Robin Bowie, founder of Dexion Capital, outlines the trend towards listed closed ended investment companies and highlights Dexion's unique position in this expanding sector.
London-based Dexion Capital Plc researches, develops and markets alternative investment products, and, via a sister company Dexion Capital (Guernsey) Ltd, manages four London-listed closed ended investment companies, namely, Dexion Absolute Ltd, Dexion Trading Ltd, Dexion Equity Alternative Ltd and Dexion Alpha Strategies Ltd. It is currently the largest manager by AuM of exchange-listed funds of hedge funds globally, with USD 1.75 billion in assets under management.
HW: What is driving the current trend towards closed ended investment companies?
RB: In accessing opportunities that involve alpha, the product providers are seeking permanent capital, and the investors want liquidity - these two aspects are not easily reconciled in any normal fund construct.
People on both sides of the fence have realised that the closed ended company structure is a very well suited permanent capital base for alternative assets as a whole, because it gives the fund manager permanent capital and it gives the investor liquidity - it's an ideal area for development.
The trend is for bigger institutions to start focusing on this market, whether it be as a vehicle for private equity, as in the KKR/Apollo deal, or whether it's for the closed ended investment company route with funds of hedge funds and possibly in the future, big real estate transactions coming through.
Within the hedge funds area, which is where we have specific expertise at Dexion Capital, we have revolutionised the sector by selecting what we consider to be best of breed institutional quality fund of hedge fund managers to run vehicles that are different from each other and have different roles within normal portfolios.
HW: Is it an easy model to replicate?
RB: From a fund structure perspective it is a relatively easy model to replicate because the information is in the public domain as to the structure, and as long as one has a top quality provider the answer is yes, but the closed ended investment company structure is such that it is the investor base - and the maintenance of that investor base - that is very difficult to replicate, because it involves years of work in identifying and developing those investors.
The reason that closed ended investment companies go to discounts is either the investment management company is not good enough, therefore they disappoint on their investment objectives, or that the investor base is not broad enough and is not constantly increased and maintained.
Dexion Capital does a good job of informing its investor base of what is going on, but it is also developing those investors on a worldwide basis, and that is why the recent announcement that we are using Deutsche Bank as a partner in our distribution business has so much validity.
HW: Are you seeing investor interest from outside the UK?
RB: Traditionally, our business has been built on a UK client base, but more and more evidence has been shown to us that international investors are willing to get involved and see the benefits of the structure.
At present, we have three different currency classes within Dexion Absolute - sterling, euro and US dollar - and we are looking to add another currency class - Australian dollar - in the next issue. We have investors from eleven different jurisdictions and we are now getting real traction both in continental Europe and in the Far East.
HW: Why is a London listing popular with closed ended investment companies?
RB: Because the governance and oversight, daily trading and the ability to pull in the market makers, all available in London, are key to making these vehicles work. For example at Dexion we work with eight market makers, such as ABN Amro, Deutsche Bank, Dresdner, HSBC, UBS, Winterflood etc, all based in London.
HW: Is liquidity a key attraction of these closed ended vehicles?
RB: It is the availability of daily liquidity that encourages investors, and once you have a big fund like Dexion Absolute, which is USD 990 million, you have quite significant turnover, so it is relatively easy to trade in USD 5 million T plus 3 by picking up the telephone.
It is this ability to access a relatively illiquid opportunity set through a vehicle that they can trade T plus 3 that is proving attractive to investors.
We have discovered that there are a lot of asset management companies in the world that have a requirement for mark to market. The traditional way of giving monthly NAVs for hedge funds 20 days after month end is increasingly unattractive for investors, but most investors are now looking for monthly or quarterly liquidity. It is difficult for funds of hedge funds to given them this given the underlying illiquidity of the assets, and so we have a vehicle whose time has come.
HW: What are the specific attractions for institutional investors of using a Dexion Capital listed closed ended investment vehicle?
RB: Institutional investors find these closed ended vehicles attractive, first because of corporate governance - you have an independent board that oversees each vehicle. With a normal Cayman offshore fund, which is what you would find in the open ended sector, there is always a question mark amongst trustees as to whether that is a prudent vehicle to invest in, whereas the closed ended company has the advantage of being regulated by the UK Listings Authority (UKLA), which is a subset of the Financial Services Authority, plus the London listing rules have their own constraints and reporting requirements that give comfort to institutional investors.
Second, Dexion Capital is a consultant in the fund of hedge funds area. It is important to understand that our business is driven out of advising institutional investors on allocations to the hedge funds sector, and we believe we have one of the best understandings of the sector as whole. This means when we present the product to institutional investors we give them all the due diligence work that we have done, including our comprehensive framework for looking at fund of funds' organisations and business processes.
Third, Dexion Capital constructs its products based on what the market is telling us, and we then use our 4-man research department that has been operating for six years to research the best fund of hedge fund managers that we short list and then select to run the portfolio.
