HSBC Next Generation Fund: HSBC Alternative Investment

HSBC Alternative Investment is capitalising on the wealth of talent spinning out of existing hedge funds and prop desks to create a fund of hedge funds to capture the high returns of emerging managers.

All the signs are there. Investors are keen to access emerging managers and their superior performance. But the problem is how to unearth these more nimble but hard to find newcomers.

HSBC Alternative Investments saw the gap in the market and acted, launching its Next Generation Fund with internal money last year and opening the fund of hedge funds (FoHF) to external investors at the end of January this year.

The move into emerging managers by HSBC Alternative Investments may be bold but it is not unusual for the group. The management company was one of the first investors into what are now some of the most widely known and best-performing hedge funds in the world. It was one of the first investors in Lansdowne in August 2001, Brevan Howard in March 2003 and DE Shaw Oculus in 2004. For HSBC, emerging managers have always been a focus and driver of returns.

The new FoHF is targeting talented managers spinning out of existing hedge funds as well as the prop desk leavers, keen to prove themselves. The portfolio at present displays a good mix of geography although there is a strong bias towards equity hedge funds. Allocations range from 8%-12% in the eight funds with all but one coming from existing hedge fund houses.

“The increased opportunity set, the improved operational infrastructure and the strength of the launches has made it a much more interesting and viable offering,” says William Benjamin (pictured), head of European research at HSBC Alternative Investments. To be considered for inclusion in the FoHF, the underlying fund will have less than $300 million of assets under management and, most importantly for HSBC, a provable track record.

As a day one or early stage investor, HSBC has an enviable record for picking hedge fund stars of the future. Benjamin hopes the company can replicate the success of the flagship HSBC GH Fund, a $2.4 billion multi-strategy FoHF which has exposures to some of the biggest hedge funds names and that some of the portfolio names in the Next Generation Fund are destined to become the “household names of the future”.

The FoHF currently has assets totalling $100 million and hopes to grow to $500 million by the end of 2012. Initial investors in the FoHF are a mixture of high/ultra-high-net-worth individuals, family offices and small institutional investors. HSBC hopes larger institutions, keen to get exposure to emerging managers, will see the HSBC vehicle as a good investment.

HSBC began creating the FoHF at the start of 2011, initially meeting with more than 70 managers before selecting six to launch the FoHF. Now with eight underlying funds in the portfolio, investing in Europe, globally, Asia and emerging markets, Benjamin believes the fund has a good geographical breakdown. Strategies are mainly concentrated in equity long/short with a couple each of macro and market neutral fund managers.

The FoHF will be managed by Simon Garfield, senior portfolio manager at HSBC Alternative Investments.

Prime objective
Benjamin says the aim is to maintain a concentrated portfolio. “We will add two to four more [funds] over the course of the year. If you think about $500 million split across that number of funds, and the sizes of the funds, it is diversified enough to play to a large client base.”

HSBC is facing some limits, however. Some strategies, such as distressed debt, will be more difficult to accommodate in the FoHF, which is offering monthly liquidity to investors.

Emerging managers tend to outperform larger, more established players. Data from Hedge Funds Research shows managers established for less than two years have almost consistently outperformed those with a track record of two or more years. From 1996 to 2010 new managers delivered better results almost every year, with the exception of only three years: 2003, 2004 and 2009.

“The object of the whole platform is to find managers and invest in them when they are at their best,” states Benjamin.

HSBC is looking for underlying funds that are slightly higher up the risk/reward spectrum than some of the larger funds. “When you have a newer fund with a slightly more ambitious target, the manager is keen to get off and work and make that happen,” according to Benjamin.

While enthusiastic about emerging managers, HSBC is conscious of the risks of taking a punt on an unknown entity. So investments in underlying funds are limited. At present investments range between $25 million and $50 million. HSBC says it will consider investments of up to 50% in an existing fund with AUM of up to $500 million. Concentration in funds with over $500 million will be limited to 20%. However, initially HSBC is looking for managers with AUM under $300 million.

There are no hard and fast limits set for allocations to specific strategies or geographic areas. The idea is to create a balanced portfolio that does not restrict future allocations. “Obviously it is a concentrated portfolio, ranging between 10 and 15 managers. So you end up with higher or lower exposures than in a more diversified fund. We are cognisant of that when looking to add funds,” says Benjamin.

“The most important thing for us is that we get the right funds; the mix is secondary. If we feel we are becoming overweight in one area, then we will look to add something else.” At the end of 2011, emerging markets-focused funds accounted for 28% of the portfolio. Although HSBC has spotted some interesting opportunities in emerging markets, it is holding off further allocations for the time being, explains Benjamin, as it does not want to have too high a concentration in this area.

