A second look at first loss platforms
First loss platforms, investment vehicles designed to facilitate allocation to hedge funds while limiting downside risk, are not new entrants to the hedge fund world, having been around in some form since the early 2000s. However, increased interest in these niche structures has been seen from investors and the media of late, driven by reports of participation by big names such as Paulson & Co and Hayman Capital.
These platforms, which typically see interest from family offices and other smaller hedge fund allocators, seem attractive for several reasons. These include consistent (at least to date) mid to high single digit returns, few down months and better alignment of interest between managers and investors, despite significantly higher performance fees. The alignment of interest is due to the manager, as the name suggests, absorbing first losses, typically up to 10%. In addition, the managers typically running first loss capital are smaller emerging managers or traders that some investors simply cannot gain access to in any other way.
This sounds like a win/win situation, but how, in an increasingly challenging hedge fund environment for the hedge fund industry, are these platforms able to generate steady returns, with limited, or no, downside? And what are the risks of allocating to them?
A first loss platform is essentially a collection of managed accounts where each account’s portfolio manager (“PM”) absorbs the losses up to a defined amount. The loss is absorbed by the PM posting an amount, typically 10% of their allocated trading capital, which can be thought of as collateral. In other words, if a PM wants a $100m account from a platform then they are responsible for allocating $10m with the remaining $90m being allocated by the platform. This $10m first loss tranche, in theory, protects the investors from losses of up to 10%, as negative P&L is allocated to the manager’s capital first. Investors’ capital is only negatively impacted if losses exceed the manager’s $10m buffer. The managed account structure gives the platform the flexibility to pull accounts before losses of more than 10% are experienced, theoretically protecting investors.
In return for absorbing losses, managers are typically very well compensated, with 50% performance fees not uncommon. There are even platforms that, reportedly, pay up to 70%.
As well as taking the losses, managers also receive the gains until their tranche is made whole again; then profits are split determined by the performance fee. This is known as a first:first structure.
It sounds great: consistently positive returns, diversified multi-manager products, position level transparency via managed accounts and alignment of interest with the underlying managers; what’s not to like?
Despite gaining more attention, there are still only a handful of platforms offering this type of structure. Having spoken to some industry participants, there seems to be significant divergence in the operational sophistication of the platforms. Am I surprised? Perhaps not; with little attention from institutional investors, one can imagine that some platforms may choose to take the path of least resistance (and possibly cost), in ticking the operational boxes, rather than institutionalising their processes and procedures.
Whilst portrayed as limited risk products, first loss platforms are complex investment vehicles. There are many questions to be considered in performing due diligence on such vehicles, including the following:
What is the source of PM capital? One of the selling points of these platforms is that PMs put up their own money, aligning interests. Does the manner in which the PM funds the first loss tranche really align his/her interests with those of investors? For example, are PMs permitted by the platform to take out loans to cover the capital? Where the PM runs another product, are they using AUM from this to fund to the first loss platform? What level of due diligence does the platform perform on the source of capital?
Are losses made by portfolio managers segregated in each managed account? We understand that, on some first loss platforms, the first loss capital supplied by each PM can be pooled, with the pool absorbing losses that extend past 10% for any particular PM. This essentially adds a further layer of capital protection for investors. This surprised me somewhat and I would question whether the PMs fully understand this. It makes sense from the platform’s perspective as there is a larger buffer to absorb losses, but surely this would impact the calibre of PMs the platform can attract? Would a top quality PM allocate personal capital to a platform where those assets were at risk from other PMs?
How does the platform manage strategy diversification and liquidity? Strategies that limit left tail risk, i.e. low net, high turnover, liquid, diversified and/or relative value style trading strategies, are ideal for a first loss platform. I believe such strategies represent the majority of platform allocations, though not all. Surely there needs to be some diversification in order to avoid having, for example, 20 merger arbitrage PMs subject to the same deal break, or 20 statistical arbitrage PMs exposed to the same quant crisis (e.g. August 2007). I would therefore not be surprised to see some platforms move slightly down the liquidity or complexity curve to achieve diversification.
