Many Hedge Funds Still Smarting From the Financial Crisis

Date: Thursday, April 7, 2011
Author: Azam Ahmed, DealBook

Last year, Kenneth C. Griffin, the founder of the hedge fund giant the Citadel Group, celebrated his second year of double-digit gains.

But despite the strong performance, Mr. Griffin has not climbed back from the losses endured during the financial crisis. Citadel’s flagship fund is still 15 percent below its peak, according to people with knowledge of the firm who were not authorized to speak publicly.

Even as the industry reclaims its former swagger, Citadel and hundreds of other hedge funds are struggling to hit their so-called high water marks, their historic highs at which they can begin collecting profits again. The research firm HedgeFund.net estimates that roughly 35 percent of the 2,500 funds that have continuously reported since 2008 have not recovered — with smaller hedge funds dominating the list.

With so many firms yet to make a full comeback, analysts and industry experts anticipate a shake-out in 2011. Troubled funds risk losing top traders or analysts to rivals, or worse, closing down altogether.

“For the folks back in the money again, the industry is in a pretty healthy place,” said William C. Crerend, chief executive of EACM Advisors, a roughly $3 billion firm that invests in hedge funds. “But for the subset for whom that’s not the case, there is a lot riding on this year.”

The high water mark is a critical level for the industry. Hedge funds typically collect 20 percent of any investment gains, but they forgo the fees as long as their assets are below the peak. That means Citadel has not collected profits on its main fund since before the financial crisis, despite returning 62 percent in 2009 and 10 percent last year. Citadel declined to comment.

Digging out of a hole can take years. A fund that was overseeing $100 million and lost 25 percent, for example, must post returns of nearly 35 percent on the remaining $75 million to reach its high water mark.

“If you’re down 50 percent, you’ve got a lot of wood to chop,” said William Ferri, head of alternative investments at UBS.

The situation is worse for hedge funds that deployed sidepockets, the controversial separate accounts where managers placed hard-to-sell assets from their funds until the values bounced back. Assets that go into sidepockets are typically marked up only after they are sold, and therefore do not contribute to performance. So a manager has a smaller pool of assets to drive returns.

Some funds gave up almost immediately. Tontine Associates, once a $10 billion firm that was founded by Jeffrey Gendell, decided to liquidate two of its funds in 2008 after one of them lost about 70 percent. Drake Management, a firm that once managed close to $5 billion, closed its main fund the same year.

It is difficult to know exactly which portfolios remain underwater for now. Hedge funds, which submit their returns voluntarily to data trackers, sometimes choose to stop reporting their numbers during periods of poor performance.

Credit Suisse, which follows industry returns, has said the number of managers reporting shrank about 10 percent since 2008, reflecting a combination of fewer funds and fewer managers willing to share their data.

Philip Falcone, whose Harbinger Capital Partners gained 116 percent in 2007 after betting against the subprime mortgage market, stopped broadly sharing some details about his performance last year. After losing 12 percent in 2010, Mr. Falcone’s flagship fund has continued to fall through February, pushing his goal line even farther away.

Still, many of the industry’s top names are back on track. Bridgewater Associates is managing close to $90 billion. John Paulson, the head of Paulson & Company, netted about $5 billion in personal gains on his portfolios. Collectively, hedge fund assets stand at precrisis levels and could hit a record $2.25 trillion this year, according to a recent survey by Deutsche Bank.

“It’s a very bifurcated industry right now,” said David Shukis of Cambridge Associates. “You read that investors are starting to look for smaller funds, but it’s still the case that the big funds are getting bigger.”

For big funds or star managers below their high water mark, the situation is not necessarily dire. Established players with billions in assets can muddle through for a few years on their management fees, which usually amount to 2 percent of assets. Citadel’s flagship fund charges investors directly for expenses incurred, which are often higher than the industry standard.

Other notable managers start new strategies to help make up the gap. If they can entice investors to give them fresh funds, the firm can collect performance fees on the new portfolios.

“If you find a good manager below his high water mark, you can cut deals with a guy like that,” said Mr. Ferri of UBS.

Ospraie Management, a commodities shop run by Dwight Anderson that shut its flagship fund in 2008 after steep losses, decided to open two new hedge funds the next year. Ospraie, which honored high water marks for previous investors, now manages more than $800 million, according to a person with knowledge of the firm.

Some managers with low assets opt to close up shop and reopen under a new name. John Meriwether — whose first firm, Long-Term Capital Management, imploded, leading to a bailout orchestrated by the Federal Reserve — started JWM Partners. After dropping more than 44 percent during the crisis, he closed the firm. Last year, Mr. Meriwether started a third hedge fund, JM Advisors.

Smaller funds with less-connected managers will have a tougher time staying afloat. Without a large staff or infrastructure, such portfolios can make do for a while, especially if a partner’s assets make up the bulk of the money.

“In some cases the assets left in the fund are general partner assets, and they are willing to hang around and ride it out, because what else are they going to do?” said Jay B. Gould, a partner at the law firm Pillsbury.

But unless there is a streak of strong returns, the losses will inevitably catch up with them — and they will most likely fizzle out.

“Many of these smaller funds are guys you’ve never heard of,” said Brian Peterson, who runs the hedge fund index group at Credit Suisse. “When a lot of these funds do leave the industry they’re not as noticeable as when a large fund leaves.”