The Hedge Fund Industry: Going Where?

If there was ever an industry in turmoil, Hedge Funds 2009 squarely falls into this category. Characterized by terrible press, awful returns, massive capital outflows and threatened regulation, the future of the industry appears in doubt. Or does it? Notwithstanding these challenges to its role in the investing landscape, I believe its future is secure albeit in a somewhat different form: fewer multi-strategy firms, particularly where strategies have vastly different liquidity profiles; capitulation of the public hedge fund complexes; a massive shake-out across the fund-of-funds industry; and a quest for truly orthogonal investment approaches and data sets. I do not see the absolute level of hedge fund compensation as being at risk, but the timing and manner of payment, e.g., matching the timing of incentive compensation with realization of gains. But for those who are sounding the death knell of the hedge fund industry, think again.

The hedge fund will rise again and preserve its role as a differentiated alpha generator - but only for those which generate REAL alpha for those that are willing to pay. But the shape of the industry may change as well. While the 2000s witnessed the creation of a barbell (small funds and mega-complexes) with the middle being squeezed, we may see the renaissance of the mid-sized hedge fund, one with enough resources to compete but at a size where true, uncorrelated alpha can be generated.

From the investor perspective, here are some of the ways in which hedge funds - as an industry - failed:

• Lack of positive absolute returns
• Significant correlation with broad market indices
• Absence of beneficial diversification from multi-strategy funds
• Liquidity profiles out-of-line with investor expectations

The theory behind hedge funds (get it, "hedge" funds) was to generate attractive returns in any market environment, and to fully align the motives of the general and limited partners. Many in the industry, however, strayed from these objectives. "Crowded" trades (e.g., piling into the same trades as your buddies); off-the-hook asset growth (where management fees far exceed the costs necessary to run the business; and a relative returns, "benchmark beating" mindset. These conspired to damage the reputation and status of the hedge fund industry, and justifiably so. Further, you had the IPO-ing of several hedge funds both here and in Europe, which continued to dilute the hedge funds' original mission. There is an inherent conflict between being an alpha generator and an asset manager striving for growth, and those that went public clearly lost their way. Succession planning and a currency for incentivizing employees? Garbage. Top ticking a trade, scooping out liquidity playing the "greater fools" game? Absolutely. Sheer size also didn't help with correlation, because as more assets flowed into a strategy only two things could happen: liquidity would suffer as positions got chunkier (and more risky), or positions became more diversified, returns would fall and correlations would rise. Either way, a bad outcome.

Almost by definition, hedge funds have to become smaller. Generating real alpha on a $10 billlion+ fund? Good luck. On $500 million, perhaps $1-2 billion, tops? Much more likely. Separate funds could fall under a single complex, as long as each strategy could be invested in individually such that investors could create the risk/reward/liquidity profile they want. If the days of the long/short fund with a 20% carve-out for illiquid assets isn't gone, it should be. Create a side-car fund that can be subscribed to separately if the liquid long/short book wants to size up in a particular trade (which effectively becomes illiquid), or finds an attractive PIPE or private equity opportunity in its area of expertise. But the commingling of assets with vastly different liquidity characteristics simply doesn't work, and recent market events have shined a bright light on this unanticipated and disastrous liquidity mismatch.

I think the fund-of-funds industry will undergo a massive shakeout, as its denizens have become "the rating agencies of the hedge fund world," replete with conflicts, systemic breakdowns and breaches of fiduciary duty. Who in their right mind would be comfortable ceding due diligence responsibility to a fund-of-funds after what we've seen over the past 18 months? They are getting paid handsomly for doing essentially one thing: homework. Unfortunately, it appears as if their dog ate it. Again and again and again. And while it's not fair to paint an entire industry with a broad brush, the breakdown is so pervasive and the breach of trust so great that it's not clear who will - and deserves - to survive. What could have been a rallying cry for the fund-of-funds industry - "We didn't put our investors into Madoff because our due diligence turned up too many red flags" - has become a source of derision and humiliation. Caveat emptor, friends.

But when the dust settles there are still a few immutable truths:

• Sophisticated investors have trilions to put to work, and a hedged approach to investment will be more desirable than ever
• Investors will be less convinced that mega-funds are a source of true alpha, and will work to create diversified portfolios of individual managers meeting their criteria
• Great managers do exist who are willing to more closely align their motives with those of their LPs, e.g., matching investment liquidity and incentive compensation horizons
• Great managers, however, are a very scare commodity, and will continue to garner 2/20-type fees as they do today

While tomorrow's trends are unlikely to look like those of yesterday, the top performing hedge fund manager will live on and thrive, Government regulation be damned.

Bulging Side Pockets: Turning Hedge Funds into Private Equity Funds?

Many hedge funds are in trouble. Whether due to bad security selection, issues that were once considered liquid that now "trade by appointment" or by jittery LPs, managers are having to generate cash to meet a flood of redemption requests. This has placed tremendous pressure on managers who are not only depressed to see management fees drop while high-water marks remain far out-of-reach, but who have hard decisions to make about which assets should be converted into cash.

