Wyoming pension cracks whip on managers riding in on high horses

As Cynthia Lummis, Wyoming's state treasurer begins searching for absolute return funds she offers some helpful advice on how to speak to uninitiated institutional investors

In the 1990s, I was general counsel to Wyoming Governor Jim Geringer. We had been legislative colleagues for many years before that - he had chaired the Senate Appropriations Committee, I chaired the House Revenue Committee. He was a civil engineer by training and farmer by occupation, I a natural-resources attorney and rancher.

We had complementary policy expertise, liked to work and respected each other. It was a great match. On one occasion I prepared testimony for him to deliver before a Congressional Committee regarding the valuation of trona for purposes of applying federal mineral royalty rates.

I was personally knowledgeable about the subject and consulted other experts. I submitted the requisite number of copies of the Governor's testimony in advance to the Congressional Committee staff, gave the Governor a copy of his testimony to review on the flight to Washington, sent him off and patted myself on the back for a job well done.

About a month later I received a transcript of the testimony the Governor had delivered to the Congressional Committee, and was asked to review it for accuracy before its inclusion into the Congressional record. To my surprise, he had delivered only one sentence verbatim from the testimony I had prepared for him, and the sentence was: "I am Jim Geringer, Governor of Wyoming."

Everything else was different; he did not alter the policy conclusions or recommendations, but changed dramatically the way they were presented. I thought my draft was better.

However, his version was simpler, more 'down home' and used less jargon, and included more overarching policy statements. To this day, I think my version was a more precise statement of Wyoming's position on trona1 royalty-valuation methodology, but his version was probably more approrpriate for the audience.

And in the end, what is more important - that Congress have a precise statement of Wyoming's position, or that they understand Wyoming's position? When conveying information to decision-makers, I'll take understanding over precision any day.

That is what I am going to discuss. You have all seen statistics regarding the billions of dollars that are going to pour into the hedge fund space in the next few years. Two thirds of the largest US institutional funds - those with assets of more than $10bn - will be entering the hedge fund space in the next two years.

We institutional investors have a herd mentality, many of us are new to hedge funds and the herd is stampeding in your direction. (Recall that I'm a rancher, so you may have to put up with several ranching analogies here).

So how can you sort out this stampeding herd, in order to provide them with approrpriate care and feeding for their specific needs, thereby simultaneously increasing their wellbeing and your profits?

The path to profit is to work with the investor, increase their understanding and to provide trustworthy stewardship of the assets - the herd.

If you are lucky, all of your meetings will be with informed, knowledgeable investment professionals at pension funds, foundations, endowments and family offices who speak hedge-fund-speak, and who are empowered to make investment decisions without first consulting with a lay board of directors.

At some point, however, your luck will run out, and you will be facing a lay board, or an investment layman who is nevertheless empowered to make investment decisions. Today, you are faced with both - I sit on the Board of Wyoming's Retirement System, a layperson board which is empowered to select external investment managers for all asset classes.

Further, as an elected state treasurer I invest the state's permanent funds, so my lay staff and I manage all of Wyoming's relationships with external managers every day. I have to explain this stuff to legislators, my fellow elected officials, and to the public.

I am an institutional investor, a layman, and a Johnny-come-lately to hedge funds.

Your modest task is simultaneously to determine the goals of my fund, gain an appreciation of my risk parameters, evaluate my level of knowledge about hedge funds, explain your strategy at a level which is consistent with my level of knowledge about hedge funds, explain your strategy at a level which is consistent with my level of knowledge - don't be condescending but don't speak over my head - gain my confidence and, hopefully, gain a client.

While it sounds like Mission: Impossible I have what I hope will be several practical suggestions based on my experience so far as a first-time investor in hedge funds.

1. When speaking to lay investors or lay boards, the precise can be the enemy of the understandable

Take, for example, the terms 'alpha' and 'beta'. You would be stunned if you realised how few lay board members know what you are talking about when you use those terms. How will you ever explain portable alpha to someone who does not yet get alpha?

