The End of the 3 and 30

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IT SEEMED an odd weekend for a death. The Boston weather was warmer than usual; the July haze sporadically coated the city skyline. Most people of means were on the Cape, Nantucket, or the Vineyard, but Harvard Management Company cub Jeffrey Larsen, by this day in 2007, a very wealthy man and principal of hedge fund Sowood Capital, was sitting in a cold sweat in his Back Bay office.

Larsen was sweating because, by that day, the 29th of July, he had lost nearly 50% of his fund's capital, or approximately $1.5 billion, with a bet gone poorly. What had started as a quotidian trade—going long senior debt while simultaneously shorting junior debt and stock, with large amounts of leverage—had turned into a trader's nightmare. Two days previously, a Friday, he had been down 10% on the month. Now, two days later, he was on the phone to Ken Griffin's Chicago-based Citadel Investment Group, hoping to salvage a semblance of value by selling his positions onto the larger hedge fund. By that evening, his firm was dead.

It did not end there. As with any hedge fund implosion, the reverberations of capital losses were felt far from the nerve center of the fund's 500 Boylston Street offices. In Sowood's case, investors saw their sizeable investments cut in half in one weekend. Numerous capital pools—including Harvard University—lost tens, even hundreds of millions of dollars, having been directly invested in the fund. One other fund—the Massachusetts Pension Retirement Investment Management Board (MassPRIM)—also felt those reverberations, but in a different way: The firm to which they were paying approximately $5 million (the 1% management fee on a $525 million investment) and 10% of profits to perform due diligence and provide diversification—fund of hedge funds Arden Asset Management, of New York—had been invested with Sowood. Arden had taken many millions in fees in the first few successful years of Sowood's existence. Arden would take none of the losses.

Superlative Yale endowment leader David Swensen once famously decried these hedge fund pooling vehicles as “a cancer on the institutional investor world.” This metaphor is not entirely appropriate. Cancer, in the extreme, swiftly decimates its host, ending the life of both intruder and intruded. With hedge fund blowups, however, history has shown that the institutional investor is harmed while the middleman survives—albeit with less fees and reputation. With numerous funds of funds seemingly exposed to every recent hedge fund implosion or scandal—including Amaranth Advisors, Level Global Investors, Diamondback Capital Management, and, of course, Bernie Madoff—has the time now come for the cancer itself to die?

THE SEARCH for uncorrelated alpha came relatively late to the world of pension and endowment funds. Alfred W. Jones created the first hedge fund in 1949. The Rothschild family created the first fund of hedge funds in 1969—Leveraged Capital Holdings—which was followed shortly by the first American permutation, Chicago-based Grosvenor Capital Management. For decades, hedge funds and funds of funds were the domain of the high-net-worth crowd; the goal was shoot-the-lights-out performance, and assets were gathered as much via Geneva or Upper East Side cocktail chatter as through more traditional means. Leverage was high. Stakes were high. Institutions, as a whole, did not play this game.

Enter the 1990s. In general, endowments were the first to allocate to these alternatives, the result of savvy CIOs and Board members who had been privy to the social milieu of the 1980s. Their access came via two routes: Like Harvard's Jack Meyer and Yale's Swensen, some institutional funds invested directly with hedge funds; others opted to take the funds-of-funds route. Pejoratively, this second group was often considered less sophisticated than the first, with the aggregator access point considered a quasi-outsourcing of the hedge fund allocation decisionmaking process. Whether this criticism was valid, this group certainly was paying for the pleasure: on top of the dominant 2% and 20% hedge fund fee model, hedge funds of funds often charged an extra 1% and 10% to their clients, ostensibly for the due diligence, access, diversification, and the benefits of capital aggregation that they ostensibly provided. As a general rule, larger funds—better staffed and with more resources—took the direct route, while smaller funds (and larger funds lacking resources, such as American public pensions) invested with the aggregators. The balance between the two styles of access subsisted for the better part of two decades.

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