18. Presentation by RVK, Inc. - Hedge Fund Structure

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Water and Power Employees’ Retirement Plan Hedge Fund Structure PresentationApril 13, 2016

DHF Overview: Implementation OptionsInvestment Structure Options• When investing in Absolute Return Strategies plan fiduciaries must

decide between using: – Off-the-shelf Fund of Hedge Funds products– Fund-of-One Hedge Fund of Funds– A Specialist Advisor– Direct Investments

• The primary factors to be weighed when choosing between these approaches include: – Whether risk and volatility are appropriately controlled through diversification– Whether the appropriate ongoing due diligence and monitoring are provided– Whether assets are sufficient to prudently adopt each approach– Whether the approach affords access to the highest-quality managers– Whether fees are appropriate and controlled

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DHF Overview: Implementation OptionsManaging a Hedge Fund Program• Successfully managing an absolute return program includes:

– Discovery, evaluation, and selection of new absolute return investments – initial and ongoing

– Due diligence – both investment and operational– Negotiation over terms and fees with underlying managers– Portfolio construction and asset allocation– Portfolio reconfiguration in response to ongoing changes in the market

environment– Risk monitoring– Termination/exit of investments as necessary and feasible

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DHF Overview: Implementation OptionsFiduciary Duty• Fiduciaries should ensure that hedge fund strategies are appropriate

for the plan before inclusion by conducting an in-depth review of the asset class

• Part of a fiduciary’s duty is to also ensure that the program for executing a hedge fund mandate provides at least the following:– An effective process for discovering, evaluating, and selecting actual

investments;– Adequate diversification, as quickly as prudently feasible;– An effective process for accurate, on-going monitoring of the risks taken by the

managers of these investments;– An effective process for monitoring the performance of these investments and

exiting them when necessary and feasible;– A program that is cost effective; and– A program that can grow and evolve over time

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DHF Overview: Implementation OptionsInvestment Structure Options• Off-the-Shelf Fund of Hedge Funds (FoHFs) Approach

– A FoHFs manager creates a portfolio of hedge funds, resulting in a single, diversified investment vehicle for a number of investors (commingled fund vehicle).

• Fund-of-One Fund of Hedge Funds (FoHFs) Approach– A FoHFs manager creates a customized portfolio of hedge funds, tailored to a

single client’s investment goals (sometimes referred to as a separate account).

• Specialist Advisor/Consultant Approach– A consultant specializing in hedge fund investing creates a customized portfolio

of hedge funds. Level of client discretion in fund selection decisions varies by advisor and/or client.

• Direct Investment Approach– The “Do it Yourself” approach where the client uses internal expertise and

appropriate systems to create a diversified portfolio of hedge funds.

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DHF Overview: Implementation OptionsContinuum of Implementation Approaches

Direct Investment Approach

Specialist Advisor/Consultant

Approach

Fund-of-One Fund of Hedge Funds

Approach

Off-the-Shelf Fund of Hedge Funds

Approach

Higher External

ManagementCosts

LessControl over

Strategy

Greater Control over

Strategy

Lower External

ManagementCosts

Less Client

Resources Required

Greater Client

Resources Required

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DHF Overview: Implementation OptionsOff-the-Shelf Fund of Hedge Funds Approach• Advantages:

– One investment provides instant diversification– Manager has ability to make tactical allocations to various strategies– Outsourced manager search, selection, due diligence, risk management, and reporting– Reduced headline or “blow-up” risk through a diverse manager lineup– Possibility of improved access to top-tier hedge fund managers closed to other investors– One relationship, one set of documents, one redemption schedule– Better liquidity than a newly-constructed direct HF portfolio of the same managers

• Disadvantages:– Charge an “extra” layer of fees on top of underlying hedge fund fees– Possibly too much diversification

• Research shows that benefits can wane beyond 15-20 managers– No control over underlying strategy and manager selection– Typically little or no contact with underlying managers– Ability to be nimble in rebalancing may be impaired due to lock-up periods– Less transparency: investors typically receive “risk-level” transparency (geographic/strategy

exposures, gross/net exposures, etc.) but may not have visibility of all underlying hedge funds

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DHF Overview: Implementation OptionsCustom Fund of Hedge Fund Approach• Advantages:

– One investment provides instant diversification– Manager has ability to make tactical allocations to various strategies– Outsourced manager search, selection, due diligence, risk management, and reporting– Reduced headline or “blow-up” risk through a diverse manager lineup– Possibility of improved access to top-tier hedge fund managers closed to other investors– One relationship, one set of documents, one redemption schedule– Better liquidity than a newly-constructed direct HF portfolio of the same managers– Characteristics of the portfolio can be tailored to client needs– Scale generally allows lower fees than an equivalent allocation in an off-the-shelf vehicle

• Disadvantages:– Charge an “extra” layer of fees on top of underlying hedge fund fees– Possibly too much diversification

• Research shows that benefits can wane beyond 15-20 managers– Little control over strategy and manager selection– Typically little or no contact with underlying managers– Ability to be nimble in rebalancing may be impaired due to lock-up periods– Less transparency: investors typically receive “risk-level” transparency

• (geographic/strategy exposures, gross/net exposures, etc.)