You should define these terms of art before you use them, even if you know you are making the fifth presentation they have heard that day.

Precision can be disadvantageous when making a 30-minute presentation to a lay person.

Choose, instead, to help them understand. Tell them that, simply stated for today's purposes, 'alpha' is the excess return you get above the market rate of return, and 'beta' is the risk you are taking. Then be sure you have included a glossary of terms in your presentation materials and for their future reference, point the glossary out to them. Better yet, do not use the terms alpha or beta in your presentation - I dare you.

(In my other life, 'alpha' refers to the alpha male in a wolf pack that was introduced into Wyoming pursuant to section 10(j) of the Endangered Species Act. The night before preparing this text, I prepared a memo on the history of the litigation surrounding the introduction of the Canadian grey wolves into Wyoming. I also referenced AuM's in that memo - it stands for Animal Unit Month in livestock-grazing parlance.)

Then I had to reorient myself to think of alpha as a measure of return on investment and AuM's as assets under management. We are lay board members with very complicated lives within and outside of this investment world so the more you can help us understand, the better.

2. Know your audience and tailor your remarks accordingly

When the Wyoming Retirement System selected an external manager for its absolute-return strategy, some members of the benefits sub-committee attended the interviews, which were being conducted by the investments sub-committee. The board chairman, who had never served on the investments committee was in attendance.

I sat across the table from her and watched her face during the interviews and the discussion. She is a smart woman but she was totally lost. The managers, as I like to say, "lost her at 'hello'." And when one presenter discussed offshore vehicles and derivative positions she was not only lost, but also concerned.

Her face read like this: "What will I tell my fellow teachers if this hedge fund scheme goes belly-up, and they know I voted for some Cayman Islands/derivatives thing that I don't understand?" The discussion period revealed that only two of us had any clue what the board had just heard. In the end, the lay board turned to the consultant and said: "Who would you choose?"

The consultant selected two very complementary strategies - one a real return and the other an absolute-return strategy - and recommended initial funding at $75m per manager. The board approved only the real-return strategy. And, yes, the consultant's recommendation that was rejected was the guy who talked about offshore vehicles and derivative positions. A firm with a sterling reputation and successful strategy lost out to the tune of $75m - and the investors in the Wyoming Retirement System lost out - because the presenter did not understand his audience.

Perhaps the moral to the story is, make sure the consultants love you, because they may be making the manager selections for these institutional investors with lay boards of directors. I think, rather, that the moral to the story is: 'know your audience and tailor your remarks accordingly.'

PRIVATE EQUITY, PUBLIC UNDERSTANDING

The most-revered private-equity expert in the United States and perhaps in the world is an attorney with the firm Kirkland & Ellis by the name of Jack Levin. He was described by Chambers & Partners as the "father of private equity." I asked Jack Levin to speak to a meeting of state treasurers I was hosting in Jackson Hole, in my beloved Wyoming. To my delight and to my surprise, he accepted my invitation. (He normally only speaks to groups whose understanding of private equity is commensurate with his own, to the extent that anyone breaths the same rarified air as he.) As you can tell, I admire him greatly.

His speech was fabulous, truly fabulous, and totally within the grasp of any state treasurer. Afterwards, I learned that Jack had many colleagues helping him with his presentation, that Jack himself had toiled no less than 40 hours on that presentation, and that he had tirelessly practiced his delivery.

"Why?" I asked one of his colleagues, "Jack Levin knows this subject cold." The answer should have been obvious to me: "Because Jack wanted his audience to understand private equity, he had to put in a tremendous extra effort."

Jack's colleague might have said, "Jack had to work hard to 'dumb down' the topic for the audience." But Jack's colleague knew that Jack's motivation for spending so much time on a topic he knows better than anyone in the world, is to make sure it doesn't stay that way. He was speaking to a room full of investors, and he knew it.

To speak advanced private-equity-speak would have been a disservice to the private-equity funds he represents in his law practice, and to quality investments that are trying to attract institutional capital. Many of you in the absolute-return strategy business can speak advanced-hedge-fund-speak. You can dazzle investors with your vocabulary. Note that I said dazzle, not impress. To be impressed, one must have an understanding of the presenter's knowledge, but be simultaneously dazed and confused by it.