One way managers can delay the inevitable: putting less-liquid assets into "side pockets" and shifting them from main funds into long-term liquidation vehicles. These assets generally attract management fees but not performance fees until sold. The more assets that are classified in this manner the less cash that is available to meet investor requests, and the longer investors are locked-in to the managers whom they've decided they no longer want to be in business with. Hedge fund investors have unwittingly been turned into private equity investors, forced to stay invested for an indeterminate period of time. Certainly not what they thought they were signing up for.

This concept was briefly touched on in a recent Wall Street Journal article, but it is an issue that requires far more consideration and analysis.

"I don't think people are selling their less-liquid holdings to meet redemptions, they're just telling investors they can't have that portion of their money or that it's in a liquidating class," (emphasis mine) says Brett Barth, who helps run BBR Partners, a firm that manages money for wealthy families.

The hedge fund manager argument for side pockets: "Being forced to sell illiquid assets in a "fire sale" damages all investors." While this is surely true, what about those investors who want to fully cash out, regardless? What about investors who got cash prior to the re-classification of certain assets as "illiquid," getting a better deal than those who unfortunately delivered their redemption notices a little later? The first issue can be dealt with by creating a vibrant secondary market in side-pocket investments, just like the market in LP interests for hedge, private equity and venture capital funds. The second issue is more complicated, and will invariably result in a spate of lawsuits by LPs saying they were treated unfairly relative to other investors by the GP.  And this doesn't take into account the "side letters" that frequently exist between large LPs and GPs, often providing preferential liquidation terms and fee concessions. This isn't a terrible time to be a hedge fund attorney: it's just that the business mix has changed from new fund formation to litigation.

Conceptually, however, does the "side pocket" concept make sense? Did LPs really think that GPs would fully use those illiquid asset allocations provided for in their fund documents? Think about the percentage of illiquids relative to total fund assets now - likely way beyond the amount stipulated in fund documents as the mostly liquid assets are being sold to meet redemptions while the remainder is left behind as a long-term liquidating stub. This stub, as noted earlier, has private equity-like characteristics, yet LP allocations did not take this shift in liquidity profile into account. My guess is that new hedge funds, when they emerge, will likely have much tighter documents than those cut in this decade, with greater restrictions concerning illiquid asset percentages and rules for shifting assets from the main fund into side pockets. But the issue of current side pockets will continue to loom large, as many of their holdings will be worked out over many years. 

One of the first posts I ever penned discussed the convergence of hedge and private equity funds, where hedge funds were becoming greater participants in buyouts, venture capital and structured investments. I keyed on the issues of valuation, compensation and disclosure as being three vital elements for hedge funds successfully making this transition. But this was in the context of all assets being held in the main fund, not in side pockets. Today's situation is far more complex, especially as hedge funds did not take my advice back in Summer 2006. LPs are getting upset and will only get more so in the coming months. But given the latitude offered most of their GPs, they've got no one to blame but themselves.

Hedge Fund Fees and Liquidity - Setting it Straight

The current fallout associated with DB Zwirn is causing a renewed focus on both mark-to-market practices and, by association, pay-for-performance practices. The way it's being depicted in the media it's almost as if someone woke up and realized, "Hey, if hedge funds have illiquid investments kind of like private equity firms, then shouldn't they get paid like private equity firms (e.g., upon realization)?" 

I've been beating this drum for a long, long time, because if you've spent much time in the industry and have experience with both liquid and illiquid assets it becomes very clear, very quickly that there is an inherent conflict. How, exactly, can a manager justify a quarterly mark on a fundamentally illiquid position and deem it fair to get paid on an upward revision in value? You can't eat that revision, you can't monetize it, yet somehow you should get compensated for it? Interestingly, these are often the same managers who squawk about being judged on a quarterly basis when their strategy is fundamentally long-term. Why should one really be surprised about this asymmetry - heads I win, tails I don't lose. It is this ego and greed that drives many - but clearly not all - good hedge fund managers.

I actually think I wrote a pretty good post on this issue last year, with the following paragraphs being particularly relevant to the current media frenzy:

If positions are held for trading, meaning that short-term assets are being funded with short-term liabilities, then you've got to use either market prices or prices privately received from, say, five dealers, who are quoting based upon taking the bid (or at least the mid) side of the trade. And these are the prices that should be used for both NAV and performance fee calculations for funds, and carrying values for banks and other kinds of asset managers. Let me repeat: if the asset is a trading asset funded with short-term trading liabilities, then you need true marks. No marking to model. Period. Because as we all know, models don't begin to reflect the realities of financial distress, and are inevitably skewed in favor of the manager, if not intentionally then at least subliminally because managers, by definition, tend to love their positions.

Conversely, if positions are held for investment, it must be demonstrated that such investments are funded with liabilities of like or longer duration. This way, an investor can take comfort in knowing that while the values used might not be market-based, the manager can ride out adverse market conditions and not be forced to liquidate at the worst time. However, investment assets should not attract performance compensation until they are sold, and Management must provide clear documentation as to the process used to value these assets for NAV calculation purposes. This necessarily sets a higher return threshold for investment assets relative to trading assets, as should be the case: if one is giving up liquidity and the ability to collect quarterly performance compensation, then the expected return on these assets better be huge. This is where Management's view comes into play. This approach treats investment assets as if they were private equity in nature, being funded with long-term liabilities and attracting performance fees only when sold.

