oriented manager might want to "just say no." Why risk pissing off existing LPs, frustrating new LPs and potentially damaging performance in the name of a new asset gathering exercise? I don't know why. Money talks. But sometimes you just have to talk back.