Principal-protected strategies taking hold

Principal-protected notes and other capital-guaranteed products that use hedge funds as an alpha source have found a market among pension plans in Europe and are triggering some interest in the United States.

Socit Gnrale Corporate and Investment Bank in New York this year launched a $50 million principal-protected strategy for an un-named U.S.-based pension fund. The principal-protected note is overlaid on a hedge-fund-of-funds portfolio managed by the firm’s Paris-based subsidiary, Lyxor Asset Management. Michel Serieyssol, the bank’s New York-based managing director and head of pension solutions, said the firm had done a number of similar deals with U.S. pension plans in “an early effort to reach out to plan sponsors.”

Capital guarantees wrapped around one or more hedge funds of funds offer investors protection that the money they invest in the strategy won’t be lost. These wrappers, or insurance-based approaches, typically are created by investment banks.

Cautious clients use them as a “risk-free” way to invest in hedge funds; others use them to get around local legislation in Europe that limits exposure to hedge funds; and some use the principal protection to get exposure to alternatives through a form of portable alpha if a plan’s own funding position and asset allocation make this difficult, according to Rene Herren, head of product structuring at Man Investments of Pfaffikon, Switzerland.

Mr. Serieyssol said principal-protected notes offer pension plans a portable-alpha approach that can meet some of the pension liability sensitivities while generating a higher return in their existing portfolios. “The institutions we speak to say they see this approach as a complement to their existing asset allocation,” he added.

According to industry sources, Socit Gnrale SA, BNP Paribas and AXA Group, all of Paris, are believed to be some of the main providers of these strategies in Europe. Jean-Eric Pacini, BNP Paribas’ head of structured-product sales, and Sara Dennehy, AXA spokeswoman, did not respond to calls for comment.

No one at Credit Suisse was available for comment by press time, according to Amy Thompson, spokeswoman for the firm’s investment-banking division.

But the jury is out as to whether capital guarantees are the most effective way to invest in hedge funds, and funds of hedge funds, in particular.

According to Aoifinn Devitt, independent consultant and director of London-based Clontarf Capital, capital guarantees on funds of hedge funds can be “misconceived” because, by their nature, such funds’ volatility is generally much lower than in equities.

“The chance of losing your shirt in a fund-of-funds investment is very low. You could lose much more in direct equity investing,” she said. And the layers of fees associated with structured products can truncate overall returns.

Little information is available about the use by European pension plans of principal-protected notes based on hedge funds. In continental Europe, most investment banks work directly with pension plan clients.

In the United Kingdom, executives at a handful of pension plans have expressed an interest in using hedge-fund-based principal-protected notes, particularly where they have hedged their interest rate risk, but no deals have yet been concluded, according to two independent consultants who specialize in hedge funds and structured products.

At the end of March, 44% of London-based Man Investments’ $68 billion in assets under management was in these products.

A “significant part” is sold to pension plans, particularly in Germany and Italy, and increasingly in Spain, said Man’s Mr. Herren.

In Europe, demand varies according to each country’s local regulations, and there appears to be interest in pension plans regardless of size or sponsor.

“We can’t put these users into a category,” Mr. Herren said.

The potential demand for capital guarantees on hedge funds of funds is large if institutions allocate between 5% and 10% of total assets to alternatives as expected, but European pension plans have not yet made such a commitment to hedge funds, said Laurent Le Saint, Paris-based managing director and head of structured alternative investments at Socit Gnrale Corporate and Investment Bank.

Most demand at Socit Gnrale has been from pension plans in Scandinavia, the Benelux region and France, with some interest in the United Kingdom.

A number of large and midsize pension plans lacking internal resources to manage direct hedge fund investing have been using capital guarantees on hedge funds, Mr. Le Saint said. Typical investments for clients in midsize pension plans would be between $30 million and $70 million, he added.

“Our aim is to transform the payoff structure of a hedge fund portfolio to meet capital requirements or the needs of a particular investor,” said Mr. Le Saint.

He said Socit Gnrale is working on building a U.S. business for capital guarantees on hedge funds.

“The U.S. pension market has deep pockets. We don’t need to go for a large part of [pension plans’] investment portfolios to make a sizable transaction,” Mr. Le Saint said.