Hedge funds tip-toe toward an uncertain future

Date: Thursday, December 10, 2009
Author: Joseph A. Giannone, Reuters

It wasn't too long ago big-time hedge fund managers like James Pallotta were erecting monuments to themselves. In Pallotta's case, it was a $21 million Georgian-style mansion he built in 2007 in Weston, a leafy Boston suburb uncomfortable with such displays of wealth.

Yet Pallotta soon would become a symbol not of conspicuous consumption but of the dramatic comedown of a once seemingly indomitable industry. In July, Pallotta, a protege of hedge fund legend Paul Tudor Jones, said he was liquidating Raptor Global Funds, a firm that once managed $9 billion but was hit hard by losses and redemptions last year.

He had plenty of company in that regard. After the worst performance in decades, investors yanked $300 billion of cash over three quarters starting late last year. And more than 2,100 funds were liquidated since the end of 2007, according to Hedge Fund Research Inc.

As if the market meltdown weren't enough, the hedge fund industry took a beating over Bernie Madoff's $65 billion Ponzi scheme one year ago, followed by the widening Galleon Group insider-trading case. The upshot is that an industry never comfortable with scrutiny and second-guessing has come under the microscope, with regulators and investors clamoring for change.

"Because of what happened, people will be very, very cautious about who they give their money to," said Joseph Perella, legendary dealmaker whose Perella Weinberg Partners manages $5.2 billion in assets. "Institutional money will look for places they view as secure, not just places that perform."

So what will the post-crash, post-Madoff, post-Galleon hedge fund universe look like?

One way or another, the wild west of American capitalism is expected to become just a little more civilized, humbler and almost certainly less lucrative, according to interviews with many industry sources.

A return to the golden age of fat fees -- usually 2 percent of assets and 20 percent of profits, though some stars charged much more -- and practically zero oversight is considered extremely unlikely, these sources say.

But will hedge funds resume their two-decades long dominance of the U.S. investment scene? That depends on just how tough the Securities and Exchange Commission, the Obama administration and their European counterparts intend to get.

In March, Treasury Secretary Timothy Geithner testified about plans to tighten oversight of hedge funds. The betting is mandatory registration with the SEC is inevitable. This is a requirement the industry has long resisted, fearing it would compromise their trading strategies by forcing them to show their hand.

Another proposal from U.S. President Barack Obama's administration would make the largest hedge fund advisers -- the ones that could set off a crisis of Long-Term Capital Management proportions -- subject to additional supervision by the Federal Reserve.

Although most analysts agree that the era of benign neglect is over, several hedge fund executives expressed doubt that the new regulations, if they come at all, will represent much of a threat.

"There have always been calls for greater hedge fund regulation, even going back to the early 1970s," said Robert Burch IV of A.W. Jones & Co, whose grandfather, Alfred Winslow Jones, formed the very first "hedged fund" with $100,000 of capital in 1949.

Burch noted that the SEC tried to compel hedge fund registration about four years ago, but that plan was dropped in the face of opposition from the industry.

"There will be a lot of noise and in the end not much action," said Marc Faber, an investor and publisher of "The Gloom, Boom & Doom Report" out of Hong Kong. "The financial lobby is so powerful. I don't think the government will reform the industry that much."

But it will certainly try, and that's part of what has fund managers increasingly on edge these days.


The other driver for change will come from customers, who expect to get premium performance for the big, if shrinking, fees they pay.

When times were good -- that is, for most of the past 20 years -- hedge fund managers could do pretty much as they pleased. Fees crept ever higher. Managers could impose multiple-year lock-ups on cash, tough "gate" terms to postpone withdrawals and could keep their investors in the dark.

And still investors lined up around the block for a piece of the action.

As recently as 1990, the industry managed just $38 billion. That's roughly what is handled today by just one fund -- Ray Dalio's Bridgewater Associates. Then pensions and other big institutions began piling in, and assets worldwide swelled to nearly $2 trillion at its 2007 peak.

At that time, more than 10,000 funds were in business as Wall Street's top traders left their banks to pursue even greater wealth. Five years earlier, there were only 5,400 funds in existence.

That spectacular growth led to industry changes long before the financial crisis. Fund managers were forced to build solid operating companies to meet all the compliance requirements of big investors.

Some of the biggest outfits turned into institutions themselves. Highbridge Capital Management became a unit of JPMorgan Chase & Co, Goldman Sachs built its asset management arm into one of the biggest players in hedge funds. Och-Ziff Capital Management and Fortress Investment Group became listed companies.

Indeed Fortress' five founders, eager to focus on investing, recruited a professional manager, Daniel Mudd, to deal with day to day corporate management.

"The hedge fund business today is a business. It wasn't always a business. Years ago it was a profession. It certainly wasn't an enterprise that required a great deal of organizational skill," said Michael Steinhardt, legendary fund manager famous for generating a 24 percent compound average annual return over 28 years beginning in 1967.


Hedge funds are private investment pools reserved for rich individuals, pensions and endowments -- all of whom are in theory sophisticated investors with pockets deep enough to absorb big losses. As the free-wheeling cousins of mutual funds, they can and did pile on debt to amplify returns, take short positions and place bets across many markets.

For the most part, they also delivered. Since 1990, which is when Hedge Fund Research began tracking the industry, its composite index of hedge funds generated an average annual net return of 12.2 percent. That compares favorably with the 7.99 percent returns of the S&P 500 Index (with dividends reinvested) and the 8.14 percent annual returns of a benchmark Barclays Government/Credit bond index.

And while the industry got clobbered during the financial crisis, hedge fund managers like to point out that the industry did not require a nickel of taxpayer money to bail it out.

