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.