It all seems brutally straight-forward to me. It always has. But in an industry where the words "hedge fund" have come to mean a fairly standard set of terms and conditions - 2% management fee, 20% performance fee, fees paid quarterly - investors have gotten locked into a compensation paradigm that no longer fits portfolios that have become increasingly chocka-block with illiquid assets. Theoretically, in a perfect world, I'd argue that managers should get paid on positions as they get closed out, whether they are held for one day or five years. This eliminates the impact of marks on compensation, offers 100% transparency and truly aligns the motives of managers and investors. Sure, record keeping would suck, but this can be figured out. I'd be interested in the arguments contrary to this position, except those which say "The best managers simply won't accept this." Over time things can change but it depends upon investor resolve and insight, two things that have clearly been lacking in this latest wave of hedge fund melt-downs.

Long PM Health/Short Tums

What do you get when you cross good, thematic long-term investors and stock pickers with quarterly or annual redemptions? Perverse decision-making and style drift. Or a portfolio manager with an ulcer. There is a fundamental mis-alignment of motives in the hedge fund business, and my guess is that it will push truly excellent investors into one of two camps:

1. Becoming "institutional," substantially growing assets, running an overly diversified portfolio in order to dampen volatility by pandering to institutional risk-aversion, and generating mediocre returns in the process; or
2. Becoming disenchanted with the focus on quarterly performance and forcing out most outside investors or imposing a super long-term lock-up which will likely have a similar effect.

I've spoken to several friends in the fundamental long/short business who are good, really good, and they all get stressed out and irritated by quarterly performance measurement because this is not their investment horizon. Many of the value-oriented funds I know will hold investments for years - whose value naturally oscillates due to both company-specific and market forces - but ultimately the thesis plays out over time. Their approach is more akin to Warren Buffet than it is Jim Simons, and turnover as a rule is quite low. Just look at Berkshire's stock price; it whipsaws around regardless of the rate at which book value compounds over time. Market sentiment, sector rotation and macroeconomic factors have dramatic effects upon stock prices over short time periods, which may have little to do with the intrinsic value of a business. Quarterly reporting and redemption horizons that are mismatched with investment holding periods exacerbate the problem and lead managers to consider portfolio management decisions that are suboptimal for maximizing long-term returns. Two excellent managers I can think of off the top of my head, David Tepper and John Zwaanstra, run very concentrated, volatile portfolios with dramatic swings in performance year-to-year. And their investors understand this and are willing to take the roller coaster ride. But they are rarities indeed.

So why has this pervasive asymmetry existed? Because hedge fund managers ask for it. If a manager wants a quarterly payout, they have to live by quarterly reporting and performance measurement. Period. And if they complain that their investment horizon is long-term and that they shouldn't be judged on short-term results, then they shouldn't get paid that way, either. In a perfect world, managers would collect fees to run the business and attract and retain talent (management fees), but would have both performance fees paid and lock-ups match their investment horizon. So, if a manager had a three-year investment horizon on their thematic portfolio, they should get paid on positions in the book on a rolling three year cycle. This would result in a true melding of the hedge fund and private equity models, where performance fees are paid upon realization, not on period mark-to-market values, and capital is committed for long time periods. The same thing can be said for quantitative managers: stat arbs and other high-frequency strategies with short-term signal horizons should get paid out quarterly - but they should have redemptions quarterly as well. This is akin to the CTA business, and quite frankly it makes a lot of sense.

I believe this is a sensible, rational, and fair way to align manager and investor interests and to let the long-term fundamental manager do what they do best - invest, not trade. People would once again get paid for alpha generation and not simply asset gathering, and portfolio managers would probably have far fewer ulcers. Long portfolio manager health, short Tums.

Where is the Hedge Fund Industry Going, 2 Years Later?

In one of my first posts I made some projections concerning the future of the hedge fund industry:

1. The number of hedge funds, higher or lower? - Answer: LOWER
2. The "shape of the hedge fund industry?" - Answer: BARBELL
3. Will fund-of-funds continue to be relevant? - Answer: YES, BUT LESS SO OVER TIME

A recent commenter asked the following: Roger, have your view changed since your original post? I think it is high time I revisited my earlier predictions to see if anything has, in fact, changed my views.

Number of hedge funds

My bottom line on this issue back in July 2006 was:

All of this points to an industry which will grow smaller by number of constituents but be made up of the super-big and the super-small, each geared towards a specific pocket of investors.

