The State of Play One Year on From Lehman

Part one: supply and demand

SIMON KERR

A year ago the financial world was transformed by the demise of Lehman Brothers. Lehman filed for Chapter 11 bankruptcy protection on 15th September 2008 but the absence of a rescue package was the trigger for a reaction in markets that had been building for some years. The hedge fund bubble had already begun to stretch with the failure in 2007 of two hedge funds sponsored by Bear Stearns, just as the travails of markets can be dated back to the collapse of Northern Rock in the same period. By the third quarter of 2008, the hedge fund bubble was becoming strained and it had burst entirely by the end of that year. On the anniversary of Lehman’s collapse, The Hedge Fund Journal looks at the aftermath left behind by the market tsunami. Further prognostications will appear in a second instalment next month, but for now we look at where supply and demand meet – in hedge performance and the fees charged for it. Welook at the changes to overall industry shape and some of the recent dynamics, but it always begins and ends with performance.

Performance, performance, performance
The starting point for hedge funds is always performance. Hedge fund and market returns are shown in Fig.1 and Table 1. The hedge fund returns of 2008 were disappointing. Yes equity markets were down 40% and hedge funds only lost around 20% of their investor’s capital, but those returns were not what investors expected from “expensive absolute return vehicles”. Of course there were a whole series of special factors operating in the latter part of 2008 – the dash for cash, a huge spike in volatility and correlation amongst strategies and assets, not to mention widening spreads and deteriorating dealing liquidity, an absence of true market values in some asset classes and an inability to realise assets or hedge them economically. All these factors contributed to the downward spiral of falling asset values, deteriorating sentiment and an absence of risk assumption, and the end-result of the tailspin was investor redemptions. The exposure of the Madoff Ponzi scheme in December merely exacerbated an existing problem, particularly for funds of hedge funds.

When it comes to returns, markets experienced an awful year in 2008 and hedge funds as a group a bad one (see Fig.1 and Table 1).

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Equity markets finally bottomed in March this year, but hedge fund managers do not change their exposures overnight, and hedge funds have since participated in the 50% equity rally to a limited extent. The first half of this year was an inversion of the second half of last year. In H2 2008, 70% of all hedge funds lost money, but at the half way stage of this year 80% of hedge funds had produced a positive return. Last year most hedge fund strategies lost money (except CTAs and short-sellers); this year most have made money (except CTAs and short-sellers). There was a sequence of six down months last year, and so far in 2009 there have been six straight up months. Last year hedge funds out-performed falling markets by falling less.

stateofplaytable1This year, against strongly rising markets, hedge funds have produced positive returns, but have risen much less. The individual funds that did well last year have not shone this year, and the worst performing funds of last year are amongst the best performers in 2009. In particular, hedge funds with a longer term time-frame and fundamental bias in stock selection have suffered, some big names amongst them. Early this year the scale of last year’s losses and redemptions weighed on the managers of some funds to the extent that they shut-up shop rather than battle on. For example Peloton Partners called it quits in March 2008. Another group of well-regarded managers decided to exit the hedge fund business: as the rally unfolded and their funds were not seen to be participating, so the pain of last year bled into this for firms like William von Mueffling’s Cantillon Capital Management. Handling the same problem in a different way, fabled stock picker Jim Pallotta is closing the hedge funds of his Raptor Capital while he re-thinks his strategy.

Attrition of capital, attrition of funds
Overall the hedge fund industry lost about 40% of its assets last year – half from investment performance and half from redemptions – and more firms than ever left the business (see Fig.2). In fact, the events of the last 12 months have brought about a rate of attrition amongst hedge funds not seen for four decades. In the late 1960s, the demise of the American go-go managers decimated the immature hedge fund industry over the course of a number of years. Last year about 10% of hedge funds went out of business. In the first half of this year the attrition rate amongst US-based managers has been between 4% and 5%. Firms and managers have left the business for a number of reasons, including shrunken capital bases and high-water marks.

