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Hedge Fund Fees on the Decline | Many Will Close

Fund Industry Hurting

Hedge Fund Fees on the Decline

It's quite an interesting time in the hedge fund world ... many of the newest breed of hedgies were gunning returns by the use of heavy leverage. With the incredible volatility, lack of trend, and loss of leverage - many are simply being rolled in this market. I've been doing a lot of reading of various articles on how funds are reducing fees, and the potential (as we've discussed) to simply shut down business. For those new to the game hedge funds make money 2 ways, from the "annual fee" (if you will) similar to a mutual fund and then the performance fee. The compensation system is typically 2% annual and 20% performance, meaning you take home 20% of all gains in the fund. Hence why leverage is a thing of beauty. If you have $750M in "real" assets, and lever that 10 to 1 you suddenly have $7.5 Billion. If you return 9% for the year, you made 9% on $7.5 Billion insteas of $750M. The difference? $67M in "performance fees" on the $750M is "levered up" to generate $675M in "performance fees" on the $7.5 Billion. Some funds purpotedly went higher than 10:1 leverage. Basically a "great margin call" has been going on across America.

Now the one saving grace (in theory) for investors in said funds is if you fall below what is called the highwater market - you don't make money on the performance fee until you make the investors whole. So for example - in 2008 you have $100 and you lose 14% - you are down to $86. If you make 15% in 2009, you are back to $99, but you earn only your annual fee and no performance fee. So only in 2010 can you start earning the big bucks again. Solution? Close the fund in 2008 and say "we'll be back with a shiny new fund soon" - of course which starts from $0 and hence performance fees can be earned from day 1. This was actually one of my bigger fears towards the back end of 2008. A myriad of levered funds closing shop and selling their positions, causing a lot of pressure on the stock market.

I came upon this story yesterday which just shocked the system - only 1 in 10 hedge funds is currently at a place they can generate performance fees. I did not realize things had gotten so dire since the whole point of being HEDGED is to (in theory) protect from the massive gyrations in a market. But since incentive fees are so high most of the new gun hedge funds shoot for outsized gains and obviously lost risk control measures. Fund of funds, which allocate across various hedge funds (and layer yet another fee on top of it) are in even worse shape. Keep in mind this data is through the end of July - with the raging in this market in August and September we might be talking just a sliver of a sliver of hedge funds who could be earning performance fees year to date.

* Just one in 10 hedge funds is currently receiving performance fees from their funds, raising questions about whether their business model is robust enough to survive the current downturn. Nine out of every 10 of the 4,000 hedge funds surveyed globally by data provider Eurekahedge are performing insufficiently well to beat their high-water mark–the level at which they can charge performance fees, equivalent to a fifth of returns.
* All but 3% of funds of hedge funds were under the mark, according to the survey, as were 90.6% of equity long/short funds, 86% of portfolios focusing on market events, 85.4% of those investing in distressed securities, and 82.6% of futures managers. The picture was also bleak for long-only absolute return funds, 96.5% of which were below their high-water mark. The survey used figures compiled for July 31–the most recent available–and are likely to have worsened since then.

* Nicola Meaden, chief executive of alternatives investor Alpha Strategic, said some hedge funds wouldn’t earn performance fees until 2010, while another investor said conditions for small hedge funds were “as tough as any I’ve seen this decade.”

* “The hedge fund industry will begin to contract. Access to leverage will never be the same. I would not be surprised if, six months on, the industry’s assets under management have fallen from $2 trillion to $1.5 trillion. The number of hedge fund managers will fall by at least 25% over the next 18 months. There are too many weak players.”

* Data provider Hedge Fund Research found 350 hedge funds were shut in the first half of this year, 15% more than the first half of last year, and setting the industry on course to beat last year’s 563 closures.

We've had a great gold rush into hedge fund world - too much capital chasing too few ideas. Too many copy cats, too many "me toos" and too much leverage disguised as "genius". You could see that by the fact that so many hedge fund players who failed over the past decade just chalked it up to a "black swan event" and within 2 years had a whole new host of capital to work with because they were "still genuises who simply made 1 mistake." That is too much money chasing too few ideas. Frankly in that system there is no reason to watch your risk - you make generational wealth by pressing the envelope for 3 years, pushing hard on the pedal - make your money, and then if you blow up.... well so be it. You've "made yours" and you have a very good chance to start over 2 years later once you write "I'm sorry, once in a lifetime dislocation in markets broke our model".

The underbrush of the hedge fund industry looks like it is going to be burnt off here in the next 4-8 quarters.

By FundmyMutualFund

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