To be honest, I don't see things any differently. The big have clearly gotten bigger, whether you are talking about Fortress, Och-Ziff, Lone Pine or Citadel. Large, sophisticated investors have placed increasing value on the institutionalization of the largest players, offering stability of management, infrastructure, reporting, risk management and a control environment worthy of larger investment dollars. Part of this trend has slowed the small fund launches, notwithstanding the rise of the seeder programs. There has also been a continued trend towards multi-strategy funds, giving the managers the ability to allocate capital to those strategies best suited to current market conditions. Also, there has been a shake-out over the past two years, driving the marginal players out as the smart money has either gravitated towards the large, established players or the high-profile new fund launches by successful portfolio managers. I think it is increasingly hard to sustain a single-strategy effort in the face of competitive pressures from the multi-strategy behemoths. So net net, I still see the number of hedge funds as being on a slight downtrend before it plateaus. And I believe the market is getting more efficient at picking the great from the good, creating a healthy, purging cycle that will also force consolidation across the hedge fund universe.

Shape of the hedge fund industry

My view two years ago:

...you have a group of large, global players populating the upper end of the spectrum with a churning, roiling lower end where some simply die off while others make it happen and jump to the big leagues after putting up serious numbers over a 2-3 year period. At the  end of the day, you end up with an industry that has the characteristic shape of a barbell.

I am more confident in my view today than I was in July 2006. The "great squeeze" of the middle that was happening  two years ago is alive and well today. The big have gotten bigger. The middle have either made the jump to the big leagues or are in an increasingly tenuous position. And the small is an amalgam of new starts, falling stars and a small group of single-strategy managers with laser focus who are happy with their business. And as the costs of entry I'd argue have gone up, not down, this serves to reinforce the barbell shape of the industry. Why have costs gone up? Even in the face of rapidly declining technology costs, the infrastructure necessary to run institutional money has gone up, up, up, in terms of people, systems and the time it takes to administer such an organization. Further, as the largest firms move into every market and asset class, it has created an arms race that makes it increasingly difficult for smaller funds to compete. I believe this is an inexorable trend that shows no signs of abating.

The relevance of fund-of-funds

Roger, circa mid-2006:

While I believe there will always be a group of institutions that will simply want the added protection of having a professional fund-of-funds manager when they report back to their boards, this group will, without question, shrink over time and place ever greater downward pressure on fees for providing these services.

This is an interesting one. I'd say that I got the theme right but the timing wrong. Why? Four words: Amaranth. Sowood. Bear Stearns. If there is anything that can shake the confidence of an institutional investor it is a colossal blow-up, and these are just three of the many we have witnessed since my original post. And the big beneficiary of this waning confidence in one's due diligence ability? Fund-of-funds. These institutional investors still need to generate returns, and they're not running away from the asset class. But many would rather pay away some fees and get the imprimatur of a top fund-of-funds than go it alone and risk personal and professional ruin. I'm not saying this is rational, but it is what it is. Plenty of fund-of-funds got smoked in these three high-profile explosions, but the mere perception of greater stability and security offered by fund-of-funds is enough to make the marginally-confident institutional investor sign up. But as a trend, I believe that alternative asset allocations will continue to rise, and that many will reach a cross-over point between hiring a fund-of-funds and building an in-house due diligence and risk management team. Eventually, both economics and control will dictate the construction of these in-house efforts, leaving fund-of-funds to a more marginal role in the investment landscape. That said, in light of the jittery markets and high-profile instances of hedge fund failures, this trend will take longer to play out than I had originally anticipated.

I guess two out of three ain't bad.

Internal Hedge Fund Platforms: Get the Model Right or GET OUT!

Trashing in-house hedge fund platforms is currently all the rage. And why not? They had a bad year, no? This from today's Institutional Investor's emii.com:

Poor performance by in-house hedge funds launched by investment banks and the like may lead some big Wall Street names to exit the field, Dow Jones reports. While many a top hedge fund enjoyed returns that outperformed the standard indices, a number of in-house HF offerings by the likes of Goldman Sachs, Bear Stearns and Barclays have not.

And there were several pieces in the past week that were in this same vein. Bottom line - this is not new news. Most banks have gotten this business wrong for quite some time, in pursuit of its promise of great riches. And last year's weak performance does not begin to illustrate the core problems of most internal hedge fund platforms. Recently stories are trying to sell longer-term business model issues as near-term news. Sorry to disappoint, but these writers don't really get what's going on. Fortunately, I do.

Most pure quants and trend followers had a bad year in 2007. They got whipsawed, statistically durable relationships broke down and they generally got hurt. Luminaries as bright as Jim Simons, Cliff Asness and the Goldman and BGI quant groups got hurt, and they were by no means alone. Whether the teams in this area were internal or external, the markets brought harsh reality to the lot. And let's talk about hedge funds investing in structured mortgage paper. Unless you were shorting like a Paulsen you were getting murdered. Again, it didn't matter whether your were internal or external. Someone ripped your face off, pushed you in front of the mirror and you screamed for the last five months of the year. This is just the way it was.

