By Lawrence Delevingne
Photographs by Mark Hartman
Goldman Sachs Asset Management is doing fine, thank you very much.
Despite bad press for the bank generally and a backlash by many investors against the fund-of-funds model, clients are continuing to put money into Goldman's fund-of-funds unit within the $65 billion alternatives group of GSAM. Executives say the unit has consistently grown its business since the financial crisis and through its public relations debacle stemming from Securities and Exchange Commission allegations of misleading clients, which have since been settled.
Since early 2009 Goldman's fund-of-funds assets have increased roughly 13% to around $21 billion as of July, leading Chris Kojima, co-head of the firm's alternative investments and manager selection unit as well as its global portfolio solutions one, to say that its team is the "largest, deepest and strongest" in its long history, with more than 100 professionals, 40 of them on investment and risk-management teams, across ten offices around the world. And that's not to mention the broader resources of AIMS and GSAM, which manages $802 billion all in as of June 30, including private equity investments and proprietary hedge funds like Liberty Harbor and Goldman Sachs Investment Partners.
Still, things haven't been perfect. High personnel turnover has caused at least two big investors to rethink their relationships with the bank. The $22 billion Texas Permanent School Fund plans to pull out of a $500 million fund-of-funds mandate, and the $4 billion Philadelphia Public Employees Retirement System killed a $25 million fund-of-funds investment because of recent employee departures.
At least seven senior professionals have exited Goldman's fund-of-funds group over the past four years. Most recently in May, Jeff Blumberg, a managing director in London responsible for Europe and Asia, left to become Egerton Capital's chief operating officer. Kojima dismisses the effect of the departures, saying, "There's always some natural evolution in a long-standing business in a dynamic industry."
Moreover, GSAM's main institutional fund of funds has lost more than 40% of its assets since its peak in 2007. Goldman Sachs Hedge Fund Partners had about $1.92 billion in assets under management at the end of March. That's compared with $3.26 billion at the end of 2007, $2.25 billion at the end of 2008 and $1.97 billion at the end of 2009. In response, Goldman says the fund is "one small slice" of the overall business and that many investors moved money to a more concentrated strategy, and therefore the fund's asset drop doesn't represent a decline in assets.
Goldman wouldn't comment on the performance of its funds or even provide a list of specific offerings. But the firm granted AR staff writer Lawrence Delevingne a rare on-the-record interview with two top executives in its fund-of-funds unit: Kojima, a 16-year Goldman veteran, and Kent Clark, who has risen to co-head of both alternative investments and manager selection and global portfolio solutions over 18 years at the firm.
Clark and Kojima discussed their outlook for the hedge fund industry generally, arguing the continued case for funds of funds and saying that they are keen on macro and long-only managers. At the same time, they believe investors may need to be more realistic about the returns that can be achieved going forward. In typical Goldman fashion, they ducked questions about such issues as how much firm capital is invested in the unit and whether their fees have changed since the fund-of-funds backlash. But they insisted Goldman Sachs's broader image problems haven't hurt their business and that the new financial reform legislation won't matter either.
AR: Congress just passed a law limiting banks' ability to invest in hedge funds and private equity. Will that mean that Goldman will have to take capital out of its fund-of-funds unit?
Chris Kojima: Our investors are among the world's leading pension plans, sovereign wealth funds, financial institutions, endowments, foundations and families. Essentially all of the capital in our AIMS hedge fund program is from these institutional and individual clients, for whom we serve as fiduciaries.
AR: Does the fund of funds invest in any of Goldman's internal hedge funds?
Kent Clark: Since our clients have direct access to internal Goldman Sachs funds, the AIMS group as a policy matter does not invest in any Goldman Sachs hedge fund or private equity funds. Most of our clients partner with us to source and evaluate external managers, and to design portfolios and risk management solutions around these diversified investment options.
AR: How do you expect hedge funds to change in the future?
Kojima: The outlook is still positive but different than what we've seen over the past ten years. The fundamental value proposition of hedge funds is to deliver returns that are attractive but to some degree unrelated to more traditional or easy-to-manufacture returns. We believe that is still the case.
The twist is that, more than ever, getting better returns will require careful manager selection both on an investment side—to get the good returns and avoid the poor returns—as well as on the operational due diligence to avoid the ticking time bombs, since there really isn't any return upside to go along with operational problems.