Markets have bounced back, and so too have hedge funds. The average fund is up 18.8 percent through November 30 and many of the hardest hit funds have roared back, often recouping last year's losses.

Even so, last year forced many investors to take a hard look at their one-sided relationship with hedge funds. In particular, the Madoff revelations cast a long shadow on funds-of-funds and drove demand for independent auditors and bookkeepers.

Hedge funds on average suffered losses of 19 percent in 2008, and the reluctance of some managers to honor redemption requests sparked howls of protest from investors.

Lawmakers, meanwhile, were eager to put a leash on shadowy tycoons they suspected of driving America's economy into the ground for personal gain.

With funds depleted, and new money hard to raise, the balance of power shifted.

"After the last year, fund managers have to recover losses before they can get incentive fees," said Meyer, who sold his Chicago-based Glenwood Capital to Britain's Man Group in 2000. "They're all very hungry for fresh money, so they're more likely to be investor friendly."

Among other trends, more investors are demanding their money be kept in separately managed accounts, which lets them monitor their portfolio and insulates them in the event of heavy redemptions in a hedge fund.


The near death experience for many investors last year reinforced forgotten lessons about liquidity and leverage. Risk-taking, in general, will be more muted than before the debt bubble finally popped, according to many experts.

"You learn from an episode where you discovered that the capital markets can be far more volatile than you ever thought and grossly illiquid," said Lewis Sanders, who recently left Alliance Bernstein Holding as chairman and CEO after 32 years. "If you don't have really good risk analysis, the clients will be reticent to invest."

Prime brokers, for example, will keep a tighter rein on debt extended to funds.

"If you think about it, the sources of capital really had no regulatory oversight. They were prime brokers in investment banks that were not regulated," said Sanders, who will soon launch Sanders Capital LLC with about $3 billion.

Though hedge funds held up better than expected during last fall's market turmoil, the extensive use of leverage by arbitrage and credit funds forced waves of fire-sales last fall when markets began their downward spiral.

"There's going to be fewer hedge funds and those that survive will be a lot more disciplined. They will be macro funds or traditional funds that go long and short and they don't use a lot of leverage," said Faber.

Big changes are also coming in fees, as investors use their newfound clout to strike better deals with managers.

"Most investors out there cannot produce a return that is sufficient to justify a 2 and 20 fee," said Brian Singer, who formerly helped oversee $258 billion for UBS Global Asset Management's investment solutions unit.

Singer in July launched Singer Partners LLC with some progressive fee terms, including provisions that defer performance fees for several years.

Veteran manager Howard Marks of $67 billion Oaktree Capital Management in Los Angeles said the past two years have revealed which managers really helped clients and which ones were merely propelled by a bull market.

Looking ahead, he added, "2 & 20" as an industry standard could come under fire as investors push back.

"Getting money with incentive fees should be special. The fact that everybody could do it means something was wrong," said Marks, whose firm was among the few winners last year. "The ones who did a bad job should get out of the business."

Throughout 2009 large institutions like the California Public Employees' Retirement System (Calpers) have lobbied their fund managers to revise their terms. Some industry surveys showed the average cost of hedge funds may already be drifting lower, closer to 1.5 percent management fees and 15 or 18 percent of profit.

A few industry veterans say the old fee structure bears some blame for encouraging over-expansion of funds and for managers taking greater risks to achieve target returns.

"Incentives in the industry were very bad. They continue to be bad today," said Brian Singer. "Those incentives resulted in poor behavior on the part of investment managers."

As an example, he pointed to funds that would pursue low-probability, high-risk bets like the yen-dollar carry trade. "In late 90s and earlier this decade, we had a lot of hedge fund players that didn't have skills put on these catastrophic risk trades and leveraging them. They worked until they all blew up," Singer said.

Firms like Oaktree that distinguished themselves during the crisis have been seeing increased demand from investors.

"Successful hedge funds will be entrepreneurial; it is the essence of the craft," said Paul Singer (no relation of Brian), founder of $15 billion Elliott Management and one of the most successful hedge fund managers of the past 30 years. "Given the typical fee structures of hedge funds, they need to do something different to make money in a consistent way."


Ultimately, it will be the investors and their purse power that will weed out the industry.

Last year hedge funds did not make many friends if they lost money, halted withdrawals and charged their usual high fees.

Even so, Leon Cooperman, head of $4 billion-plus Omega Advisors since 1991, predicts investors will come back to hedge funds but more tentatively and with a greater focus on firms that inspire confidence.

"Hedge funds will become larger, more professional. Fewer one-man and two-man shops. There's a certain scale needed," said Cooperman, who had led Goldman Sachs Asset Management during a 25-year career at the bank. "Investors will put their money with a firm that's been around. It's all about process and controls and reputation."

Meyer, whose Glenwood seeded hundreds of firms over the years, observed that some of the changes investors are seeking today were commonplace at hedge funds in the seventies. Back then, short sellers were happy to discuss their positions, he said, because shares were easy to borrow and it helped to drive prices down.

And in a world where there were only a few hundred managers and funds were relatively small, investors were fully apprised of what was happening in their portfolios.

"You know how they talk about increasing transparency? When I started, every manager would tell you about his portfolio," he said. "I've been involved in hedge funds since the 1970s, and I can tell you the hedge fund industry has changed constantly -- and it never repeats."

The business is also not one that will just roll over and perish. The promise of solid returns across every markets, come rain or come shine, by managers with proven track records will be hard to resist.

That brings us back Pallotta, who even as he closed his fund told clients he would consider launching a new offering to take advantage of the bargains created by the financial crisis. He made sure to keep his management firm open and ready for whatever his next move may be.