So Goldman (quant), Bear (mortgages and mis-management) and Barclay's (quant) suffered the same as off-platform funds, so this this whole line of argument is a bunch of garbage (pronounced gar-baaaaage). It makes for a good story, but this isn't the real story. The REAL story is why most on-platform funds suffer from adverse selection, where the best of the best either start their own hedge funds or get a sizable book at an established hedge fund, while the remainder trade in-house. Here are some of the issues:

• Compensation
• Autonomy
• Stability of investment capital
• Compounding of capital
• Branding
• Ego

Compensation is an easy one. Most in-house operations don't pay nearly as well as hedge funds do. Because it is just not the bank culture to pay like hedge funds. If you want to be successful running an in-house platform you need to pay a much more competitive wage. And if you have truly great traders, it is worth it. And the more liquid the portfolios they run (and therefore attract a lower amount of regulatory capital), the better the deal for all parties involved. I could talk about this for days but this is the gig. Pay fair, create a separate culture for the in-house group versus the traders in the broker/dealer and get on with it. Or don't even try.

Autonomy is what it is. Some top traders just want their own show. And they have to go; because if you contort yourself to keep them they will kill the culture and damage the platform. However, if what they really want is to do their thing and be left alone then agree to clear parameters for book size, portfolio construction and risk parameters. And stay on it. But a little light mentoring and strong risk oversight can give the bank the security and comfort it needs while giving the trading team the perceived autonomy it wants. Again, a culturally challenging thing to do but absolutely necessary for building and running a successful in-house operation.

The biggest fear traders have is getting their capital yanked away from them and precisely the wrong time (or at any time, for that matter). If you run and hedge fund with some locked-up capital, you don't deal with this risk. This is a tricky point, because as head of an in-house platform you want to balance favorable capital treatment (which generally connotes the ability to liquidate positions at a moments notice) with giving the trader a measure of comfort (that you won't arbitrarily make them cut the book). Given these opposing needs, a pretty big measure of trust needs to exist between the trader and trading management, because the manager can't get the security they really want without killing the capital treatment (which the bank won't accept). It is what it is. The answer to this one isn't perfect.

Compounding of capital is an interesting point. When you run a hedge fund that starts the year at 100 and you generate 20% gains, you begin the next year at 120. In a bank where you are trading prop capital outside of a fund structure (i.e., in a managed account with the assets held on the bank's balance sheet), that 20 gets swept out and the trader begins year 2 at 100. Over time, the loss of the value of compounding can be stunning. Once an on-platform team begins trading client capital, this issue is ameliorated through a melding of manager and client capital which both benefit from compounding. But when a trader is running purely prop funds, they generally lose the benefit of compounding. Just something to be aware of when negotiating a deal.

Branding means more to some than to others, especially once client capital is being managed. The trader generally wants to own their brand and to have portability, which I think they need to have if you want to attract and retain (for a period) the true rock stars. Inevitably the rock stars are going to want to set up their own fund, and the strong in-house platform should be supportive of that move subject to terms in the agreement that provide a package of benefits to the bank, i.e., capacity guarantees, fee discounts, distribution agreements, etc. If a bank tries to hard to keep the intangible assets (the brand, the track record, the models) all to itself, it will lose out on the best teams out there. Because the best will want to be in-house at the right time and for the right reasons, and if they feel like they are being held up they simply won't do it, or will be resentful and cost the bank in other ways down the road.

Ego really relates to branding as well as portability. Many platforms don't anticipate teams being able to leave in a pre-agreed manner, and end up fighting bitterly with the team when the time comes for them to externalize. This just dumb. Put it all on the table upfront, let the team keep the brand, track record, and models should they leave, with the proviso that the bank gets the benefits mentioned above. it become a win-win, where only the best teams are able to spin-out because of strong performance and investor demand, which creates enormous value for the bank through their capacity option, discounted fees and distribution rights. This is the natural evolution of things. Don't fight it.

In sum, the in-house platform isn't dead. It has been dead for most for a long, long time. It is precious few firms that have ever done it well, but those that have created tremendous value for shareholders, traders and fund investors.

Alternative Asset Managers and Down Market Cycles: What to Expect

The equity market has been a roller coaster, characterized by bone-jarring volatility and single-stock blow-ups that are enough to make even the most steely-eyed hedge fund manager cringe. And private equity firms have seen arbitrage spreads explode, fueled by the knock-on effects of broken credit markets and concerns over whether the PE firms or the banks will walk away from agreed-to transactions. But these are merely observations. The real question is, how will a persistent down market impact the returns of the hedge fund and private equity industries? My handicapping: most participants will suffer and suffer badly. Why? In summary:

• The net long exposure of most hedge funds will weigh on returns. Historically it has been difficult for most hedge funds to add significant alpha on the short side, the side which may well be the key driver of returns for quite some time.

• The excess capital across the private equity industry and sharply wider financing spreads will hurt new deal returns. An unfriendly equity market will make for a limited IPO calendar, eliminating an exit that has proved so fruitful for many of the largest PE firms and their investors over the past three years.