In thinking about some of the things to watch out for, there are still a large number of managers who are below their high-water mark and maybe have been for some time now. They may be coming up on three years without collecting an incentive fee. One thing we are cautious about is managers who may not have the economics to keep their teams together in their current format.
The industry, and the use of hedge funds, is evolving. Rather than a bucket that sits to the side of everything else—95% traditional, 5% hedge funds—we're seeing that different styles of hedge funds are finding their way into parts of the portfolio that are adjacent to similar risk factors. For example, we're seeing equity long/short managers being used increasingly by institutions as a portion of their equity allocation.
AR: What about the future of funds of funds? Are clients now more skeptical about the value they can offer?
Kojima: That really hasn't been our experience. In fact, investors we're talking to today have an even deeper appreciation of the need for thoughtful manager selection, portfolio construction and risk management. This comes partly as a result of 2008 volatility and partly as a result of some well-publicized manager-specific challenges. Today there's a full understanding of how difficult these activities are. Looking back, in '05, '06, '07, when everything was seemingly going well, the difficulties were perhaps not as apparent.
In recent years many institutional and individual investors have been confronted with so many challenges all at once: spikes in volatility, unforeseen correlations, hidden illiquidity, significant drawdowns. In some ways, if you can have a broader discussion—not so much selling a product, but having a thoughtful conversation about the place of hedge funds, asset allocation, risk management—that's just a welcome conversation. Whether it leads to Goldman-specific funds is another question, but we always welcome the discussion.
AR: In the past few years, have you been able to negotiate better terms and fees with the hedge funds you invest in?
Clark: We are constantly exploring the ideal array of terms with underlying managers. And these terms are not only economic—they include terms governing liquidity, transparency, mandate, key-person and affiliate transactions, among other things. Of course, this isn't a one-size-fits all approach. Judgment, informed by extensive manager-specific diligence, is needed to determine what is appropriate.
Our historical and recent investments in our hedge fund resources—our team, our risk management systems, and client service technology—have enabled us to continually refine and improve how we deliver solutions. This might involve new terms, more customization, more options. It's often an iterative conversation with clients.
AR: How has the publicity surrounding the SEC's charges against Goldman affected your group?
Kojima: The investors we've had the privilege of working with often have had relationships with us for many years. I'd say the client support has been very good. We're fiduciaries for our clients, full stop. In some cases, the recent conversations we've had with clients have taken the form of education and clarification, where we're ensuring they understand what it is we're doing for them and what we've always done for them. And that is to serve as their fiduciaries as we deliver them solutions for their hedge fund investing programs.
AR: You say there hasn't been a material impact, but haven't some people redeemed?
Kojima: Investors are always managing their portfolios, and so there will always be some redemptions and new commitments. Since early 2009 we've seen our assets increase around 13%, and today we're around $21 billion in assets.
AR: Is that from fund performance or capital inflows from investors? How much from each?
Clark: It is from a combination of inflows and market appreciation, but we don't break it out.
Our focus is consistently on investment performance and risk management and client service. If we perform well, our belief is that the business will continue to grow.
AR: Have you altered your terms for investors following the financial crisis?
Clark: We continually reevaluate terms of underlying managers. The financial crisis has forced many investors to consider fundamental questions about asset allocation and risk management. We've been working with investors to help them look at their portfolios from a variety of perspectives: liquidity versus illiquidity, inflation versus deflation, developed versus growth markets. It's critical to look beyond traditional classifications and focus instead on how the portfolio behaves across different scenarios. Part of this analysis involves a thoughtful review of terms of the underlying managers, including transparency, liquidity, and economics, and we are constantly reevaluating terms. But this is only part of the whole equation. The focus needs to be on risk management, not just risk metrics.
AR: But what about the terms of your funds of funds? Have they changed?
Kojima: Our historical and recent investments in our hedge fund resources—our team, our risk management systems, and client service technology—have enabled us to continually refine and improve how we deliver solutions. This might involve new terms, more customization, more options. It's often an iterative conversation with clients.
AR: Why shouldn't investors go direct into hedge funds, as many are doing? How have you made the terms better for me?
Kojima: There are some institutional and individual investors that have the expertise, resources and ongoing commitment to select managers and to monitor these managers. But this requires a global sourcing network, an extensive due diligence team, market insights, deep risk-management capabilities, legal resources and technology infrastructure. Some investors looking at hedge funds want to partner with us to fully access our capabilities. Others want to complement their own resources. We're pleased to engage with investors across this entire spectrum.
