Q&A: An Endowment-Style Portfolio In Closed-End Form

Aug 23 2012 | 4:14am ET

Times are tough for private equity—which means, according to Hatteras Funds' Bob Worthington, that opportunities are ripe.

Hatteras, which has $2 billion in assets under management, is trying to profit from those opportunities, investing a substantial chunk of its flagship fund of hedge funds in private equity funds starving for funding. The balance of the fund is invested in more than 100 hedge fund managers, which may make Hatteras as close to a university endowment as is available to individual investors, who can get a piece of the fund for a minimum investment of just $50,000.

Worthington recently spoke to FINalternatives Senior Reporter Mary Campbell about the outlook for private equity, the benefits of diversification and the economic outlook.

Can you tell me something about the Hatteras Core Alternatives Fund?

It was actually the flagship fund for starting Hatteras in 2004. In early 2005, we converted it into a registered fund under the 1940 and 1933 Acts. It’s a closed-end fund that takes in money on a monthly basis. Due to the investment thesis, we then offer a soft one-year lockup and a quarterly redemption after that.

Why did you opt for that structure?

Back in 2004, there was very little thought of putting alternative investments into publicly-traded funds. While this is a very big growth area today, it really wasn’t in the thought processes of most alternative managers back then. 

Second, 75% of the fund’s investments today are in underlying hedge funds. But what differentiates the fund from almost all others is that 25% is invested and culled from underlying private equity and private investment vehicles.

It is impossible, I would argue, to achieve any type of daily liquidity or daily valuation if you want true private equity exposure. Therefore, the fund is a tremendous vehicle for clients or small- to mid-sized institutional investors that don’t have the ability to access private equity. That’s especially true now, given that we’ve built a good private equity book over the last eight years. It’s a fund in which investors can actually gain exposure to private equity, day one, that’s already in the ground, invested.

How do you select underlying managers?

The fund is led by Mark Yusko and is supported by his 50-plus person team at Morgan Creek Capital Management. The selection process and the sourcing process are driven by the team at Morgan Creek and its principals, who have decades of experience managing large endowments.

The process starts at the top: It’s an open-door policy. The team meets with a large number of hedge fund managers and private equity managers that are fundraising every year. They funnel those offerings through an investment process that features a number of different criteria, from experience to positioning in the marketplace. They then put together a portfolio through an asset allocation and portfolio construction process that we believe offers ample diversification, while providing risk mitigation with the possibility of reasonable returns.

Do you have any size constraints when considering investments? How long do you tend to hold your positions?

When we add to private equity, we typically want to make $5 million to $10 million commitments. We tend to invest in private equity funds that have $100 million to $1 billion. And once we make the commitment, we’re pretty much in that investment for the life of the fund.

The hedge fund side is a combination. We have investments in some very large funds such as Citadel Investment Group, D.E. Shaw Group and Brevan Howard Asset Management. We also have some really good niche managers. There, of course, liquidity terms could range anywhere from 15 days to two years of a lockup, followed by monthly or quarterly redemption or, in some cases, if they’re really exceptional, semi-annual redemption.

What is your approach to risk mitigation?

We want hedge funds to achieve a reasonable rate of return and, for the most part, we want them to do that with less volatility than a straightforward, long-only portfolio. We try to achieve, on the hedge fund side, equity-like returns with volatility that could be 30% of the Standard & Poor's 500 Index.

We want diversification from our hedge funds, so if somebody wants to take a lot of risk and hit a home run, then they should go invest in a single hedge fund—maybe they’ll hit a home run, maybe they’ll hit a single, or maybe they’ll strike out. But a diversified portfolio of hedge fund managers with different strategies is great for someone who wants a steadier return stream, one without the extreme volatility that has been inherent in the equity markets over the last five or 10 years.
We view this not as a get-rich investment, but as a consistent, disciplined process that should, if done correctly, keep you ahead from an inflation-adjusted basis.

You invest with over 140 managers across five strategies. Why so many?

Well, there’s a philosophical reason and years of experience behind that. The senior people at Morgan Creek come out of the endowment world, where the very successful endowments are really diversified. If you look at the portfolios of Harvard University, Yale University, Stanford University, the University of North Carolina and others, there are a high number of managers in there. Since they have perpetual lives, those portfolios can pull off that diversification. They don’t want to get 30% a year—well, anyone would want that, but it’s taking too much risk.

In addition, there are a large number of managers in the fund because what we’ve done on the private equity side is very, very unique. We have created what we call "backward time diversification" in that portfolio: We want to deliver to our clients exposure to multiple vintage years. Vintage years contribute to performance. We also want to diversify them by strategy and geography. So right now, the private investment portfolio, while it’s only 27% of the fund, represents a large number of underlying funds. We have a core base of hedge fund managers, with turnover of 15% a year, but the number of private equity funds will continue to grow because each year we want to commit to another five to seven private equity funds.

On the hedge fund side, do you choose strategies or managers?

If you look at the broad-based strategies on the hedge fund side, we have opportunistic equity (which is really long/short equity), enhanced fixed-income, absolute return (which is really a name for more arbitrage-oriented strategies) and tactical trading (which could be corporate macro or managed futures). We have targets for each strategy.

So the opportunistic equity target is 30%, enhanced fixed income is 20%, absolute return is 15% and tactical trading is 10%. We’re going to have exposure to all four strategies at any one time. Today, we’re slightly over-weight opportunistic equity. We are underweight tactical trading at 7%.

A hedge fund manager may have a specific expertise; maybe they’ve done a good job, and maybe they haven’t. But if we feel that it’s not an opportune time for that segment of the market, we find a manager with a strategy that’s better suited to the next two to three years.

Obviously, there are times when managers haven’t performed or something’s changed at their company or within their personnel, and we’ll move on. But we take a long-term view; we’re not watching these guys month by month and saying, "Oh, you had a bad two months so you’re out."

What opportunities do you find particularly interesting in the current environment?

Clearly, one thing that’s interesting to us is private equity. Most people don’t understand how great the opportunity now is in private investments. Everyone wants liquidity because of the volatility of the last five or 10 years. We continue to face tremendous economic headwinds, with the troubles in Europe, the fiscal cliff in the U.S., China’s hard landing, the list just goes on and on. But because of those concerns, it’s a very difficult fundraising environment for private equity, which pushes valuations down. So we think that this is one of the best times to be investing, for those who can allocate to private investments.

It’s also a good time for different strategies within long/short equity. We think volatility is going to continue to be prevalent through the markets for the next three or four years because of the over-leveraged developed world. You're going to see some pretty sizeable write-downs causing tremendous volatility in equity markets and in some parts of the fixed-income market. We think a better way to invest is to do it through long/short equity managers. You can find—and we believe we have found—managers that are good at knowing when to increase or decrease their gross or net exposures, depending on the environment.

How has the fund done to date?

We’ve outperformed the HFRX Global Hedge Index by about 1.5% a year, net of all fees, with one-third the volatility of the S&P500. And that return stream was created during the time we were building out the private equity portfolio. For the first five or so years of the portfolio, the privates actually detracted from performance. We knew this would be the case going in, but the average underlying investment in the private equity fund is now over three years old and in the last year, private equity has been additive above and beyond the hedge fund portfolio. This has helped differentiate the portfolio when compared to other funds of hedge funds.

We take the view that this is a great time to be investing, adding new money or holding on, because the private part of the portfolio looks to be harnessing itself quite well. If the distributions from your private equity portfolio outweigh the capital costs, we call that a self-funding private equity portfolio and that’s a great thing.

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