Bridgewater Associates had a very interesting report yesterday that addressed this very issue. Here are some of their thoughts as it relates to the hedge fund industry:

For the most part, hedge funds have gotten through the credit crunch relatively unscathed. For example, the average hedge fund generated a return of 12.5% last year and 2.5% in the fourth quarter. And private equity funds generated an average return of 11%. The main reason that these two groups held up as well as they did is because the equity market has not fallen nearly as much as the bond markets (i.e., spreads), and the majority of the risk allocation of these funds is in the equity market. And because their performance held up, they have not been forced into much asset liquidation to speak of. But stock market action is beginning to pressure the hedge funds and private equity players.

Hedge funds used to be a lot more hedged than they are today. Today, just about anyone who wants higher fees based on total return calls themselves a hedge fund, even if they are just a buyer of assets. And the fat cash flow yields in global stocks have also attracted a number of hedge funds into net long equity positions. As a result, hedge funds are now heavily long the equity market. Based on fund by fund holdings data we estimate that hedge funds are net long about $150 to $200 billion in U.S. equities (foreign equities are not included in this figure).

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Hedge funds are also highly leveraged. Losses raise a fund’s leverage ratio, which requires asset liquidations to bring the leverage ratio back to normal.

Let's see, big net long equity exposure + high leverage + down markets = not good. Clearly we are both taking an industry-wide view of things, but I think it is important to have a grip on the thematic issues in order to gauge possible broad-based effects. Earlier this week I wrote a post that identified industry-specific knowledge, liquidity and value-orientation as being key components for success in volatile markets. Let me add a long time horizon to that list. One of the big issues plaguing many hedge funds is a focus on managing to monthly and quarterly numbers. In real life, this is no way to run a business. Some of the greatest investments of all-time have looked really crappy at the beginning and the thesis has played out over time. If you've got the time, which means either long lock-ups, stable and mature investors, eye-popping long-term performance or both.

I happened to be at the Greenlight Limited Partners Annual Dinner last night, and David Einhorn did his usual impressive presentation of 2007 results with an overview of trends, risks and opportunities today and in the future. The great thing about David is that he is very honest, very humble and very, very focused on sticking to his long-term value mission. In quest of high IRR value-based ideas, wherever they be found, even if they take a long time to play out. He gave examples of positions that have been in the book for five years, making lots of money for investors on an IRR basis but only after the market finally bought into the Greenlight thesis. Several other funds I respect a great deal roll this way, including Rob Medway and Yale Fergang's Royal Capital and Seth Klarman's Baupost Group. It is funds like these that can withstand the pain, and which also have the skills and experience to manage an active short book as part of a true "hedge" fund portfolio.

Bridgewater also had some cautionary words for the private equity industry:

Private equity also looks vulnerable... One element that we showed was the recent deterioration in the yield on private equity deals, driven by too much money chasing too few good deals. This contrasts with the fat yields that existed a few years ago. Those fat yields contributed to the recent high returns on private equity (2007 private equity returns were 11% according to Cambridge Associates and the average return over the past three years was 20% per year). The recent skinny yields, combined with public equity market weakness, are a bad sign for future private equity returns.

I heartily agree. This is an area I've written about quite a bit, both about the glut of capital saturating the high end of the industry and new types of structures (like KKR's investment in Sun Microsystems) that might become the vehicles for deploying capital. Until credit market capitulation is complete, bank balance sheets have been rebuilt (through a combination of external fund-raising via SWFs and other deep-pocketed investors and internal fund-raising through a Fed-induced steepening of the yield curve) and investors have coughed up and marked-to-market all that seemingly low-risk paper trading at 20 in their books, it will be hard to see how debt capital formation will support the scale of private equity transactions we've witnessed in the 2005-07 period. So where does all that private equity go? Either to far less levered deals generating far lower IRRs than in recent years, or into PIPEs and other types of minority stakes that offer downside protection but with modest upside and 10-12% IRRs instead of the 25%+ IRRs we've become accustomed to. In short, it is hard to see the halcyon days for the private equity industry in the near term.

So in the final analysis I think we all need to dial down our expectations. Structural issues will continue to depress hedge fund and private equity returns until the credit cycle and its impact on global equity markets plays itself out. It won't be pretty but we'll all get through it. And some will thrive. Those who have the breadth of skills, the capital and the long-term orientation to take advantage of others less fortunate.

Is Old Lane Old News?

Now that it appears that Vik has nosed into the lead in the great Citigroup CEO race, what of Old Lane? When it came out that Citigroup was buying the new Old firm back in April, I had hypothesized that they were essentially paying an $800 million executive recruitment fee. Sure, there was spin that Citigroup's alternatives business was going to broadly distribute the Old Lane product across its broker network, and use it as lever for growing its alternatives franchise. But I wasn't buying. Who would pay such a sum, call it 15-20% of assets, for a new hedge fund firm with just ok returns? No rational financial institution, IMHO. I know, I know, we are talking about Citigroup here. I felt that promises of an Old Lane product push was a bunch of smoke to get at Vik and John Havens, two quality managers with bulge bracket Wall Street cred.

