Wednesday, December 4, 2013

Human Arbitrage: Hedge Fund of Funds

Human Arbitrage: Hedge Fund of Funds

J. Tomilson Hill has built the largest hedge fund of funds business in the world as part of Blackstone’s alternative empire.  As Randall Smith relates in yesterday’s Deal Book[1], Mr. Hill has enjoyed massive financial success at Blackstone after being ousted at Lehman about 20-years ago.  Mr. Hill has parlayed his investment banking background together with his prep school and Harvard education to become a vital intermediary between investors and hedge fund managers.

The hedge fund of funds is a professionally managed portfolio of hedge funds.  As you might expect, fees and incentive bonuses are stacked atop more fees and incentive bonuses.  As a result, this is a very expensive way to invest.  Although hedge fund of fund fees have been pressured downward, it still costs investors 2.5% to 3% in total management fees and another 15% to 25% in profits to invest in hedge funds through a fund of funds structure.
New CIO (1996)
Why would anyone invest in a fund of funds?  There are three reasons.  First, there’s access.  With Mr. Hill’s insider resume he can probably pry open doors that your average millionaire can’t even knock on.  Second, there’s expertise.  Picking apart a hedge fund strategy isn’t straightforward, so expertise is a necessary ingredient.  Third, there’s diversification.  For most small investors, it is impossible to build a properly diversified portfolio of hedge fund managers.

Haven’t I just made the case for Mr. Hill’s hedge fund of funds?  Hardly.  While Mr. Hill has unfettered access to the hedge fund industry, his collection of products has become so large at $53 billion that his odds of producing exceptional performance have become low.  And while the diversification argument has merit for small endowments and mere millionaires, it makes little sense for large investors like public pension plans to use hedge fund of funds, except for one factor.  It’s human arbitrage that is making Mr. Hill incredibly rich.

Public pension plans are paying Blackstone and other brand name hedge fund of funds millions of dollars in fees to select managers.  For a fraction of what they’re paying Blackstone, the public funds could hire the necessary experts to directly invest in hedge funds.  However, politics and appearances render it next to impossible for public funds to compete for talent.  As a result, many public pension plans are short the requisite talent, while Mr. Hill and his competitors are long that talent.  Under these circumstances Mr. Hill can charge five to ten times what it would cost a public pension to do the same thing directly.

Politicians and the public prefer a system in which hedge fund of funds earn millions in fees to a system where professional pension staff make six figure salaries for doing the same thing: picking managers.  However, sticking with the fund of fund approach enables Mr. Hill to add to his collection of Renaissance and Baroque bronzes.  But there is good news for public pension employees and taxpayers.  They can see where their fees have gone.  Mr. Hill’s bronzes are on exhibit at the Frick Gallery in Manhattan.

A final note:  I don’t understand why Deal Book wrote the story about Mr. Hill and Blackstone.  It is the kind of material that Blackstone’s publicist would write and put on the firm’s website.  I don’t think Mr. Hill needs the help.


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