Starting a Hedge Fund in a Shell-Shocked Age

Date: Monday, June 29, 2009
Author: Dealbook.blogs.nytimes.com

In a small office in London’s upscale West End, three veterans of high finance are getting ready to start their own hedge fund.

It’s a scene that was common enough in the world’s financial hubs during the boom years. But in the post-Lehman, post-Madoff and post-credit-crunch world, starting a hedge fund has become harder, riskier and potentially less lucrative. So why do it? That’s what DealBook recently asked Mahmood Noorani, one of the founding partners of the new London-based fund, Gyldmark Liquid Macro Fund.

“We think it presents an opportunity to finally do things right,” he said about the timing of the new venture. “And it was the events of 2008 that convinced us that the right time is now for what we want to do.”

Mr. Noorani, along with his partners, Alastair Hollingdale and George Hatjoullis, may represent the new face of the hedge fund start-up: arrogance and mystery are out; liquidity and transparency are in.

These are not fresh-faced recent college grads hanging out a shingle, as so often seemed to be the case as hedge funds proliferated just a few years ago. Gyldmark’s three founders have worked in finance for decades and held senior roles at bulge-bracket firms llike Morgan Stanley, Credit Suisse and Bank of America. Mr. Noorani and Mr. Hatjoullis were most recently portfolio managers at BlueCrest Capital, a large hedge-fund firm based in London.

The image of the hedge fund industry took a big blow last year. Hedge funds were down an average of 19 percent in 2008, stung by the market rout, and about 15 percent of hedge funds imposed restrictions on redemptions to stave off capital flight. Nearly 1,500 hedge funds were liquidated and $600 billion in assets were eventually pulled from the industry, according to Hedge Fund Research.

So hedge fund investors — usually institutions or wealthy individuals — have become understandably hesitant about handing over their money, especially to a new fund with no track record. To address these concerns, start-up hedge funds, like Gyldmark, need to adapt to the new market and reconsider how the industry does business.

The Gyldmark fund, which is scheduled to start July 1, has several features that appear to be devised to appeal to investors who were burned in last year’s meltdown. For example, the fund says it plans on investing only in exchange-traded instruments, highly liquid foreign currencies and major government bond markets. Sticking to these asset classes could make it easier to unwind the portfolio rapidly, minimizing the problems that many funds encountered in 2008 when their esoteric and hard-to-value assets could not be sold fast enough to give investors their money back.

The fund will also allow investors to make monthly redemptions, with five days’ notice. That is in stark contrast to the usual hedge-fund redemption period of every three to six months.

“If we have highly liquid positions, why shouldn’t we let you get out quickly?” Mr. Noorani said. “To hold onto investors’ money for an extra three months and to charge them a management fee for the cash sitting there, they’re not that happy about it.”

New funds are also looking for innovative ways to reassure investors that the interests of the fund managers and the investors are aligned. Like many other funds before the crash, Gyldmark is requiring its partners to pay half of their annual compensation into the fund. More
unusually, though, the fund has a clawback provision, which means that they could be forced to give back money to cover losses in future years.

And then there is the issue of fees. Mr. Noorani says that investors are telling him that they no longer want to pay high management fees, so Gyldmark is eschewing the standard 2 percent management fee and 20 percent performance fee that hedge funds have come to rely on. Instead, it is going with a 1 percent management fee and 25 percent performance fee.

“We don’t get rewarded by building assets,” Mr. Noorani said. “We get rewarded by performing.”

Investors are also demanding better oversight of the trading activities of firms in which they invest. Bernard Madoff, who confessed late last year to perpetrating a vast fraud, was not technically running a hedge fund. But his Ponzi scheme has frightened those who put money in opaque investment vehicles and created a push for better auditing and oversight.

With additional hedge fund regulations being debated in Western capitals, some funds are hiring firms to oversee their activities, which act a bit like private regulators. Gyldmark has brought in a firm called PCE Investors, which oversees all of the fund’s operations, risk management systems, trading and compliance systems. PCE can see what Gyldmark is trading and can block trades that are outside the fund’s mandate.

Gyldmark has a provision stating that the fund will automatically be liquidated and moved into cash if it is down 10 percent in a given year. PCE enforces that provision and can override the partners if they fail to comply.

Mr. Noorani said he thinks it is important that hedge funds start to hand over certain functions to third parties — which should have the power to shut them down if they don’t live up to their investor agreements. “That creates a separation between the chief investment officer of the fund and it allows the third party to keep them in check,” he said.

For now, hedge funds remain only lightly regulated in most places, but change is afoot. Mr. Noorani says he expects increased regulation to raise costs for hedge funds, but adds that he is not afraid of the red tape coming his way.

“I love what I do, I love investing, and I want to keep doing it for another 20 years, and I don’t want the industry to crumble,” he said. “So if the regulator is going to give the industry some respectability and longevity, I don’t have a problem with that.”

Gyldmark has only recently started marketing its fund to investors, and is on track to raise $100 million by the end of the year, Mr. Noorani said. If all goes well, he hopes to expand the fund to $1.5 billion to $2 billion in assets under management in a few years.