The Hedgeweek Interview: Randall Dillard, Partner, Liongate Capital Management

HW: What is the background to the company?

RD: I had just retired as Managing Director of Nomura Merchant Banking. My intention was to stop being a proprietary and principal investor and do something radically different. I was dead bored within a year. I missed the creativity of making money and working with talented and driven people. So I established Liongate Capital Management, a fund of hedge funds management company, with Jeff Holland from Deutsche Bank.

At Nomura, my group had effectively been a captive hedge fund, which transacted and traded across a wide spectrum of alternative asset classes including high-yield fixed income, equity, derivatives, foreign exchange, and even private equity.

The main difference is that I am now an owner and can operate in a boutique, partnerial environment.  I found that managing traders, research & credit analysts, brokers and private equity teams previously is an invaluable background from which to select hedge fund managers, providing a superior skill set from which to assess their investment strategies.

HW: What are your products?

RD: Our first product is a fund of funds named Liongate Multi-Strategy Fund. The Fund was launched on 1 April 2004, after over a year of research and preparation.

We designed the portfolio to be best of breed by risk-adjusted return. In our first six months of trading, we have earned a return of 10.70% (22.55% annualised return) with a standard deviation of 3.23 %.

The fund was at the top of the InvestHedge fund of hedge funds rankings in the period May to July 2004, one of the largest industry databases, and ranked 3rd out of 1,178 funds of hedge funds in the HFR database in the latest available period April to August 2004. We are pleased with its performance so far, although we are not complacent.

HW: How frequently do you reallocate the portfolio?

RD: Frequently. Liongate is a multi-manager fund that tilts its allocation towards diverse strategies which we expect will outperform in their current market cycle.  We have found that many large hedge funds are operating in similar capital markets. The weight of capital has been squeezing the margins out of many market opportunities, particularly arbitrage situations. The best risk-return opportunities exist in strategies where there are fewer hedge funds and capital deployed, so we are over-weight in these niche strategies. Since May, we have adjusted about one-third of the portfolio, despite the redemption constraints inherent in hedge funds.

Fortunately, there is almost as much investment opportunity within sub-strategies as between investment strategies. The value creation of fund of fund managers this year has been to select managers who can execute winning sub-strategies within poor capital market conditions. Being nimble on portfolio allocation this year is absolutely essential for profitability.

HW: What are your key reasons for hiring managers?

RD: The best managers this year generated profits using original ideas. Managers should have a strategy that we understand, together with proven ability to execute profitably. Ideally, we would have managed the manager’s strategy once before ourselves. Sustainable, good performance takes both an unwavering commitment to finding managers with a competitive investment advantage in their target market and, additionally, a commitment to intelligent aggressive portfolio management.

HW: When do you fire managers?

RD: We will certainly remove underperforming managers who demonstrate declining risk return prospects. Hedge funds are not a branch of poverty law.  We will usually change managers, however, which are experiencing increasing operational risk or deteriorating risk management. We watch personnel turnover carefully as ultimately it is people who make judgments and manage risk

HW: How many managers do you have on the substitutes’ bench?

RD: We have invested in 25 managers and have about 50 on the substitutes’ bench. We follow about 200 managers actively. 

HW: What trends do you anticipate to the end of this year?

RD: The recent period of underperformance for most hedge fund strategies is not persistent – just annoyingly elongated. The business cycle and market expectations of global growth prospects had little momentum. Securities in most classes were trading close to fair value.  Volatility was low and there was a high correlation between the fixed income and equity markets. The investment climate for most strategies is improving, though we believe that most strategies will continue to underperform previous levels through to the end of the year.  Until a clear market direction develops, we will continue to place an emphasis in our portfolio on those funds with niche trading strategies, with a continued focus on capital protection.

HW: Is there evidence that some managers are now switching strategies to take advantage of related opportunities? What are your thoughts on this?

RD: Yes. Market conditions are encouraging managers to do this more. Some managers have taken more capital than they can profitably invest within their usual trading strategies and have used that capital to quietly diversify their hedge fund business.  This clearly creates new risks for these managers. We are detecting style drift increasingly and believe that many of these trading shifts have not added value.

Generally, we believe that investors should continue to be cautious on style shifts, even strategy switches which managers understand. Investors should regard them as risky and potentially disruptive to their own portfolio. We watch for style drift carefully.   What is important is that managers disclose any change in investment approach, to give investors an opportunity to evaluate whether a change is justified and reasonable.

HW: Some funds of funds have complained that managers are not taking enough risks in the current environment – what are your views on this and on risk in general?

RD: What fund of fund managers really mean is that managers are not making enough money, with many producing negative returns after fees. This year has been dismal for most hedge fund strategies, with an uncharacteristically slow bleeding of fund valuations.  Some excellent managers have been defensive generally, and positioned to preserve capital. Managers who grew impatient, however, and made large directional trades were wrong more often than right. Some experienced larger than expected drawdowns. Consequently, many investors may re-weight their investments significantly in the first quarter of 2005.

HW: What makes a hedge fund manager special enough for you to select him?

RD: To start with, the manager must be smart, ethical and independent.  We like managers who are receptive to open relationships and information transfer.  We prefer those managers who are committed to recruiting and rewarding a rounded team of the highest quality.  And we look for managers who have a consistent track record in buying cheap or selling expensive assets correctly, or judging the direction of their target market accurately.  Excellent managers are not commodities.  We are looking constantly to find managers that fit within our portfolio.

HW: Are investors’ expectations moving upwards and how do you deal with this?

RD: No. Investor expectations are moving downwards in terms of return targets. Institutional investors in particular are willing to trade return for less risk. This means that fund costs will be rising and margins will be declining for the hedge fund industry, leading to a consolidation of the fund of funds industry, as managers seek economies of scale to stay profitable. We will continue focusing like a laser beam on risk-adjusted return. Highly profitable funds will always have a place in the industry. Investors stay with hedge funds because they make money.  This is, after all, the ultimate objective of hedge fund management, and this is why I started Liongate Capital Management.

HW: How do you distribute your product/s?

RD: So far, we have not had to market the Liongate Multi-Strategy Fund. We launched the fund in April this year and closed for new subscriptions the next day. We are considering opening our fund during the first quarter of next year, and will consider a distribution strategy then.

HW: Are you planning any further launches?

RD: We are currently focused on the Liongate Multi-Strategy Fund. Where we see that Liongate can offer high levels of added value, we will consider other launches in the future.