The requirement for liquidity is fairly obvious. The platform needs to be able to risk manage each account on a real-time basis; should a PM be down 7% or 8% then a decision would likely be made to pull the account. This works in a liquid environment but what about during a stressed environment, when even the most liquid securities can quite easily gap down more than 10%? We have seen platforms with allocations to event driven, credit and convertible arbitrage strategies. How does the platform define “event driven”? Is it hard catalyst merger-arbitrage, special situations or an activist strategy? Is “credit” corporate or government, emerging or developed market, relative value, investment grade or high yield? Is a convertible arbitrage strategy liquid enough for such a structure? I would want to understand the liquidity of the underlying strategies.
How is risk managed? First loss platforms surely live and die by their risk management capabilities. If the platform cannot effectively manage the large number of accounts to prevent blowing through the first loss tranche then what’s the point? I would be interested in the calibre and experience of the platform’s risk team, as well as its scope and resources. In our review of SEC filings, we have identified one platform with as few as six employees across the business. These six are responsible for managing over $500m across more than 60 managed accounts. One wonders how many of these six are risk professionals and, at a broader level, whether these platforms are sufficiently resourced.
This becomes increasingly important when a PM finds himself/herself down more than 10%, and therefore eating into investors’ capital rather than the first loss buffer. At this point there is a clear incentive for the manager to start taking excessive risk in order to replenish his/her tranche. The first:first structure then potentially becomes an issue.
Whilst cutting accounts at -8% should, theoretically, protect against excessive risk-taking, a combination of weak risk management and esoteric strategies could easily lead to this situation.
How does the platform assess and monitor compliance? What checks and monitoring are performed on the compliance framework at the underlying manager? The typical first loss manager is a small emerging PM, hence more often than not managing an unregulated entity with no internal compliance function. I would question the platform about the monitoring performed on such PMs. The SEC frequently reviews multi-manager platforms with a focus on the platform’s monitoring of both internal and external PMs.
A real life example of the risk to investors is a fund run by a player in the first loss industry that is currently going through a liquidation process as a result of an investment made more than five years ago. The underlying manager, and two of his investment entities, were subject to an SEC enforcement action for making materially false or misleading representations in their marketing material. In addition, the manager knowingly concealed defaults on the fund’s core credit investments. This clearly shows the need for strong compliance processes and procedures.
What PM due diligence/background checking is performed by the platform prior to onboarding? Our research suggests that a platform’s due diligence on a manager may be somewhat limited, focusing on the PM’s ability to extract dollars from the market. We would question the thoroughness of background and reference checking on both the PM and any senior operational staff at the manager. We feel this is particularly necessary given the relatively unknown, emerging manager status of many of the PMs.
Who are the platform’s service providers? Special attention should be paid to the platform’s service providers, especially the quality and reputation of auditors and administrators. In our research we have seen platforms utilising the smallest multi-manager administrator by assets under administration and the second smallest hedge fund auditor2 This is perhaps an example of what I mentioned earlier: ticking the operational box in the cheapest and least onerous way.
How is best execution/counterparty risk addressed? Some platforms may utilise US-based prime brokers for execution; these same prime brokers may also assist them in their manager sourcing, the lifeblood of their business. This could lead to a lack of proper attention being paid to best execution or counterparty risk. In a stressed environment, would platforms be willing to move balances away from their prime brokers, if those prime brokers are also a source of good managers?
While several platforms have demonstrated downside protection on the investment side, as with most alternative investments, they are not without their risks and operational considerations. While risk needs to be taken somewhere to generate returns, taking operational risk has no upside for investors, only downside! Any investor considering an allocation to a first loss platform would be wise to do so with caution and a well-stocked armoury of questions. It will be interesting to see how these platforms perform through the next market correction, as operational robustness is often the bedrock for survival in such an environment.