Fast forward to today. Was I right? Are quants grumpy? Has anybody heard of a sub-prime mortgage? Of course I was right. Citigroup looks to be getting their new CEO (Pandit), a top guy who may run investment banking or some other super senior job (Havens), Old Lane's performance is weak and the product isn't being pushed by anybody. Assets are reportedly around $4 billion, less than the $4.5 billion when the deal was announced. Ho hum. Old Lane is truly old news. So what does the rich Old Lane price tag look like now? Just like I said nine months ago - the biggest headhunter fee on record. Vik did an amazing deal for which he should get the props - getting paid to find himself. Now if only I could do that deal...

The Pressures of Scale in the Hedge Fund Industry

The hedge fund industry is rapidly becoming an amalgam of "haves" and "have nots," with the larger, more established, "institutional" funds getting larger with the small and mid-size funds more or less bumping up against an AUM ceiling. Of course there are exceptions, but this is the general trend I've been witnessing for the past year or so. In fact, I wrote about this in one of my first posts as a blogger, titled Where is the Hedge Fund Industry Going, 7/17/2006:

As noted above, it seems that the "middle class" is getting squeezed and will have to make a decision - to "go global" or "go local." To be truly multi-strategy and have access to the best investment ideas across the spectrum,  a firm really needs representation in New York, London and Hong Kong, at a minimum. This is not cheap. A close friend of mine, who happens to be a very successful  long/short hedge fund manager running about $1.2 billion, recently told me that he feels at a competitive disadvantage to some of his peers who are running $3 billion and more. Why? Because they have the resources to set up offices in these locales (without presumably placing pressure on team compensation in the process) and gaining better access to information and ideas in these regions, and he feels somewhat strapped, especially in a tough market like this one. I couldn't believe I was hearing this from a friend running over a billion dollars, but times really have changed. So, if a guy running a billion is feeling pinched, how large do you need to be? $3 billion? $5 billion?

It seems that the high end will be defined by those with the resources to support and sustain a global multi-strategy platform, with a world-class infrastructure to support the operation. So what about going local, staying pure to your initial style and demonstrating superior alpha generation across a manageable asset base? I think this is a viable and rewarding strategy for someone who either runs their firm as a lifestyle business, or is setting the stage to build a track record sufficiently attractive to garner the assets necessary to make the jump from local to global. This will serve to create a dynamic where you have a group of large, global players populating the upper end of the spectrum with a churning, roiling lower end where some simply die off while others make it happen and jump to the big leagues after putting up serious numbers over a 2-3 year period. At the  end of the day, you end up with an industry that has the characteristic shape of a barbell.

Just as I was thinking about discussions I've had recently with several friends at hedge funds large and small, I read about Perella, Weinberg's acquisition of Xerion, a $400 million AUM special situations fund. And if you read the comments from Xerion's founder, it appears that he and I arrived at the same conclusion as it relates to the pressures of scale.  From the Wall Street Journal 10/02/2007:

Behind the trend is the growing realization by those who run smaller hedge funds like Xerion that their job has gotten much harder. The firm has scored gains of 30% so far this year betting against financial companies and subprime debt, and by making wagers on so-called special situations, such as shares of early-stage commodity producers, according to one investor. Xerion, which was formed in January 2006, was up about 12% last year.

But its founder, Daniel Arbess, said so much money is flowing to larger funds that it makes it harder for smaller firms to raise cash. The 100 largest hedge funds control about 70% of the money in the hedge-fund world, up from less than 50% at the end of 2003. That leaves thousands of smaller players scrambling for the rest.

"We don't need to sell out now," Mr. Arbess says. "But the hedge-fund industry is becoming winner-take-all, with the vast majority of capital going to the largest, most institutionalized firms."

Daniel is right. He could keep right on growing incrementally, but not getting the big allocations necessary to bring him to the next level any time soon. And then the question becomes: is it important to get to the next level to be competitive? My friends who run the $1.2 billion long/short fund found their budget too tight given their goals, namely to source and due diligence ideas globally and to build a local presence in the key global financial hubs. So their rush to scale is not driven by more management fees to pad their wallets - they are spending virtually all of their management fees on running and growing their business; it is to have the fee stream necessary to support multiple offices and to build a bench of top talent that can operate a global platform. This is not growth for growth's sake but growth for the sake of incremental alpha generation. Other funds might not feel the same way, such as a geographically concentrated small-cap hedge fund whose capacity really maxes out in the $300-$500 million range. This can be a nice, profitable business run by a small team - as long as performance is strong. But if performance wanes, poof! Not such a nice business any more.

The WSJ story goes on to describe some of the perils of growth, where the motivations aren't quite as straight-forward and returns-based as those of my friends:

Still, some investors are concerned that the rush to establish large, "multiple-strategy" hedge-fund firms that embrace different investments might not work out. They cite Amaranth Advisors, a multiple-strategy fund that collapsed last year after heavy energy-trading losses. They worry that some of the hedge-fund managers selling out are simply cashing in while the money continues to flow.

Others say the push to purchase hedge funds and offer more strategies to clients is simply a way to increase management fees, rather than a means to deliver top-notch returns.

