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Talking Funds of Funds With Citigroup's Ray Nolte

He says the industry's rising tide hasn't lifted all boats.



runs a $37.6 billion alternative investment business called Citigroup Alternative Investments. It's organized around private equity, managed futures, structured products, real estate and hedge funds. Late last year, Ray Nolte moved from Deutsche Bank to become chief executive of Citigroup Alternative Investments' Fund of Hedge Funds Group. At Deutsche Bank, he was chairman of the Deutsche Bank Absolute Return Strategies Fund of Funds and its single-manager hedge fund business.

In an interview with

, Nolte describes the challenges of managing a large, institutional fund of funds group. Describe how the hedge fund business is organized within Citigroup Alternative Investments.

Ray Nolte

: CAI has been managing fund-of-hedge-fund portfolios since 1994. We have a team of over 40 professionals who are dedicated to providing the highest level of investment management and client service. Our investment professionals possess broad capital-markets backgrounds and extensive experience in hedge fund strategy allocation, manager selection, due diligence and risk management.

Do you find it more challenging to raise assets today than, let's say, a couple of years ago?

The hedge fund industry has become substantially more competitive in terms of raising capital for both hedge fund managers and fund-of-hedge-fund managers. During the past five years the industry has experienced a proliferation in terms of the number of hedge fund managers and the amount of capital flowing into this space.

However, only a fraction of the 8,000 hedge funds have been able to successfully raise assets to substantial levels. The most talented managers, with stellar track records and pristine operations, have seen their assets double or triple over the past few years. Meanwhile, for the majority of managers, the rising tide has not lifted all boats to scaleable levels, which will eventually lead to consolidation or reductions in the numbers of managers over time.

People wonder whether funds of funds are worth the cost. What's your take on that?

We believe funds of hedge funds play an important role in helping private clients and institutions diversify their overall portfolios. Historically, core diversified fund-of-hedge-fund portfolios have generated on average 7% to 10%, net of all fees.

Given the amount of time and resources we allocate to sourcing, evaluating and monitoring hedge fund managers, while also providing active portfolio management, it seems that the standard 1% management fee and 10% incentive fee is reasonable in today's environment. To be sure, if fund-of-hedge-fund returns level off and only provide investors with the potential of earning 5% to 7% returns, net of fees, then we could begin to see fee compression within the space. It is not unrealistic to think that fund of hedge funds could someday range between a 0.75% to 1% flat fee, with no carry, as the industry matures and the opportunity sets become smaller.

As a major bank/Wall Street institution, have you been able to attract and retain key talent? Are we seeing hedge fund pros heading back to the Street?

From our perspective there continues to be a strong bid for talented people in the hedge fund industry. In years past, it was primarily traders, analysts and portfolio managers that were migrating from traditional fund houses and banks to hedge fund shops. As many of the large hedge fund businesses mature and become more institutionally focused, we're seeing a strong premium being put on managerial, legal, business and client-service expertise. Indeed, world-class corporate lawyers are taking chief operating officer positions at top-tier funds, and compliance officers are being pulled out of banks to head up the compliance and regulatory divisions of funds as many begin to ramp up for



Do you see the industry getting more and more institutionalized, and why?

The initial phase of institutionalization began when large endowments and foundations, like Yale and Harvard, began to allocate large percentages of their investable assets to alternative strategies. In doing so, they were acknowledging that the talent pool and risk/reward tradeoff was more attractive in private equity and hedge funds than in traditional equity and fixed-income investments. Soon thereafter, corporate and public pension funds began to size up opportunities and loosen their own investment guidelines to include allocations to hedge funds.

This trend represented a big change for hedge fund managers, for now they needed to upgrade their businesses to meet the institutional needs for a sound infrastructure, sustainable investment and risk processes, responsive client service and reasonable fees. We see this trend continuing as corporate, public and nonprofit institutions grapple with mediocre returns from traditional investments and growing gaps between their assets and liabilities.

How do your clients react to the overall mediocre performance? How did Citigroup's fund-of-hedge-funds business do last year?

Indeed, 2005 was a mixed year in terms of performance. Most of the big gains were achieved during the fourth quarter, as global equity markets rallied in September and November. For CAI, 2005 was a strong performance year, and we ended up in the top quartile in several consultant universes.

Where do you see growth looking forward?

We anticipate a continuation of the growth in assets at the top-tier A managers. This will continue the trend of a bifurcation of the industry with the large, well-established A managers capturing a majority of the assets, and in fact turning away assets, while the B and C managers will struggle to raise assets.

New strategies will continue to emerge as managers seek out new areas to generate returns. This has been particularly true in the areas of specialty finance, emerging markets and restructuring. We have been and continue to be invested outside the U.S.; in fact, there are significant opportunities with hedge funds investing in the non-U.S. markets.