Don't Bank on Hedge-Fund Gold Rush

Date: Friday, January 14, 2011
Author: Hester Plumridge, The Wall Street Journal

One sign the financial world may be returning to normal: Hedge-fund start-ups in 2010 reached the highest level since the boom, with 715 new funds launched in the first nine months of the year, according to Hedge Fund Research. Former Goldman Sachs proprietary trader Pierre-Henri Flamand has raised $1.2 billion for new firm Edoma Capital; his former Goldman colleague Morgan Sze hopes to raise a similar amount for a new Asian fund. And Morgan Stanley plans to spin out its proprietary trading desk as a stand-alone firm.

But would-be hedge-fund tycoons shouldn't get their hopes up. Granted, the climate is improving. The industry is seeing net inflows after two years of bleeding assets, with a strong uptick at the end of last year. Pension funds are increasing allocations. But many of last year's launches were new funds created by existing managers. For all but a handful of stars, starting a new firm is much tougher now than it was during the boom.

Goldman Sachs Group's headquarters in New York.

First, the demise of the fund-of-hedge-funds sector has deprived start-ups of the main source of seed capital. Fund-of-funds assets under management have fallen by a quarter in the wake of the Madoff scandal and investor concerns over the impact of double-layering of fees on returns. The bulk of new hedge-fund investment now comes from big institutions that typically lack the capacity to do due diligence on small start-ups and focus their investment on larger firms with longer track records and stronger balance sheets.

Second, barriers to entry and costs of doing business have risen. Hedge funds face new registration requirements with the Securities and Exchange Commission and greater reporting burdens under new European rules. New funds need at least $100 million in assets under management to be commercially viable and attract investor interest, compared with around $50 million a few years ago, according to people who advise hedge-fund start-ups.

Not surprisingly, many smaller firms are seeking refuge with larger asset managers, while bigger firms are eager to offer more-diversified products to increase their chances of retaining assets. The result has been a flurry of consolidation, with Man Group acquiring GLG Partners, Royal Bank of Canada buying Bluebay Asset Management and Henderson Group buying Gartmore, the latter a traditional fund manager with a sizable hedge-fund business.

But the biggest challenge is that many hedge funds are struggling to demonstrate the outperformance required to justify their fees. The average return for the industry globally in 2010 was 10.4%, according to Hedge Fund Research, below the 11.6% rise in the S&P 500. Unless prospective start-ups can convincingly demonstrate a track record of generating solid, risk-adjusted returns, they are unlikely to receive funding. Good news for former Goldman proprietary trading stars, but not so promising for lesser mortals.

Write to Hester Plumridge at Hester.Plumridge@dowjones.com