August 22, 2008

Hedge Funds Face Shock Waves
Bottom Line

Things are tough and getting tougher in the hedge fund (HF) business. The easy bull-market ride is over, capital has dried up, and even the S&P 500 index is outperforming most HFs. The $2 trillion industry has been hit hard by the global credit crunch, with some managers having to sell assets at fire-sale prices to meet margin calls from prime brokers. Others have been forced to shut down. In the first quarter of 2008, liquidations of HFs climbed 20%, the number of fund launches fell, and 170 funds closed, an increase of roughly 30% over the year-earlier period. Since that time, the situation has worsened.

Investors have been quick to jump ship from underperforming funds. Investment in HFs dropped precipitously to $29 billion in the first half of the year from $118 billion during the same period last year, according to Chicago-based Hedge Fund Research. And their performance was negative for just the second time in nearly twenty years.

HFs that were invested primarily in collateralized debt obligations have already been falling by the wayside, but many more are on the edge of a cliff. These would include funds that have made heavy bets on rising commodity prices and falling financials. The abrupt end of the lucrative long-term bet on commodities and the simultaneous shorting of financial stocks put the bite on hedge funds last month. The Morningstar 1000 Hedge Fund Index fell by 3.07%, its worst monthly showing ever. Also included in the high-risk group are the funds that bought discounted low-documentation loans from the banks. Markets for many assets are now relatively illiquid. This leads to greater risk, a rising cost of funds and greater volatility.

Most HFs have no locked-in capital. Their investors are impatient and nervous about the widely publicized financial crisis. Their cost of borrowed money has risen sharply as the prime brokers have tightened credit terms. Many will find credit unavailable given the risks they have taken on their books. The risk goes both ways:

HF managers are keeping a close eye on the banks that act as the funds’ prime brokers. The big investment banks perform multiple roles for HFs: as bankers, holders of HF assets, even lenders of stocks the hedge funds short. In the past, the stability of prime brokers was rarely questioned, but fund managers caught a fright in March, when Bear Stearns nearly went bust. Now HF managers aren’t taking their prime brokers for granted. They’re spending more time checking their contingency plans. They’re making sure they have their insurance policies up to date and have backup relationships.

Whispers are now surfacing that the traditional hedge fund model is broken. HF investors demand large returns with relatively little volatility. Grinding out these returns month after month has become increasingly difficult. In recent weeks, we have seen short-covering rallies in financial stocks of 20%-to-40% intra-day in the major names. Funds can only make money if they have a very stable investment base. Unlike the private equity fund model that locks in long-term investment from banks and others, most hedge fund investors get very antsy if losses continue for too many months, and the losses these days can be quite large. HFs themselves are a major source of volatility and risk and few of their investors can stomach major month-to-month volatility.

Many managers are paid based on hurdle rates and if they don’t make these hurdles, they won’t get their fees. For example, a typical HF manager charges a 1%-to-2% management fee and a 20% performance fee. In the mutual fund business, beating the S&P would be more than enough to survive, and even prosper. HFs, on the other hand, are expected to make money regardless of whether the stock market is up or down, and if they don’t, the 20% portion of the fee structure is worth nothing. As well, most HFs have a ‘high water mark.’ It requires managers to make investors whole before they can start collecting their 20% of the profits—regardless of how long that takes.

Many HFs will not be able to redeem their investors because of their liquidity problems. Some are ‘gating’ investors, suspending redemptions, which will make investors in other funds that much more nervous. In coming months, we could well see some HFs fail, another manifestation of wealth destruction arising from the spinoff effects of the housing crisis.

Bottom Line: Many have been surprised that the largely unregulated HF industry has weathered the financial storms of the past year as well as they have; but now the ships are taking on water and some are sinking fast. This will only increase the turbulence as the financial turmoil continues to pick up steam.