Hedge-fund industry 2.0 taking shape

Date: Tuesday, July 7, 2009
Author: Matthew Lynn, The Age

There are signs of life returning to the hedge-fund industry. Assets under management are rising. New funds are being launched. Some are even making money.

Reports of hedge funds' demise are exaggerated even if it isn't quite time to raise prices in Mayfair's fancy restaurants, or get into the interior-decoration business in the Hamptons. The industry is going to stick around as an important part of the financial universe.

It would be crazy to imagine that things will go back to the way they were before the markets collapsed in 2008.

Hedge-Fund Industry 2.0 - as one would say in computer-speak - will be very different from Hedge-Fund Industry 1.0. It will be less mysterious; investors will take more control; it will move into the space vacated by investment banks; and there will be fewer, but much larger, funds.

Right now, there is plenty of evidence that investors are willing to put money into the funds again.

About 150 new ones were started from January to March this year, according to statistics compiled by Hedge Fund Research Inc. Some of them are pretty big. Roc Capital Management, started by Arvind Raghunathan, raised $US1 billion.

Assets are on the rise as well. Barclays predicted in a recent report that assets managed by hedge funds would increase more than 8 per cent this year, as much of the wealth kept in cash during the collapse of 2008 moved back into markets.

Business confidence

And the funds are making some money. The average return in May across all classes of fund was 5.2 per cent, according to Hedge Fund Research. With such figures on their side, the funds can feel confident about pitching for business again.

Even so, the post-crash industry will look very different. It will change in four big ways.

First, there will be less mystery.

It might be unfair to group hedge funds with fraudster Bernard Madoff - but, hey, nobody ever said business was fair.

There was a style of hedge-fund marketing that could be accurately described as "Madoff-esque''. It basically said: "Give your money to this incredibly brainy, plugged-in guy, and he'll make a fortune for you.'' It mixed in a twist of social cachet, hinting that the mere fact of investing took you up a notch on society's ladder.

Seductive mystery

Plenty of hedge funds used precisely those techniques: They created an air of seductive mystery to raise money.

Post-Madoff, it isn't going to work anymore. Hedge funds will have to say exactly what they are investing in, what strategies they are using, and how they are generating their returns. The industry will have to find a whole new - and less emotionally manipulative - way of selling itself.

Second, investors are about to take control.

Regulators around the world will come up with dozens of new rules for the industry. Those can probably be avoided. There will always be an offshore island somewhere ready to offer the industry a regime of minimal regulation.

But even if they can evade the regulators, they can't evade their investors, who are well aware of the fraud during the boom years. They will remember the way many funds shut their doors to redemptions as soon as the going got tough. They are going to demand higher standards of investor control.

The days when you handed over your money to the manager, and then lost all influence over it, are gone. In the medium term, that will bring about more change than any new regulations.

Market void

Third, they are about to invade the space occupied by investment banks.

After the collapse of Lehman Brothers Holdings Inc., there are fewer investment banks. Those that remain have less money, and will be more careful with how they spend money.

There won't, however, be any less demand for risk capital. From emerging markets, to new industries, to new kinds of financial instrument, there will be plenty of people demanding funds. As the traditional investment banks pull back, that leaves a space in the market that hedge funds can occupy.

Finally, there won't be so many funds around.

The days when every 30-something trader with a few years' experience in London or New York could re-emerge as a hedge-fund entrepreneur and raise a few million are over.

"The hedge-fund industry will emerge from the financial crisis - smaller, in terms of the number of funds, but eventually larger in terms of assets under management,'' State Street said in a report last month.

Quite right. The higher level of regulatory oversight, the demands of investors, and the need for more sophisticated strategies will make running a fund a high-cost operation. There isn't going to be much space for "two guys and a BlackBerry'' outfits. Instead, there will be a few, well-run firms.

The Internet survived the dot-com crash and went on to become a huge industry. But there was a big change between Web 1.0 and Web 2.0. The hedge funds can pull off the same trick, but Hedge-Fund Industry 2.0 will be a completely new animal.