As large firms buy up hedge funds and bolt them together to form multiple-strategy funds, many could prove unable to appropriately allocate capital and manage the risk of these varied investments, says Gregory Curtis, chairman of Greycourt & Co., a Pittsburgh firm with $10 billion in assets that invests in hedge funds for wealthy individuals. He says that even successful hedge-fund managers usually know little about allocating money among different strategies -- or how to manage all the risk.

I find these arguments pretty weak when it comes to well-managed firms, and right on when it comes to hype-machines that are great at asset gathering but lousy at investing. But at the end of the day there will always be good and bad funds, and it is incumbent upon potential investors to say "Hey, these returns aren't sustainable. They were concentrated in a few trades and their risk management culture is marginal." It is so easy to follow the herd and get caught up in the group-think - which inevitably leads to pain. And we've seen this time and time again.

But I think Xerion's move is rational and a sign of the times. If good small and mid-size firms want to achieve scale they might be best served selling out, and getting a smaller share of a much larger pie:

Mr. Arbess, who will become a partner at Perella, said that selling out to the larger firm will help cut Xerion's trading costs, give it better client service and technology -- and enable it to raise more money. Since large institutions such as pension plans generally want to invest at least $50 million in a fund, and don't want to hold more than 10% of assets, it makes them less likely to shift money to a mid-size firm like Xerion. That adds to the attraction of selling out to Perella, Mr. Arbess says. Perella will put $100 million into Xerion's funds as part of the agreement.

Rock on, guys. You are on the leading edge of an inexorable wave that will ripple throughout the industry for the next 24-36 months.

Single-Manager Platforms: Opportunities and Challenges

I've spent a lot of time thinking about single-manager platforms, their optimal structure and operation. I ran a big one while at Deutsche Bank called DB Advisors. Goldman Sachs recently announced the building of a similar platform in its asset management division. Most Wall Street firms have some kind of single-manager platform as I define it, and these operations are frequently characterized by:

• Legal, operating and risk management environments that are separate from the broker-dealer;

• Teams that are initially seeded with proprietary capital, but after establishing strong track records often are marketed and attract client capital as well;

• Managers who are paid better than position traders in broker-dealer Sales & Trading operations, but not as well as external hedge fund managers;

• Managers who are often either quant-driven or socially challenged, and either lack the desire or ability to run an independent hedge fund operation on their own;

• Teams that are paid off of a percentage of net profits (realized and unrealized gains less direct and indirect costs of running the business) on an annual basis and begin each year at -0-, meaning they generally don't get the benefit of compounding capital over time;  and

• Top talent from the broker-dealer clamoring to get in, sometimes causing tension between the best broker-dealer traders and senior management.

These groups can be fantastically profitable ways of deploying firm trading capital while creating valuable third-party product for distribution. This is the good news. The bad news is that these businesses are hard to run and, by their nature, are subject to massive volatility due to internal and external factors. Consider these three real-world scenarios:

1. Say that one day you wake up and your top performing manager has grown some personality and wants to leave. Well, what do you do?
2. Imagine that the market gets crushed (as it did in August) and that hedge fund returns across most strategies are poor. This results in huge mark-to-market losses for the firm and potentially a whole lot of pissed off asset management clients. Then what?
3. What about the very real possibility of some marquee traders in S&T getting angry about their comp because they are getting 10-12% of net on smaller capital amounts than their pals on the single-manager platform getting 15% on both proprietary and client capital. How do you preserve firm talent without either cherry-picking top S&T talent and putting them on the platform or paying them off the curve relative to the colleagues with whom they sit, collaborate and trade?

There are no easy answers to any of these questions, but they are questions that need to be considered if a firm is to be successful in building and operating a successful single-manager platform. Given these headaches, is it worth it? Quite simply, the answer is yes subject to a few important caveats:

Management needs the right mind-set when establishing these businesses. This means:

• Setting aside a pool of risk capital upon which it is willing to accept hedge fund-like levels of volatility in stressed environments. Because the worst thing you can do is set up a business, communicate a vision, a mission and a risk tolerance, and get cold feet right when your traders and clients need you to suck it up, keep cool and stay in the game.

• Establishing a strong, holistic risk management culture. A firm running one of these platforms will have a lot of prop capital at risk and position-level detail across all of its books. This information needs to be aggregated, analyzed and disseminated in an accurate, fluid manner, and used for managerial decision-making when viewed in context with the firm's aggregate risk position.

• Accepting the fact that successful teams will eventually want to leave and providing a mechanism for creating a win-win between firm and team. This could mean the firm getting an option on a share of the newly-established GP, guaranteed capacity, reduced fees, continued prime brokerage business, etc. In exchange, a team will get to keep its name, its audited track record, and receive assistance in moving parts of its book to other prime brokers and in setting up the new business.

• Creating open communication and understanding among business leaders in the single-manager operation and S&T. This will be required to handle situations where top traders want to move from the broker-dealer to the single-manager operation. This will inevitably come up and create discomfort among all parties, and this situation needs to be anticipated with rules of engagement defined beforehand to guard against fractious, destructive behaviors.

There are so many interconnected factors to be considered when building and operating a single-manager platform that a book could be written on the topic. But I have hopefully provided an interested party with a primer on the key issues that need to be considered.