One of the two funds in the portfolio that invests in emerging markets is Avantium Liquid EM Macro managed by Avantium Investment Management. Its founder and CEO, Kay Haigh, formerly ran the global macro trading group at Deutsche Bank and is so far the only manager coming directly out of an investment bank.

Over the past year, emerging markets and in particular Asia have provided more investment opportunities than the US and Europe, says Benjamin. As those markets develop he expects opportunities to grow.

“The Volcker rule and changes on the banking side mean that the opportunities for people in banking are fewer than they used to be. The possibilities to launch a fund can be more appealing,” points out Benjamin.

The big change in start-up hedge funds, says Benjamin, is the infrastructure and amount of capital required to get the business up and running. “In the early 2000s you could go and see a fund where it was two guys in a room with a trading station and an Excel spreadsheet,” he muses. “That just doesn’t exist anymore.” Compliance requirements as well as the predominance of institutional money have pushed the industry away from the backroom model and into a more structured and expensive business proposition. “That side of the business in a small fund is unrecognisable compared to what it was five to 10 years ago,” says Benjamin.

HSBC wants to see a robust operational infrastructure in place before it allocates funds. This is an important area during due diligence, particularly because of the business risk of investing in start-ups, says Benjamin. “We spent a lot of time with the funds making sure they were as robust as they needed to be. We entered into a consultative relationship with a few of the funds.”

Fund facts
Full name of fund	HSBC Next Generation Fund
Name of portfolio manager	Simon Garfield
Investment/management company	HSBC Alternative Investments
Contact information	Investor relations ([phone]; [e-mail])
Launch date	September 30, 2011
Inception date	January 31, 2012
Assets under management	$100 million (end 2011)
Net cumulative performance since inception	1.05%
Target return	12%-15% over a market cycle
Target volatility	8%-10% over a market cycle
Strategy	multi-strategy emerging managers
Share classes	euro and US dollar,
Administrator	State Street Fund Services (Ireland)
Auditor	KPMG
Custodian	State Street Custodial Services (Ireland)
Legal counsel	In-house
Domicile	Guernsey
Management fee	1.75% (high net worth investors); 1% (institutional)
Performance fee	10% of excess value over the hurdle rate of US dollar/euro three-month Libor plus 8% subject to a high water mark
Minimum investment	€/$25,000 (HNW investors); $2.5 million (institutional)
Lock-in	none
Redemption terms	monthly

Benjamin is keen to emphasise that Next Generation Fund is not a seeder. Although it will be a day-one investor, it is not taking a stake in the investment company. “We don’t want to be as married to the fund [as a traditional seeder]. Our objective is to invest long term but if things don’t work out for whatever reason we want to be able to move on,” explains Benjamin.

“If you have a stake in the company, then your objectives are different. You are more tied in and your alignment of interest is different. Our interest is clearly the performance of the fund. If the fund does not perform or if we have any other concerns which will cause us to want to redeem we can just do that – there is no other negotiation we need to go into or terms within the contracts.”

Future assimilation
Once the underlying fund has reached $500 million HSBC will talk to the manager about the next step. By the time it has reached $1 billion, HSBC hopes to have moved the fund into one of its other FoHFs. Managing assets of nearly $30 billion, HSBC Alternative Investments is one of the largest FoHFs and can offer emerging managers a good base from which they can ‘graduate’ to more established products.

While HSBC may not be directly invested in the management company, it still takes a keen interest in helping its underlying managers launch a stable and robust business. Benjamin says HSBC is able to guide and help managers establishing their funds and to advise them on operational aspects, including which service providers might be best for different strategies.

Benjamin believes HSBC will continue that consultative approach with all of its underlying managers. There is still a “healthy pipeline” of new launches and some good ideas, he says the company is eager to tap into.

Benjamin admits the climate for raising assets, particularly for start-up funds, is still difficult. It was not an easy environment for new managers to enter last year and this year could also prove challenging but Benjamin is undeterred. “If you are of the pedigree we are seeking to invest in and you have the infrastructure we are seeking, that should be attractive to others. There are pools of capital out there waiting to be tapped.”

Benjamin believes the Next Generation Fund will satisfy a need in the market for a way to gain exposure to emerging managers through a trusted intermediary. The FoHF, he thinks, is a good way for large institutions that have their core holdings in multi-strategy products to tap into the higher returns of smaller funds. He is confident, too, the Next Generation Fund will also spot the rising stars of the future, helping maintain HSBC’s own track record.