A Changing World For Hedge Funds
Days of massive leverage and little regulation are over; 'nobody will be leveraged that much again.'
By Gerelyn Terzo December 8, 2008
At a time when precious little is certain in the financial markets, one thing couldn't be more clear: the hedge fund industry is about to change dramatically.
From investment strategies and leverage ratios to fee structures and regulation, the asset class will be remade in coming months. Fewer funds will be managing assets, as smaller, more vulnerable funds fade into the sunset.
Hedge funds, including those with an equity long/short strategy, which account for about 60% of industry assets, took on exorbitant amounts of leverage during the equity bull run between 2004 and 2007. In an attempt to bolster returns further, these funds levered up their positions, in some cases by as much as 20 to 30 times their assets.
"The majority of the time, [hedge fund managers] were minimally hedged with only a few shorts," says Peter Rup, chief investment officer with Orion Capital Management, a fund of funds. "A few used leverage and went long, made a lot of money and fooled investors into thinking they knew what they were doing. These hedge funds generated 50% to 60% losses over the last few months and they are now exposed."
Those days of extreme leverage are gone. With prime brokers pulling back on lending, and with scarce liquidity, the industry is taking on a leverage ratio of closer to 1:1 on average. "The leverage levels that we have seen over the past few years are absolutely gone and nobody will be leveraged that much again," says Sameer Shalaby, chief executive at Paladyne, which provides software to hedge funds.
One step forward, two steps back
Hedge funds, of course, rely on fees and were paid before on a fee structure known as "2 and 20"--2% annual management fees and 20% performance fees. Widespread losses have decimated the "20" side of the equation, and investors have been pulling capital from funds furiously, which not only exacerbates the losses, but also leaves more room for fee negotiations.
"That model is dead," says Shalaby. "It's unclear what the new model is--maybe it will be '1 and 10.'"
With a leaner fee structure, whatever it turns out to be, firms will be taking in less revenue, while they'll likely also be faced with higher costs.
For instance, prime brokers, which provide clearing and settlement services as well as lending to hedge funds, are also losing revenues. Additionally, hedge funds have abandoned the once-popular single prime broker model and are working with multiple prime brokers to diversify their risk exposure, largely because of the Lehman Brothers debacle (see related story). For every prime broker a hedge fund signs up there is an additional expense. "There is less revenue and higher operating costs. On top of that, more regulation is coming and that means hedge funds will need additional compliance," says Shalaby.
Danger zone
Hedge funds, which have a near 60-year history, have largely managed to avoid heavy regulation; they are not required to report information on their holdings, leverage or strategies.
But, with industry assets under management ballooning to more than $1 trillion, and the widespread perception that these opaque funds have inflamed the ongoing financial crisis, regulators cannot ignore what they say is an increasing influence funds have in the financial markets. Chief among their concerns is the high leverage ratios the funds employ and their dealings in often illiquid and difficult-to-price assets.
"[Regulation] is absolutely happening and there's no way around it," says Shalaby. "It's unclear at this point how deep regulation will be."
New regulation could include further short-selling rules (the Securities and Exchange Commission implemented a temporary ban on short selling financial stocks in October), in addition to potential leverage constraints and capital requirements to obtain leverage.
On Nov. 13, the House of Representatives Committee on Oversight and Government Reform, led by California Democrat Henry Waxman, held a hearing on hedge funds and the financial market. Five hedge fund managers including Kenneth Griffin, the founder and CEO of Citadel Investment Group, also testified. Waxman argued the lack of oversight is a "potentially dangerous situation," and regulators voiced their worry that the failure of large hedge funds could pose "a significant systemic risk" to the financial markets. Citadel's Griffin disagreed. "No, it is not my belief that we need greater government regulation of hedge funds with respect to the systemic risks they create," he said in reply to a question posed by Waxman. Hedge fund panelists said they were not opposed to increasing disclosures to regulators but were vehemently against making those disclosures apparent to the open markets so as not to reveal investment strategies.
Fund of funds' future
Meanwhile, fund of funds, which abide by their own fee structures, aren't about to skate by unencumbered by the new world of regulation. The typical fund of funds fee makeup is "1 and 10." Combined with the current hedge fund model, investors are paying some 3% in management fees and 30% in performance fees to hedge funds and fund of funds.
"It's the double layer of fees that has always irritated investors, on top of the losses that most of them generated this year, " says Rup. (None of Orion Capital's investors, who have on average $5 million to $10 million in the funds, have attempted to have their fees lowered.)
Some multi-billion dollar hedge funds, including Och-Ziff, Tudor Investment Corp. and activist investor Ramius, manage diverse fund strategies and perform in-house fund of fund duties. This phenomenon is nothing new, but in a consolidating industry, it's likely to become more prevalent. Some of the challenges inherent with migrating to a multi-strategy operation include identifying and acquiring talent, rising internal conflicts and rivalries, as different strategy groups compete for capital allocations and managing compensation.
"I have seen any number of superior performing single-strategy hedge funds diversify themselves into 'multi-strategy,' only to then have them produce mediocre results," says Rup. He says Andor Capital Management's attempt to diversify across different strategies and industries in 2003 contributed to tension tied to compensation, which he says helped lead to the firm's demise. (Andor said that it was closing shop in October, and a person answering phones there declined to comment.)
Take the keys...
Amidst this changing backdrop, hedge funds are looking to extend their lock-up periods, the duration of time investors cannot withdraw capital. Shalaby tells the tale of one $3 billion fund, which he declined to name, that had bucked this year's downward trend. The fund has actually generated returns of some 6% this year but has nevertheless plummeted in size to about $200 million in assets under management. The primary reason? Its lock-up period. "They should have had longer lock-ups," says Shalaby.
Most funds have either monthly, quarterly or semi-annual lock-up periods in place, but those with shorter lock-ups are beginning to extend them. Several firms are nudging investors to commit to those longer periods in exchange for lower performance fees. In some cases, reduced fees are promised for the next three years. According to Damien Park, president of Philadelphia-based Hedge Fund Solutions, a company that monitors hedge fund activism, activist investors are included among those cutting fees.
Activist fund lock-up periods tend to be longer due to the length of time an activist campaign requires. "Activists like JANA Partners are offering reduced fees in exchange for longer lock-ups," he says. Most recently, JANA asked investors for two-year lock-up periods in exchange for a 1.75% annual management fee for new investors and an 8.75% performance fee for existing investors. The new fees apply to the first half of 2009. JANA plans to hike performance fees to 17.5% after that, however, and the increase is contingent on the fund recouping 200% of this year's losses, all according to Park.
A spokesman for JANA Partners declined to comment.
In late October, Ramius, which manages about $5 billion in hedge fund assets, presented a new fee structure for its $2.1 billion Ramius Fund to investors. For investors committing to a one-year lock-up period, Ramius pledged to waive 50% of all performance fees on certain returns through 2010 and all performance fees in 2011. A Ramius spokesman declined to comment.
Last week, Fortress Investment Group said its board of directors and general partner voted to temporarily suspend redemptions from its largest family of funds, the Drawbridge Global Macro Funds and the Drawbridge Global Alpha Fund. The move was in response to $3.5 billion in redemption notices, withdrawals that would have nearly wiped out the value of the fund, according to an SEC filing. With those suspensions in place, Fortress estimates assets under management of approximately $3.6 billion as of Jan. 1, 2009, down from $8 billion at the end of September.
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