It is important to note that we are not a fund of hedge funds, we select the best fund of hedge fund managers to run our funds.
HW: What else differentiates Dexion Capital from fund of hedge fund management groups?
RB: Dexion Capital's role is not only to select the best managers, but to be the ambassadors and drive the education of an ever increasing investor base, and the reason we are talking about the development of the whole sector, is we are finding that we need to put more resource into developing investors and we have to partner with people who are able to give us access to that such as Deutsche Bank or ABN Amro.
What we recognised from our investor base, in the middle of last year, was that they were prepared to increase the risk in order to seek higher returns. We said there are two ways you can achieve this: 1) You can either leverage a portfolio, or 2) you can go into strategies where other people aren't participating and where there are developing underlying markets.
We took the second route and identified a number of aggressive alpha generating opportunities. We then identified and visited a number of hedge fund management groups and asked them if they had capability in these areas. We whittled these groups down to a short list of two multi-managers and two FoHFs.
We eventually selected RMF, and the reason was because they had really thought on the R&D side about the development of the hedge funds business and they had developed this modular approach to hedge fund investing based around modules of single strategy products, thinking where is the return going to come from in the future and in 2002 they launched their commodities fund, in 2004 their Asian opportunities fund, in 2005 their healthcare fund and in 2006 they have launched their energy fund, so that timeline is quite difficult to meet for normal FoHF because they have got to forecast ahead and they then have to hire an analyst to understand the sector, find the managers and construct a portfolio. This cannot be done overnight and if you look at the big FoHFs, you will notice is that a few have been active on the R&D front, but a lot of them have simply been cramming the money into multi-strats, which is short sighted in our view.
The above process demonstrates what we think about who should manage what type of portfolio and that differentiates us substantially from any other firm in this sector.
HW: What are the potential pitfalls for listed closed ended vehicles currently being launched?
RB: They don't know the investor base, they don't know what the investor base wants, they haven't got a developed infrastructure for accessing and keeping people informed about what is gong on, and the result of that, in my opinion, is that there is much higher risk of trading at a discount.
On Day One of a closed ended investment company, the traditional problem has been that the fund of funds manager gets what he wants - locked up assets - the investment bank gets what it wants - an upfront fee - so who is left to care for the investors' interests?
If you have 100 investors on Day One, and six months later you have got five sellers, what then happens? Either you have to have five new buyers, or the other 95 investors have got to buy it, and the circumstances under which people are selling are not the same circumstances under which people are natural buyers.
HW: Why do investors such as insurance companies, pension funds and private wealth management groups choose closed ended vehicles such as those created by Dexion?
RB: The closed ended structures that Dexion has created have brought institutional quality managers to the whole market, whereas previously there were institutional quality managers for institutions and retail quality managers for the retail market.
We brought access to these institutional quality managers at a price which is relatively cheap - although hedge funds fees are expensive we haven't added significant fees for our structure. We have brought these managers in a manner which gives all investors comfort that the background work has been done in looking at these managers, evaluating them and selecting the very best of them to manage our products. Finally, the promotional and educational work is ongoing so they can be confident that more investors will get involved, increasing liquidity. Liquidity is obviously key here, as mark to market is very important to anyone managing money.
We are in essence offering a higher quality of manager and a better alpha opportunity set combined with liquidity.
HW: What is the potential risk for these investors?
RB:The risk that investors face is the discount, so we have provisioned aggressively against the discount by putting in a clause that says that if there is a discount of 5% or more over a calendar year, the investors can choose to force a wind-up of the company.
HW: Over the last 18 months hedge funds have become involved in 'convergence', expanding into new activities such as direct lending and private equity. Are they qualified to do this?
RB: Because of the background of many hedge fund managers coming from investment banks, they understand the capital structure of companies very well, and they have the analytical skills to look at opportunity sets and deal with them quite quickly.
They have the capability to allocate internal resources quickly to an opportunity set, they are innovative in the way they think, so they are able to come up with solutions that utilise capital market to get rid of parts of the equation that they don't want and to take on the part that they do want - it's that understanding and ability to react combined with the resources that enable them to take advantage quickly where private equity houses or banks may be much slower in reacting.
Therefore, I believe this so called 'convergence' is legitimate and is an area where we will see significant growth.
HW: What are the implications of this shift in styles and strategies?
RB: The industry is continually evolving, driven by innovative managers. If you looked at hedge funds a few years ago over 60% were in macro strategies, but less than 9%are in macro today. We are seeing a proliferation of strategies and managers are becoming bolder and better resourced, many are like mini investment banks capable of dealing with a lot of different opportunity sets.
HW: Will you continue to focus on hedge funds or do you plan to extend into other asset classes?
RB: We will continue to focus on the alternative asset sector as a whole and in our long-term thinking we believe that the same kind of confusion and lack of understanding about hedge funds is becoming apparent in private equity and in real estate.
We are actively considering putting researchers in place to do the background work on those areas.