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DHF Overview: Implementation OptionsSpecialist Advisor/Consultant Approach• Advantages:

– More control over strategy and manager selection• Ability to customize the risk/return/liquidity profile of the hedge fund program to the plan’s

specific needs– Potential for higher returns given lower fee charges by Advisor vs. FoHF manager

• This includes lower indirect costs (netting risk, cost to borrow) borne by investors in the FoHF structure

– Fund investments are made in clients’ name, allowing client the ability to retain exposure to underlying managers despite potential changes in advisor

• Disadvantages:– Access to certain managers may be difficult due to fund closures (FoHF may already have

capacity)– Potentially slower process to redeem from problem managers

• FoHF liquidity is often better than a direct multi-strategy manager– Potential for more visible losses and “headline” risk from individual hedge funds– More extensive involvement may be required from client to perform selection and due

diligence (compared to FoHF investments)– Administrative and legal requirements can be cumbersome

• Building a portfolio of direct managers will require document reviews and reporting requirements for each individual fund selected

– Depending on structure, fiduciary responsibility may rest with Committee/Board– Specialist Advisor utilizes lower revenue business model,

• May not have resources comparable with a FoHF9

DHF Overview: Implementation OptionsDirect Investment Approach• Advantages:

– Direct control over strategy and manager selection• Ability to customize the risk/return/liquidity profile of the hedge fund program to the plan’s

specific needs– Potential for higher returns given the elimination of a layer of fees from the FoHF or Advisor

• This includes lower indirect costs (netting risk, cost to borrow) borne by investors in the FoHF structure

– Greater transparency into each underlying hedge fund investment• Typically allows for more customizable risk, attribution, and performance reporting at the

underlying manager level vs. a FoHF– Fund investments are made in clients’ name, allowing client the ability to retain exposure to

underlying managers despite potential changes in advisor

• Disadvantages:– Access to certain managers may be difficult due to fund closures – Potentially slower process to redeem from problem managers

• FoHF liquidity is often better than a direct multi-strategy manager– Potential for more visible losses and “headline” risk from individual hedge funds– More extensive involvement may be required from client to perform selection and due

diligence (compared to FoHF investments)– Administrative and legal requirements can be cumbersome

• Building a portfolio of direct managers requires separate document reviews and reporting for each individual fund selected

– Fiduciary responsibility rests with the Committee/Board10

DHF Overview: Implementation OptionsThe Plan Utilizes a Fund of One Approach

Morgan Stanley/GAM

Direct Investment Approach

Specialist Advisor/Consultant

Approach

Fund-of-One Fund of Hedge Funds

Approach

Off-the-Shelf Fund of Hedge Funds

Approach

Higher External

ManagementCosts

LessControl over

Strategy

Greater Control over

Strategy

Lower External

ManagementCosts

Less Client

Resources Required

Greater Client

Resources Required

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The Plan’s Hedge Fund Structure as of 9/30/2015

52%48%

GAM Divergent MS Convergent

Retirement GAM Divergent MS Convergent$ 168,080,862 $ 86,592,000 $ 81,488,862

51.5% 48.5%

Health GAM Divergent MS Convergent$ 27,313,140 $ 14,071,200 $ 13,241,940

51.5% 48.5%

Total GAM Divergent MS Convergent$ 195,394,002 $ 100,663,200 $ 94,730,802

51.5% 48.5%

GAM Divergent Characteristics

• 90 Day T-Bills + 3% Returns• 4-7% Volatility Over Market Cycle• Correlation < 0.2 Equities• 0.75% Fee

Morgan Stanley Convergent Characteristics

• 90 Day T-Bills + 3% Returns• 5% Volatility Over Market Cycle• Correlation < 0.7 Equities• 0.77% Fee

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Custom FoHF Characteristics

The Plan’s Structure vs. Custom FoHF RVK Client

GAM Divergent Characteristics

• 90 Day T-Bills + 3% Returns• 4-7% Volatility Over Market Cycle• Correlation < 0.2 Equities

Morgan Stanley Convergent Characteristics

• 90 Day T-Bills + 3% Returns• 5% Volatility Over Market Cycle• Correlation < 0.7 Equities

• 90 Day T-Bills + 3% Returns• Volatility < 5% Volatility Over Market Cycle• Beta to Equites < 0.25 Over Market Cycle

• RVK believes that hedge funds can provide improved diversification and equity risk reduction than what is currently targeted while maintaining similar return objectives.

