Where have all the hedge funds gone?

Date: Tuesday, November 6, 2007
Author: Katherine Burton, Bloomberg News

The hedge fund industry is grappling with its first shakeout in a decade as investors increasingly recoil from startups considered susceptible to the toxic shocks of this year's credit markets.

New hedge funds are opening at the slowest pace since 2003 with almost all of the $164-billion (U.S.) of new investments going to managers with proven records, data compiled by Chicago-based Hedge Fund Research Inc. show.

"People are spooked," said Bill Grayson, president of 21-year-old hedge fund company Falcon Point Capital LLC in San Francisco. "There is no doubt that a few years ago, if you popped out of brand-name firm," everyone wanted to give you money. "That game is now over."

Confidence in the $1.8-trillion industry has been shaken by the worst decline in non-government debt markets since Russia defaulted in 1998. Losses forced the liquidation of Boston-based Sowood Capital Management LP, which managed more than $3-billion, and two Bear Stearns Cos. hedge funds with a combined $1.6-billion. Cheyne Finance PLC and Rhinebridge PLC, debt funds based in Ireland that together held about $7-billion in assets, went bust when investors refused to finance them.

Meanwhile, Edward Lampert attracted almost $4-billion this year. His Greenwich, Conn.-based ESL Investments Inc. has gained at an annual rate of almost 30 per cent since it opened in 1988. Hedge funds like ESL are private pools of capital whose managers participate substantially in the profits from their speculation whether prices rise or fall.

"Long time ago," as Pete Seeger sang in his 1955 folk classic Where Have All the Flowers Gone?, are the days when startups from Wall Street executives like Ron Beller's Peloton Partners LP and Bennett Goodman's GSO Capital Partners LP, which are still flourishing, routinely pulled in more than $1-billion in a matter of months.

Peloton's multistrategy fund has gained at an annual rate of 16.5 per cent since it was introduced in June 2005, and has risen 28 per cent this year. By contrast, the average equity hedge fund gained 6.9 per cent this year as of Nov. 1, compared with the 6.4-per-cent advance of the Standard & Poor's 500 Index, Hedge Fund Research reported.

About 1,200 funds will be introduced this year, down 20 per cent from 2006, Hedge Fund Research estimates. About 600 will close.

There were about 9,900 funds worldwide at the end of September. The 20 biggest managers control one-third of the industry's assets, according to data compiled by London-based research firm Hedge Fund Intelligence Inc.

"We got really burned by a startup," said Louis Morrell, vice- president of investments at Wake Forest University in Winston Salem, N.C., declining to identify the manager. Wake Forest has about 18 per cent of its $1.3-billion endowment in hedge funds. Mr. Morrell said he now won't invest in a fund unless it's been open for five years.

Managers benefiting from the flight to experience include Renaissance Technologies Corp., the East Setauket, N.Y.-based firm that James Simons founded in 1978. Mr. Simons gathered $1.3-billion for a commodities-futures fund that he started Oct. 1, and added $1.2-billion in the next month. From 1990 through 2006, Simons' Medallion Fund returned 38.5 per cent a year.

Activist investor William Ackman, who runs Pershing Square Capital Management LP in New York, attracted $2-billion in nine days, telling investors only that he wanted to buy into an undisclosed company. It turned out to be Target Corp., the second-largest U.S. discount retailer.

Investors want proof of a manager's ability to weather tough markets before giving them money, said John Griswold, executive director of the research division of Commonfund, which oversees $43-billion.

"Ideally you'd like to see a market cycle to see if the strategy and the individual can survive a downturn," he said.

Also driving the change is what Brad Hintz, a financial industry analyst at Sanford C. Bernstein & Co. in New York, calls the "institutionalization of the alternative asset sector." Changes in the market "will civilize the Wild West of hedge funds activities," he said.

As pension funds and endowments increase their hedge fund investments, they are demanding top-flight accounting, custodial and risk-management services that only the bigger managers can afford, Mr. Hintz said.

The concentration of assets in fewer hands may reduce profit margins for the firms that provide brokerage and record-keeping services to hedge fund managers, Mr. Hintz said. He estimates pretax margins for the prime brokers will drop to 41.9 per cent in 2009 from a high of 46 per cent in 2006.

Securities firms led by Morgan Stanley and Goldman Sachs Group Inc. are poised to earn a record $12-billion of revenue this year from providing so-called prime brokerage services to hedge funds, Mr. Hintz said. That may increase to $15.7-billion in 2009 as the industry's assets climb, he said.

Barry Bausano, the New York-based co-head of global prime finance at Deutsche Bank AG, said the biggest prime brokers will benefit from industry consolidation.

"It plays to the strengths of the highly rated prime brokers with the broadest geographic reach, richest product offering and largest balance sheet capacity," he said.

Investor reluctance to back newcomers may end defections to hedge funds by top Wall Street traders and bankers seduced by the opportunity to make millions, said Brett Barth, a partner at New York-based BBR Partners, which farms out money to hedge funds.

"If you are going to start out with $15-million, you can probably make more money staying on where you are," Mr. Barth said.