7 changes hedge funds need to be prepared for

7 changes hedge funds need to be prepared for
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First Published: Mon, Dec 22 2008. 10 27 PM IST

Updated: Mon, Dec 22 2008. 10 27 PM IST
Hedge funds suffered a shake-out in 2008. The average hedge fund fell almost 20%, according to Hedge Fund Research. No fund has yet required a bailout. But plenty won’t see in the New Year, and many of those that do are battered and bruised. Hedge funds managers must accept that the industry won’t be quite the same again. Here are seven changes they need to prepare for.
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Liquidity is the new watchword: Like investment banks, hedge funds didn’t think much about the structure of their funding during the boom times. But a flood of redemption requests in late 2008—just as they were struggling with illiquid markets and scarce credit—caught them out. Many hedge funds annoyed their investors by blocking withdrawals. In future, funds that invest in illiquid assets will need to lock in their investors for longer. And those wishing to give investors regular access to their money will have to focus on liquid markets.
Fees will face greater scrutiny: The archetypal hedge fund charges 2% of assets and skims off 20% of investment gains—the long-standing two-and-twenty structure. But some funds have had to offer fee holidays lately to persuade investors not to pull out their money. Investors will be more selective and are likely to put downward pressure on fees. All the same, it is probably too soon to sound Last Post for two-and-twenty.
High water marks will blur: If hedge managers lose money, they normally have to get the fund back up to its previous high for each investor—the so-called high water mark—before the investor has to pay any more performance fees. Broadly speaking, a fund that is down 20% from its peak and has a standard high water mark mechanism would need to deliver returns of 25% before getting back to its high water mark and earning performance fees again on further gains.
Off guard: Regulators missed warnings surrounding Bernard Madoff, accused of running a Ponzi scheme that cost investors $50 billion. Shannon Stapleton / Reuters
That prospect is daunting. It can leave hedge funds short of cash and their employees wondering where their bonus will come from. Some managers will throw in the towel. This is why some already use a modified mechanism allowing them to earn reduced performance fees on gains even before they have recouped earlier losses in full. Expect more funds to adopt similar policies.
Regulation will intensify: Many hedge funds, including big names such as Citadel Investment Group, have had a torrid 2008. But unlike the banking sector, they haven’t needed bailouts. That doesn’t, however, mean hedge funds will escape tighter regulation. Big losses, excess leverage, unexpected curbs on investor withdrawals, and the impact of short-selling on fragile markets make hedge funds easy targets for a crackdown.
Regulators also missed warning signs surrounding Bernard Madoff, who is accused of running a Ponzi scheme that cost investors as much as $50 billion (Rs2.37 trillion).
His investment operation appeared hedge fund-like in that it was private and he purportedly traded options as well as stocks. Watchdogs and investors will, therefore, share a desire for greater disclosure, so long as it is meaningful. The challenge will be designing sensible regulations that can be applied across a diverse industry.
Concentration will accelerate: Consolidation among hedge funds was under way before the pain of 2008. It should now accelerate. Hedge funds are set to start the new year managing little more than half the nearly $2 trillion of investor money they held earlier in 2008. Only a handful of top performers—such as Paulson and Co., which oversees $36 billion—are bigger than a year ago. Smaller firms, many of which have lost money and become smaller still, will be vulnerable to closure and consolidation. Funds under management will become increasingly concentrated among larger hedge funds, which are favoured by institutional investors and, in some cases, have achieved better investment performance than their rivals.
Funds of funds look a mess: These take another layer of fees, often 1% of assets and 10% of gains, for selecting funds for investors and doing due diligence. But they haven’t managed to do any better than average for their investors. And the Madoff scandal has damaged their reputation: Several of his biggest clients were fund of funds operations, whose investors—and regulators—are wondering what kind of screening efforts their fees were buying.
Unlevered returns should improve: The credit boom allowed funds to prosper even if their investment strategy was simply to use borrowed money to amplify tiny returns. But a smaller hedge-fund industry operating in a deleveraged financial world should be able to find more opportunities to make decent returns without exploiting leverage. A rebound in convertible issuance would be manna for the limited universe of convertible arbitrage funds. Distressed debt and even straightforward stock market strategies could also prove fertile hunting grounds.
That’s another way of saying that after a rotten year, stable and committed hedge funds should be able to do well again. That’s cold comfort for those who have lost big. But it suggests plenty in the industry will live to fight another day.
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First Published: Mon, Dec 22 2008. 10 27 PM IST