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Generic FoHF vs. Core/SatelliteSample Portfolio Structures• RVK recommends diversified hedge fund portfolios that vary in structure

based on the size, objectives, and constraints of each client• Each structure is capable of providing an attractive risk/return profile• Absent liquidity constraints, RVK recommends that some component of the

marketable alternatives allocation be in hedge funds.

FoHFs

FoHF Only

FoHFs

Niche FoHFs

Direct Multi-

Strategy

FoHF Core

FoHFs

Niche FoHFs

Direct Multi-Strategy

Long/Short Equity 1

Long/Short Equity 2

FoHF Core/Satellite

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RecommendationFund of One FoHF• Customization & Transparency

– Specialized oversight with risk management, portfolio construction, and operational due diligence.

• Explicit fees are typically higher for FoHF relative to other implementation options, but FoHFs press underlying managers for lower fees– These managers are able to demonstrate fee savings that offset a material

portion of their management fees in many cases.

• Leverage FoHF expertise in building out direct hedge fund portfolios– Reliance on the FoHF provider to assist in risk aggregation, operational due

diligence, and risk monitoring, on outside hedge fund portfolios at no additional cost.

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Fund of One FoHFNext Steps• Draft Policy Language / Define Mandate

• Draft RFP / Define Services Provided

• Select a Provider

• Example Timeline

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Fund of One FoHFDraft Policy Language and Define Mandate• The Plan is seeking a liquid, low volatility, low correlation approach.

• Achieving these goals requires changing exposure parameters relative to what is typically offered in an off-the-shelf FoHF.

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Example Portfolio Characteristics• Equity Beta: < 0.25• Volatility: Less than 5% annualized over cycle• Return Target: T-Bills + 3%

Less Exposure• Activist Equity• Event Driven & Special

Situations• Distressed Debt

More Exposure• Market Neutral Equity• Fixed Income Relative

Value• Low Volatility Macro & CTA

Fund of One FoHFDraft RFP and Define Services• RVK assists in setting minimum qualifications for responding firms, and will

develop a custom questionnaire to complement its RADAR alternatives database

• Additional Services to be Provided– Offering firms must be willing to provide Risk Aggregation services to the Plan’s

total Absolute Return portfolio, inclusive of any future Direct Hedge Fund investments.

– Offering firms must also be willing to provide ongoing Operational Due Diligence services to the Plan, in an effort to ensure operational best practices on future Direct Hedge Fund investments.

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Questions are designed to assist in evaluating firms across a broad set of criteria. • These include business and organizational stability, incentive

alignment with investors, experience of investment personnel, consistency of due diligence process, technology and systems infrastructure, risk and portfolio construction, etc.

Fund of One FoHF

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Select a Provider (Example Process)• RVK uses a comprehensive scoring process, which can be developed in

tandem with Staff, to evaluate RFP proposals.

~15-20 CandidatesEvaluate written responses, score according to developed criteria, work to create a focus list.

3-5 CandidatesConduct calls with key personnel and see demonstrations of live systems. Deeper dive into manager process and characteristics.

2-3 CandidatesPerform full onsite due diligence. Meet with key personnel, evaluate depth of team, confirm scope of services.

Scoring Criteria Semi-Finalists Finalists

Fund of One FoHF

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Phase 1

Define Mandates, Set Minimum Qualifications & Draft Questionnaire

Phase 2

Launch RFP, Evaluate Responses, and Perform Due Diligence

Phase 3

Recommend Finalists to the Board and Implement

Q1-Q2 2016 Q2-Q3 2016 Q3 2016

Conduct RFP (Example Timeline)• The timeline for conducting the RFP is flexible based on the preferences of

the Plan’s Staff and the Board.

AppendixDirect Hedge Fund Program

Generic FoHF vs. Core/SatelliteSample Portfolio Structures• RVK recommends diversified hedge fund portfolios that vary in structure based on the

size, objectives, and constraints of each client• Each structure is capable of providing an attractive risk/return profile• Absent liquidity constraints, RVK recommends that some component of the

marketable alternatives allocation be in hedge funds.

FoHFs

FoHF Only

FoHFs

Niche FoHFs

Direct Multi-

Strategy

FoHF Core

FoHFs

Niche FoHFs

Direct Multi-Strategy

Long/Short Equity 1

Long/Short Equity 2

FoHF Core/Satellite

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Example Hedge Fund Program Progression

100%

69%

16%

15%

39%

16%15%

10%

10%

10%

Current Structure Add Multi-Strategy Add Strategy Specific

More Direct Hedge Fund Investments

Lower External Management Costs

Greater Control Over Program

FoHF Multi-Strategy 1 Multi-Strategy 2 Strategy Specific 1 Strategy Specific 2 Strategy Specific 3

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DHF Overview: Implementation Options

Fund of Hedge Funds

Hedge Fund

Securities

Hedge Fund

Securities

Hedge Fund

Securities

Fund of Hedge Funds (FoHFs)Approach

Hedge Fund

Securities Securities

Direct Investment Approach

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