3. Lay a foundation for your presentation

Let's lay a foundation for absolute-return strategies. What are they, and why should an institutional investor consider adding to an already-diversified portfolio? I was told that 'absolute-return strategies' is a new, politically correct synonym for hedge funds, a term developed because the term 'hedge funds' is associated by new investors with 'high risk' and perhaps more to the point, high 'headline risk'.

That is odd, because my consultant told me one reason I should consider hedge funds is to reduce risk. Then I read:

"The goal of most hedge funds is to maximise returns on investment and the name 'hedge fund' is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market with their ability to short the market. Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds 'hedge risk'."

Here is the conclusion to which I have come: the term 'absolute-return strategies' is not really code-speak for hedge funds. They are not entirely synonymous terms. Return strategies should be lumped together for discussion purposes.

An absolute-return strategy seeks returns not related to a benchmark, while a relative-return strategy is typically used when securities are actively managed against a benchmark. A real- return strategy targets a return exceeding inflation by a premium.

Return strategies are an approach to investing, not an investment class, and numerous strategies fall within each approach.

A hedge fund is a vehicle for implementing a return strategy. Just as private equity is not a synonym for venture capital, but rather is an umbrella term under which falls venture capital, growth equity, leveraged buy-outs (LBOs), mezzanine debt and equity, secondary assets, and so forth, 'absolute-return strategies' include such things as global macro, event-driven, market-neutral, long/short equity, relative value, fixed income arbitrage, and many others represented today.

The hedge fund vehicle itself can be defined as a legal entity, a pool of talent, or both.

Why add an absolute-return strategy to an already-diversified institutional portfolio? To enhance returns, reduce risk, or both; and to provide performance with a low correlation to traditional asset classes.

Okay, I'm in. I have a portfolio full of traditional assets and I want to add an absolute-return strategy to my portfolio. I prepare an RFP, and it lands on your desk. What's next?

4. Call the contact person identified on the RFP in advance, gain an understanding of their investment goals and, if possible, a sense of the board.

As I mentioned earlier, the stempeding herd of institutional investment capital is on its way. You must sort the herd so you can provide appropriate care and feeding.

If the investment board places its highest priority on transparency and you cannot provide it, don't respond to the RFP. If you determine that the board is highly risk-averse and your strategy is heavily dependent on leverage for generating its superior returns, then you cannot provide that board with appropriate care for that fund.

Take the time to match the investor's request to your strategy; and if there is a good match submit a proposal.

5. What does this lay board or lay investor want to know, what is on their minds?

The board votes to initiate an absolute-return strategy manager search, then time passes.

The staff works with the consultant, or drafts the RFP themselves, responses come in, they are sifted, and finalists appear before the board for face-to-face interviews. What is on their minds? Here are some examples:

'I can't remember why we did an absolute-return strategy search when there is this wonderful tactical asset-allocation product that we are not considering because the strategy is real return, not absolute return.'

'How do I sort all these different strategies?'

'Is a fund of funds the best way to go or just the easy way to go?'

'Can they get access to closed funds or quality replacement funds?'

'If I go with a separate account and then change fund managers, can I take a great underlying fund with me when I go?'

Then there is the multi-strategy fund;

'How is that different from a fund of funds and is it cheaper than a fund of funds?'

'Here is a single-strategy fund investing in an area of the market in which we want more exposure. The investment team of the general partner is truly brilliant, it is totally unleveraged, and it's negatively correlated to our other investments. But does a single strategy really get us anywhere?'

Many of our other questions - such as those around fees, high watermarks, lock-ups, the usual stuff - will be addressed by the respondents to our RFP. It is the overarching, big picture questions that nag institutional investors, and those that will undoubtedly nag at my team and me as we hit this trail.

footnotes

1 Trona is a mineral consisting of sodium carbonate and occurs in salt deposits. For the chemists among you: Na2CO3NaHCO3.2H2O