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Redemptions were a natural consequence of the events of last year as described above. Hedge funds have suffered in the first half of this year from the legacy of the problems of 2008. Managers, particularly in the US, lengthened the notice periods and hard-lock provisions on their funds in the good times, and so extended the period over which redemptions became effective. Redemption notices were put in during 2008, but many became effective this year. In addition some managers suspended redemptions last year, but are allowing them again now. According to data collected by Hedge Fund Research (HFR), peak net redemptions of $152 billion occurred in the in the fourth quarter of 2008. The first quarter of this year saw net redemptions of $103 billion, and in the second half of 2009 there were net redemptions of $42.8 billion, according to HFR. The balance between performance and subscription/redemption impacts on industry assets are shown in Fig.3.

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Filings by US hedge fund groups (Fig.4) allow us to see by size which categories of hedge funds have been forced into closure between June last year and June this year. Unsurprisingly, given the economies of scale, the smallest funds were the most likely to collapse over that 12-month period.

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The sum of the total assets that left the US hedge fund industry because of closures amounted to around 4%, as of June 2009: one of the effects of the credit crisis has been to further the trend of concentrating assets in the hands of fewer players.

The number of hedge funds in the global industry is of the order of 8,800. This is net of launches and closures. In 2008 it is thought that 1,400 hedge funds liquidated while only 600 were launched, making it the first year that hedge fund liquidations exceeded hedge fund launches since the concept was first exported from the US in the mid-to-late 1990s. The trend continued into this year: there were 1,000 fewer single manager hedge funds and 200 fewer funds of funds by the end of the first quarter. EuroHedge has reported that only 47 new funds were launched in the first half of the year in Europe, down on the 106 launched in the same period in 2008 and well down on the 190 launches in the first half of 2007. So the number of hedge funds is down because of fewer launches as well as closures.

One of the reasons for fund closures is the impact of the high-water mark feature, common to modern-era hedge funds. On an industry index basis, the industry’s price (NAV) peak was as long ago as October of 2007. Based on the NAVs at the end of August 2009, a typical hedge fund still has to show a NAV appreciation of 11% to get to the old high-water mark. For the likes of RAB Special Situations Fund or Gradient Europe, down significantly more than the average hedge fund last year, it could be years until the managers are in a position to earn a performance fee. The impact has already been seen in staff movements – even partners of established funds have a disincentive to stay at funds well below their high-water mark. And there remains the classic incentive of performance fees to entice quality staff to funds at or near their peak NAVs. In this regard it is interesting to see that two founding partners and the head of Asia for The Children’s Investment Fund Management (TCI) have left the firm recently, and that on the other side of the coin Brevan Howard has just taken on three senior staff at partnership level. Brevan Howard’s flagship Global Macro Fund was up last year and is up nearly 15% this year.

The performance of hedge funds in 2008 has affected the demand forhedge funds, and redemptions from hedge funds are a manifestation of the change in the demand/supply balance. Having changed from being a scarce resource in a growing industry, what price now for alpha from the hedge fund format? The terms of business are under review.

Terms of business – redemptions
Just over a year ago, in the heat of the firestorm post-Lehman, liquidity everywhere was at a premium. End-investors sought to raise liquidity and did so wherever they could, hedge funds included. This caused a rush for the exits, and hedge funds could not respond well. Gates were raised, side pockets exploited, and investors had to queue to get out of their hedge fund investments. Even alternative asset management firms as large as Citadel, Fortress Investment Group and Highbridge Capital Management suspended redemptions. Other tactics were deployed to retain capital at hedge fund firms, amongst the most common of which included a cut in fees in exchange for a lock-up. For example, credit strategy firm Camulos Capital, which had seen its two largest funds fall by about 20% by September of last year, offered to slash its management fee to 1.25% and halve its performance fee for the following two years if investors agreed to a new one-year lockup. Ramius Capital, which has single-manager and multi-manager products, said it would implement a two-year cut in its performance fee from 20% to 15% for investors who agree to stay put. In addition Ramius offered a fee break for new capital subscriptions – no incentive fees at all on the new investment until the beginning of 2010, and then stepped rises to 10% and 15%.

