Hedge Funds: Less for More

Hedge funds are performing worse and charging more. That’s the conclusion reached after hearing numerous speakers at a recent investor conference sponsored by one of the large fund groups.The topics du jour in hedge fund land were: higher fees, longer lockups, more lenient high water marks, “sidepockets” that are being used to put aside losses, a growing gap between winners and losers, a slowdown in the money going into funds-of-funds, more “activist” managers, increasing use of “gates” to limit withdrawals and a drop in the use of soft dollars. Few bode well for investors’ returns.The good news is that after posting pretty sorry results in October, the hedge funds bounced back in November, apparently making up much if not all of the prior month’s losses. The average fund lost between 1% and 2% in October, according to Credit Suisse First Boston, HedgeFund.net, and Hennessee tallies; through October the funds were ahead on average 4% to 5% for the year. For November, helped by a 3.5% rise in the S&P 500, the funds on average gained about 2%. (Final figures won’t be out for a few days.)Still, it has not been an easy year for fund managers. On average hedge funds are now up about 5% to 7% for the year, ahead of the market indices, but certainly tame results compared to those in recent years.And yet, managers are boosting fees and demanding longer lockups of their clients’ money. How can they justify these trends?It’s fair to say that hedge funds these days fall into two categories: large firms with established pedigrees and everyone else. The giant funds that have been around for some years, that have consistently posted good results, and that are typically closed, can charge almost anything they want today, and they are.So some of the best and brightest are reportedly charging as much as 3% management fees and 35% incentive fees (D.E. Shaw), and the average fund now is moving from the traditional “1 and 20” structure to a 1.5% to 2% management charge and 20% incentive.What rationale do the managers have for increased charges? The main excuse is that competition for good people is such that compensation costs cannot be covered out of the old fee structure. This is also the rationale for an increasing tendency to monkey with so-called “high water marks.” Traditionally, if a manager lost money, he would have to make up the loss before incentive fees kicked in again. Today, managers are resetting the high water mark more often, so they can begin charging the incentive fee while still under water.Another tactic to make sure their teams are compensated adequately is to run charges such as trader bonuses through expenses, as opposed to paying these costs out of incentive income.Hello! The basis for the original system was that fund managers should receive compensation commensurate with their performance. How ironic that the detachment of pay from performance should occur at the same time as a jump in the number of hedge funds pursuing shareholder activism. While investment managers are beating up on corporate managements for excessive compensation, they are themselves expecting to be paid huge incentive fees even when they don’t perform. Something has gone askew.While fees are going up, liquidity is going down. More funds are requiring commitments of at least two years from investors, in part because they are increasingly taking on less liquid private equity-style investments. Also, by extending lockups to two years and beyond, they avoid having to register with the SEC in February. The SEC adopted the exemption in order to exclude private equity firms. It is apparently having second thoughts.Another blow to liquidity comes from an increasing use of so-called “sidepockets,” or special investments made within a fund that typically have a longer horizon before earn out and may be harder to value in the interim. The manager in essence takes the investment out of the pool for calculation purposes. Some cases have been reported of managers using such tactics to get a losing investment temporarily off the books, allowing for a higher incentive charge.Are most funds going to register? They appear to be dragging their feet, but the SEC apparently expects a large number to register in the next 60 days. Through October, the number of firms registering was not much different from last year’s level. Many firms are resisting and view registration as a costly nuisance.Many funds-of-funds are struggling, in part because investors have become resistant to paying a second level of fees on top of charges from underlying managers. Also, there are simply too many firms in this sector of the hedge fund industry, where barriers to entry are few.Even large established FOFs are concerned about a liquidity mismatch. While the hedge funds they invest in are requiring longer lockups, investors are demanding greater liquidity. While annual withdrawals used to be the norm, now FOFs are increasingly offering quarterly liquidity. The concern is that investors might collectively demand their money, only to find the FOF unable to retrieve their cash from the underlying funds.These issues have mostly gone unnoticed by investors. However, today the FOFs are said to be experiencing withdrawals, after delivering poor returns to investors in recent years. A growing number of investors have begun to challenge the necessity of paying an extra layer of fees (FOFs usually charge 1 and 10 on top of the fees charged by the underlying funds.) New investment vehicles such as ETFs and retail hedge funds are also competing for investor funds.However, as the underlying funds become more aggressive on extending lockups and raising fees, the larger FOFs will increasingly fulfill another function – negotiating better terms for their investors. This, in addition to gaining entree to the best managers, may indeed become their true value added.

Hedge Funds: Less for More

Hedge Funds: Less for More

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