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November 5, 2007
Where Have All the Hedge Funds Gone?
The hedge-fund industry is grappling with its first shakeout in a decade as investors increasingly recoil from startups considered susceptible to the toxic shocks of this year's credit markets.
New hedge funds are opening at the slowest pace since 2003 with almost all of the $164 billion of new investments going to managers with proven records, data compiled by Chicago-based Hedge Fund Research Inc. show.
``People are spooked,'' said Bill Grayson, president of 21- year-old hedge-fund company Falcon Point Capital LLC in San Francisco. ``There is no doubt that a few years ago, if you popped out of brand-name firm,'' everyone wanted to give you money. ``That game is now over.''
Confidence in the $1.8 trillion industry has been shaken by the worst decline in non-government debt markets since Russia defaulted in 1998. Losses forced the liquidation of Boston-based Sowood Capital Management LP, which managed more than $3 billion, and two Bear Stearns Cos. hedge funds with a combined $1.6 billion. Cheyne Finance Plc and Rhinebridge Plc, debt funds based in Ireland that together held about $7 billion in assets, went bust when investors refused to finance them.
Meanwhile, Edward Lampert, 45, attracted almost $4 billion this year. His Greenwich, Connecticut-based ESL Investments Inc. has gained at an annual rate of almost 30 percent since it opened in 1988. Hedge funds like ESL are private pools of capital whose managers participate substantially in the profits from their speculation whether prices rise or fall.
Fund Openings
``Long time ago,'' as Pete Seeger sang in his 1955 folk classic ``Where Have All the Flowers Gone?'', are the days when startups from Wall Street executives like Ron Beller's Peloton Partners LP and Bennett Goodman's GSO Capital Partners LP, which are still flourishing, routinely pulled in more than $1 billion in a matter of months.
Peloton's multistrategy fund has gained at an annual rate of 16.5 percent since it was introduced in June 2005, and has risen 28 percent this year. By contrast, the average equity hedge fund gained 6.9 percent this year as of Nov. 1, compared with the 6.4 percent advance of the Standard & Poor's 500 Index, Hedge Fund Research reported.
About 1,200 funds will be introduced this year, down 20 percent from 2006, Hedge Fund Research estimates. About 600 will close.
There were about 9,900 funds worldwide at the end of September. The 20 biggest managers control one-third of the industry's assets, according to data compiled by London-based research firm Hedge Fund Intelligence Inc.
Simons and Ackman
``We got really burned by a startup,'' said Louis Morrell, vice president of investments at Wake Forest University in Winston Salem, North Carolina, declining to identify the manager. Wake Forest has about 18 percent of its $1.3 billion endowment in hedge funds. Morrell said he now won't invest in a fund unless it's been open for five years.
Managers benefiting from the flight to experience include Renaissance Technologies Corp., the East Setauket, New York- based firm that James Simons founded in 1978. Simons, 69, gathered $1.3 billion for a commodities-futures fund that he started Oct. 1, and added $1.2 billion in the next month. From 1990 through 2006, Simons's Medallion Fund returned 38.5 percent a year.
Activist investor William Ackman, 41, who runs Pershing Square Capital Management LP in New York, attracted $2 billion in nine days, telling investors only that he wanted to buy into an undisclosed company. It turned out to be Minneapolis-based Target Corp., the second-largest U.S. discount retailer.
Wild West
Investors want proof of a manager's ability to weather tough markets before giving them money, said John Griswold, executive director of the research division of Wilton, Connecticut-based Commonfund, which oversees $43 billion.
``Ideally you'd like to see a market cycle to see if the strategy and the individual can survive a downturn,'' he said.
Also driving the change is what Brad Hintz, a financial industry analyst at Sanford C. Bernstein & Co. in New York, calls the ``institutionalization of the alternative asset sector.'' Changes in the market ``will civilize the Wild West of hedge funds activities,'' he said.
As pension funds and endowments increase their hedge-fund investments, they are demanding top-flight accounting, custodial and risk-management services that only the bigger managers can afford, Hintz said.
The concentration of assets in fewer hands may reduce profit margins for the firms that provide brokerage and record- keeping services to hedge-fund managers, said Hintz. He estimates pretax margins for the prime brokers will drop to 41.9 percent in 2009 from a high of 46 percent in 2006.
Geographic Reach
Securities firms led by New York-based Morgan Stanley and Goldman Sachs Group Inc. are poised to earn a record $12 billion of revenue this year from providing so-called prime brokerage services to hedge funds, Hintz said. That may increase to $15.7 billion in 2009 as the industry's assets climb, he said.
Barry Bausano, the New York-based co-head of global prime finance at Deutsche Bank AG, said the biggest prime brokers will benefit from industry consolidation.
``It plays to the strengths of the highly rated prime brokers with the broadest geographic reach, richest product offering and largest balance sheet capacity,'' he said.
Investor reluctance to back newcomers may end defections to hedge funds by top Wall Street traders and bankers seduced by the opportunity to make millions, said Brett Barth, a partner at New York-based BBR Partners, which farms out money to hedge funds.
``If you are going to start out with $15 million, you can probably make more money staying on where you are,'' Barth said.
Tried and True
Hedge-fund inflows will remain strong as the industry attracts a greater share of institutional assets, according to a report by the Greenwich, Connecticut-based consultant Greenwich Associates. Twenty-two percent of the 1,023 institutions surveyed said they would increase hedge-fund investments by 2009.
While endowments and foundations now steer an average of about 12 percent of assets into hedge funds, public pension funds allocate just 0.5 percent.
Most hedge funds can charge management fees of 2 percent of assets and take 20 percent of investment profits, known as ``2 and 20.'' Stephen Cohen of SAC Capital Management LLC in Stamford, Connecticut, charges even more. On some funds, investors pay no management fee, but he takes 50 percent of any profits.
Grayson of Falcon Point expects the pendulum to eventually swing back toward rookie managers, and he says he sees more interest in emerging managers at pension funds and at firms that farm out money to hedge funds.
``They all want to find the next great managers.''
Until the markets stabilize, however, most investors are more interested in the comfort that comes with putting their money in the hands of tried-and-true managers.
-Bloomberg-
Posted by su at November 5, 2007 4:28 PM