For those investors with an internal team, we often partner with them on specific niche strategies. Let's say they are very well resourced in the United States, but in Asia or Brazil they do not have people on the ground. Or have good coverage of equity long-short managers, but have less expertise in credit strategies. We might help amplify their capabilities in those areas. Alternatively, on their entire portfolio, we might engage with them in an advisory capacity and offer our insights as a supplement to their own. The terms, structures and economics can be highly customized in such arrangements.
AR: Do institutional investors have realistic expectations about hedge fund performance?
Clark: It's not clear that many investors have realistic expectations for traditional asset classes, and that's something that has to be the core of what types of returns you think you can generate from anything else.
A lot of this comes back to the issue of understanding whether historical track records—and many of them are quite impressive—are truly representative. That, for me, is one of the bigger questions, to see if people are actually looking at the relevant track record. It's not just that there was this great track record historically and I need that return to fit into my portfolio assumptions going forward. The question is, is that something that's sustainable in the current environment?
It's reasonable to think that, depending on the strategy, returns may deteriorate over time for some strategies that are characterized by being smaller and more limited in supply, just because the demand for those returns generally rises to basically take away any extra alpha.
But there are a couple of mitigating factors. One is continued innovation, which creates new opportunities to create attractive returns. The other is that there are some strategies where, just because of the size and depth of the markets and the liquidity of those markets, there is no real reason to believe that the alpha or return opportunity really goes down over time.
There are some strategies where we expect similar returns to what we've seen in the past. There are other strategies that will probably have more of an ebb and flow, where they'll go out of favor or their returns will just diminish, and then there will be new strategies that will come up and take their place.
AR: Which strategies do you like most right now?
Clark: We are probably distinctive in our allocation to macro-style managers and the length of time we've been investing there and probably the amount of size we have there. In terms of percentage of dollars, it tends to be about a quarter of a diversified portfolio of assets.
What we think is attractive is the amount of dispersion we're seeing globally in policy and the uncertainty that we've seen in economic prospects, and that essentially has created opportunities for macro managers over the course of the past 18 months. We expect it's a situation that should persist for some time. Macro managers certainly have the broadest view of the world. They tend to be agnostic with respect to direction, so you don't find a macro manager biased to be long equities or long dollar versus euro. They are very much trading long and short.
AR: What are the prospects for long/short equity funds?
Clark: Long/short is probably at a high level of allocation for us because of what we perceive to be the opportunity for alpha and dispersion of returns going forward. Although they've had a relatively muted year so far, there are attractive opportunities to some extent created by the market downdraft but also just based on valuations.
AR: What about less liquid strategies?
Clark: There are events and event-driven managers that should have the opportunity to play out with very positive results over the next year or so. There's plenty of cash on corporate balance sheets, and that can drive changes in structure, like M&A activity. It can drive share buybacks, which can be a catalyst for value realization even in just a traditional long-short equity strategy. So we think that managers who are playing toward a specific event and are less likely to be subject to broad market events offer a good opportunity for value added as well.
In spite of all the volatility and all of the moves in the markets over the last couple years, midsize credit managers trading in the midmarket should continue to find enough opportunities to make good returns.
There's still fallout from where we've been the last couple of years, and there's still plenty of uncertainty about the robustness of balance sheets—and in some cases business models—that selectively there could be real opportunities with credit managers.
AR: Are there any strategies you are avoiding?
Clark: Some we always avoid are ones where their return proposition seems to be almost entirely predicated on the use of leverage, which is different from saying we don't invest in managers who use leverage. But managers that are trading very small spreads, where the only way you can get reasonable returns is by gearing them up, are ones we tend to avoid.
Strategies where there is real illiquidity accompanied by leverage or even just real illiquidity we'll avoid as well. There are some strategies that could be reasonable as part of a multistrategy firm, but we don't want to see on a stand-alone basis just because they have episodes where they have great payoffs and episodes of being quiet or just unattractive. Often, multistrategy managers will make the allocations opportunistically rather than always having to be invested.
Examples of things we don't do on a stand-alone basis are convertible bond arbitrage and private investment in public equities. Those can be part of a broader mandate but are not something we would do in a dedicated way. AR
(Additional reporting by Anastasia Donde)