Global hedge fund advisory firm Sussex Partners has been in the midst of the constantly evolving relationship between hedge fund managers and investors.
Established in London in 2003 by Swiss-born Patrick Ghali along with Robin Nydes, Sussex — which advises hedge funds and other alternative asset managers and institutional allocators — has since expanded its presence globally to include New York, Zurich, Tokyo as well as London.
“We have been at this intersection, this great in-between space, between investors and managers where we get to talk to both sides,” Patrick Ghali, co-founder and managing partner, said of the firm’s position in the industry. “I talk to managers and I talk to investors and I can sort of synthesize two views and act as a sounding board and have conversations with both.”
Reflecting on the seemingly relentless evolution and expansion of the hedge fund industry in the 20 years since Sussex’s launch, Ghali noted the key change in that time has been the greater acceptance of hedge funds and other alternatives within investors’ portfolios.
“Alternatives have matured, and become more mainstream. People are more educated about them in general,” Ghali told Alternatives Watch in a recent wide-ranging interview, in which he discussed the major milestones, crises and flashpoints that have shaped the hedge fund landscape over the past two decades.
Times of turmoil
To say it’s been an eventful journey would be an understatement.
Initially used as a tool for wealthy individuals and family offices, hedge funds were given considerable leeway in how they managed client capital in the industry’s early days. But as the sector successfully weathered the fallout from dotcom crash of the early 2000s, it steadily captured the attention of larger, more institutional investors eager for non-correlated returns. Managers, increasingly keen to raise larger amounts of capital, duly obliged, and began tweaking their strategies in order to squeeze them into institutions’ risk frameworks.
“That meant lower volatility, more predictable returns, much lower drawdowns. But it also somewhat curtailed the opportunity on the upside — returns were no longer what they used to be,” Ghali observed of the drift towards institutional clients. “It may have worked for institutions, but it didn’t necessarily fit with how traders were trading their strategies before.”
Meanwhile, due diligence was often little more than a footnote or afterthought for prospective investors.
“They would often receive an annual report, with just a number on it,” Ghali recalled of the early days. “If investors wanted to ask questions, they were politely told to take their money and go elsewhere.”
The events of 2008 would change all that.
The turmoil of the Global Financial Crisis and the far-reaching impact of Bernie Madoff’s $65 billion securities fraud proved a watershed moment for the alternatives industry. According to Ghali, the pain of 2008 marked a critical point in the hedge fund sector’s journey towards greater institutionalization, eventually ushering in higher levels of transparency, stronger investor due diligence and risk management, and closer scrutiny of fund managers’ strategies and business models.
“Madoff was really bad for the industry. And it wasn’t just hedge funds — huge parts of the wealth management industry were tainted with one brush. People were saddled with some nasty losses,” Ghali said, noting how large parts of the private banking sphere, particularly in Switzerland, ultimately never recovered from the scandal’s impact.
“The GFC still feels very recent, and what surprises me is the amount of people in the industry now who never went through ’08,” Ghali said.
“For those who went through it, it’s in your bones, and it’s very much something that informs the views of those who did to this day. It’s very difficult to really understand how scary it was if you haven’t been through it, and all you’ve done is read a few newspaper clips or heard a few anecdotes.”
Changing of the guard
But has this shift towards tighter risk frameworks and closer scrutiny of the way managers trade come at the expense of the kind of blockbuster performances that initially attracted so many allocators to the industry in the first place?
“I don’t think those two things have to be mutually exclusive,” Ghali said. “Transparency and due diligence doesn’t necessarily mean you need to tell a manager that they need to manage within a certain risk budget.”
While tighter risk parameters made certain strategies more constrained in the way they traded, on the other side, the deluge of investor capital into the most successful strategies swelled some firms’ AUMs beyond a manageable capacity. In recent years, such twin pressures have ultimately led many of the larger, more successful marquee-name firms to return outside capital and convert to family offices to manage money internally – often with superior results.
“They realized they made enough money from the capital they were managing that they didn’t want these constraints, where clients were becoming constantly unhappy with the returns because of these artificial risk parameters.
“These firms running their own internal pools of capital for partners and which were unconstrained have tended to continue to be much better than the ones that were offered to institutions.”
Another key change in the two decades since Sussex’s launch has been the steady decline of the fund of hedge fund model, a once critical component of the industry, which has dovetailed with the rise of multi-manager “pod” shops.
“In the early days, fund of funds were almost like a concierge service — they picked a few well-known names, and in some cases Madoff was one of them, they charged for access, and that was it. They gave investors very little transparency and insight into what they actually put their money into.
“These were some of the high-flying titans of the industry, who were running billions — Liongate, Gottex, Vision in Asia — and they no longer exist,” he noted.
For Ghali, the growing dominance of multi-strategy hedge fund giants like Millennium and Citadel represents a “natural, logical kind of evolution” of the earlier fund of fund model.
“They are largely similar, but you remove the wrap around each manager and investors get a full look-through on their positions,” Ghali added. “Investors are able to manage that risk better — there are cross-margining benefits, better leverage, and exclusive capacity.”
Back to the future
Bringing things up to the present day, with total hedge fund industry assets edging towards $4 trillion, Ghali acknowledges the irony of managers’ current tilt towards the private capital sphere after several years of chasing institutional money.
“Hedge funds, as well as private equity, first started in the private wealth sector, then went to the institutional segment, and now everybody’s making a big push for private wealth again,” he observed.
Expanding on this point, he suggested this focus on private wealth — particularly among larger, older well-established fund managers in both hedge funds and PE — hints at the broader direction of travel within the industry over the next few years.
“KKR, Apollo, Brookfield — you name it — they’re all putting together huge initiatives to try to attract private wealth. It feels as if they realize institutions are tapped out, they need another pool of capital, and there is considerable private wealth still slushing around.”
This rotation also speaks to the often delicately-balanced power dynamic between fund managers and allocators, which has remained in a constant state of flux over the past two decades, shaped by hedge funds’ mercurial performances and perennially-thorny topics such as fees.
“There are periods where the balance of power goes towards the investor. At the moment, especially if you look at the multi-strats, it very much seems like the balance of power is back with the funds,” Ghali said.
On fees, Ghali remarked: “Fees are a constant discussion. By and large people want to pay less fees, and we’re all very conscious of that. But on the other hand, you see people queueing up to give capital to certain big-name managers at egregious fee levels and terms.”
He continued: “I also sometimes feel like many investors have moved away from being investors and are now starting to try to be traders, which is very difficult. It’s very difficult to trade managers. Trying to figure out whether a manager is going to have a better period in the next two weeks than the last two weeks is impossible. Are the next six months going to be better for a CTA than the last six months? That’s very difficult to predict. Investors should remember that they should be investors and not traders, and you need to give managers the time to do what they said they were going to do.”
This faith in the manager defies market environments and managers don’t become stupid overnight, Ghali observed.
“If someone has had a career of being good at doing this, and they have two bad months, then unless something major has changed — they divorced, someone in the family died, something that’s really distracting — then it probably doesn’t tell you very much about what’s happening,” Ghali said.
Looking ahead, as hedge funds look to adapt to new advances in data and technology, an increasingly sophisticated client base, an unpredictable economic environment, and greater regulatory hurdles, Sussex continues to relish the opportunities the business brings. Much of this is about the “why” of the firm’s advisory business and principals.
What has always fascinated Ghali is that three very successful managers can each have a completely different way of approaching the markets, and completely different views of the world — and yet they all make money.
“Every day you learn something new, and every day you have to challenge yourself and challenge what you think you knew. The intellectual part of this business is very interesting,” he added.
