Running a Hedge Fund Is Harder Than It Looks on TV

Date: Tuesday, August 19, 2008
Author: Andrew Ross Sorkin, The New York Times

Do you remember a time, only a short while ago, when virtually anybody could start a hedge fund? It seemed so easy: billions of dollars were being thrown around like confetti, even at first-time managers. You could make money with your eyes closed. Or so it seemed.

Ronald G. Insana was one of the people who chased that dream. Yes, that Mr. Insana — the man who spent more than a decade as one of CNBC’s most prominent anchormen, interviewing some of the biggest titans in business and trying to make sense of the daily gyrations of the market.

In March 2006, Mr. Insana left the network to try his hand at becoming one of those titans, setting up a fund to help investors get into hedge funds, a so-called fund of funds. Paul Kedrosky, the writer and investor, said at the time that Mr. Insana’s announcement “reminded him a little of Lou Dobbs going to Space.com at the peak of the dot-com bubble.” Mr. Dobbs’s adventure, you may recall, didn’t turn out well; he’s back on TV.

Two weeks ago, Mr. Insana announced that he was throwing in the towel. Though his career detour doesn’t rank on the flameout scale anywhere approaching the Space.com debacle, it is an unusually instructive and cautionary tale.

One of the big raps against hedge fund managers is that their fee structure is so rigged that managers can get rich even if they never make a penny for investors. Eric Mindich, the former Goldman Sachs whiz kid, left the firm in 2004 to start Eton Park Capital Management and immediately raised more than $3 billion. His firm charged a 2 percent management fee and 20 percent of the profits with a three-year lock-up — handing him a $60 million paycheck before he even opened the door.

But most hedge fund managers aren’t like Eric Mindich. They don’t start off with $3 billion and they don’t put out their shingle with a guarantee of riches. Instead, they’re like, well, Ron Insana.

If there was one thing Mr. Insana had built up over the course of his career in journalism, it was great contacts. He knew everybody in the hedge fund business, which is why, when he started Insana Capital Partners, he chose to create a fund of funds.

In his role as manager of Insana Capital Partners, he would act as a kind of hedge fund middleman, directing money to various hedge funds. The fund itself was grandiosely called Legends, which, while perhaps pretentious, made sense given the funds he could access. His clients would be invested in SAC Capital, managed by Steven A. Cohen; Icahn Partners, managed by Carl C. Icahn; or the Renaissance Technologies Corporation, run by James H. Simons, perhaps the most successful hedge fund manager on the planet. These funds are typically closed to the public.

In exchange for getting his investors behind the velvet rope, he charged a 1.5 percent management fee and took 20 percent of all profits. That may not sound like a bad deal — but consider that those fees come on top of the fees charged by the hedge funds themselves. (In the case of Mr. Simons, in particular, the fees are astronomical: a 5 percent management fee and more than 40 percent of the profits.)

Over the course of more than a year, Mr. Insana raised about $116 million. It was a respectable number, to be sure, but it wasn’t $3 billion. And here is where Mr. Insana ran into trouble.

As an investor, Mr. Insana didn’t exactly have the wind at his back. During the 14 months his fund of funds was up and running, the Standard & Poor’s 500-stock index fell more than 15 percent. While some hedge funds managed to eke out gains, many did not. Ultimately, Mr. Insana’s fund lost 5 percent.

In the mutual fund business, beating the S.& P. would be more than enough to survive, and even prosper. Mr. Insana would have been a hero. But the hedge fund business is far more cut-throat. For a small fund like Mr. Insana’s, it is imperative to make money regardless of whether the S.& P. is up or down — and because he didn’t, the 20 percent portion of his fee structure was worth nothing.

That left his management fee, which amounted to $1.74 million. (That’s 1.5 percent of $116 million.) On paper, that may seem like a lot of money. But it’s not. Like many first-time fund managers, Mr. Insana was forced to give up about half of the general partnership to his first investor — in this case, Deutsche Bank — in exchange for backing him. After paying Deutsche Bank, Insana Capital Partners was left with only about $870,000.

That would have been enough if it was just Mr. Insana, a secretary and a dog. But Mr. Insana was hoping to attract more than $1 billion from investors. And most big institutions won’t even consider investing in a fund that doesn’t have a proper infrastructure: a compliance officer, an accountant, analysts and so on. Mr. Insana had seven employees, and was paying for office space in the former CNBC studios in Fort Lee, N.J., and Bloomberg terminals — at more than $1,500 a pop a month — while traveling the globe in search of investors. Under the circumstances, $870,000 just wasn’t going to last very long.

Finally, most hedge funds have something called a high water mark. It requires hedge fund managers to make investors whole before they can start collecting their 20 percent of the profits — regardless of how long that takes. Hedge fund managers don’t get to start from scratch every Jan. 1 the way their mutual fund brethren do.

In the end, the rock was simply too heavy for Mr. Insana to keep pushing uphill. On Aug. 8, he sent a letter to investors explaining why he was closing shop. “Our current level of assets under management, coupled with the extraordinarily difficult capital-raising environment, make it imprudent for Insana Capital Partners to continue business operations,” he wrote. He said he planned to take a job with his pal Mr. Cohen at SAC. Mr. Insana declined to comment for this column.

In truth, there are thousands of Mr. Insanas desperately trying to raise money from nondescript little offices across the country. Some of them raised $10 million, some raised $100 million or more. And, as money has gotten tighter, and the bloom has come off the hedge fund rose, some have raised none at all.

Such was the case of Dow Kim, the co-president of global markets and investment banking at Merrill Lynch, who left the firm in May of last year to strike out on his own. With expectations of raising several billion dollars, he hired more than 30 people. Last week, he shuttered the business before he had even begun. In the coming months, Wall Street is going to be littered with such flameouts.

Although the big boys get most of the ink, Mr. Insana’s is a far more common story — and far more representative of what is happening in the land of hedge funds today.

Mr. Insana probably should have seen it coming. In 2002, he wrote a book called, “Trendwatching: Don’t be Fooled by the Next Investment Fad, Mania, or Bubble.” Oops.