There are chastened managers at every level of the industry, and even very well-known names have had to change their redemption terms. Steven Cohen’s SAC Capital Advisors showed US equity assets of $8 billion at the end of March last year, and by the mid-year point this year SAC had around $5 billion in US equities, according to SEC filings. In June SAC scrapped the three-year lock-up period for investments in its flagship fund; the fund now offers quarterly liquidity. Chris Hohn’s TCI was always closed to new investors and had enforced three- and five-year lock-ups. But TCI lost 43% last year and AUM have declined from $15 billion to $8 billion. TCI has told its investors they can have 20% of their capital back now, and on expiry of the existing lock-ins it will give six-month lock-ups and will move to quarterly liquidity. A sign of a return to normality is that Citadel is about to resume redemptions. Last year the firm’s Kensington and Wellington Funds suffered losses around twice the scale of the typical hedge fund, and there was a blizzard of redemption notices. This year the flagship funds are up more than 40% and the firm has scheduled two tranches of return of investors’ capital to meet redemptions. Redemptions of $250 million will be met at the end of the third and fourth quarters.

So in response to investors’ serious difficulties in making redemption notices effective last year, managers have had to change their terms of fund liquidity. Can the same be said for fees?

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Terms of business – fees
According to HFR, the average management fee charged by single-manager hedge funds in the first quarter of 2009 was 1.57%. The average incentive fee in the first quarter was 19.22% for single-manager hedge funds. The database thus reflects that the performance fee element does conform to the perceived norm of “2 and 20” – most hedge funds have a performance fee of 20%, while a minority have 15%. That management fees are so much nearer to 1.5% than 2% reflects a number of factors, one of which is the pressures that come from increased institutionalisation, while another may be manager location. Fig.5 shows that flows of capital to hedge funds have become dominated by institutional money, and these investors are aware that for longer-established managers, they have contributed more than two-thirds of the capital (Fig.6). These investing institutions have begun to react to the huge shift in supply relative to demand.

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In January this year the Utah Retirement System issued to hedge funds a summary of preferred terms of business (see http://www.scribd.com/doc/14500965/URS1 for document). The pension plan proposed that hedge funds’ management fees cover operating expenses only, and that performance fees be paid either at the end of a lock-up period or placed on a deferred schedule. This was followed up in March by The California Public Employees’ Retirement System (CalPERS), the largest public pension fund in the States, sending out a memo to its hedge fund managers. Typically performance fees are collected at the end of each year, but CalPERS suggested that instead fees should be spread out over several years. CalPERS also wanted clawbacks, which allow clients to recoup fees from previous profitable years after a period of poor performance. It seems some hedge funds are willing to fall in line with the thrust of the argument. When TCI was just starting, Chris Hohn dangled access to potential investors with extremely long lock-ins as well as an unusual 16.5% performance fee. TCI is breaking new ground again now. While the offer of a management fee cut from 2% to 1% after the three- or five-year lock ups mature has been seen elsewhere, TCI has proposed changes to the payment of performance fees. Hohn has proposed to his investors that the cut of profits that goes to the manager will be paid out either after three years, or when an investor leaves the fund.

The deputy investment chief of the Utah Retirement System has disclosed that more than half of Utah’s 40 hedge fund managers agreed to changes in their fees by the middle of this year. Four of the pension manager’s hedge fund managers had adopted the pension plan’s preferred terms in each element.

Dwight Anderson’s Ospraie Management closed its flagship fund last year. The commodity fund had large losses. This year Anderson is launching a new fund without lockups, and the fees will be 1% and 10% rather than 2% and 20%.

So it is game over then for the “two and 20” hedge fund fee model? Only in part. Just as the supply and demand balance for hedge funds was tipped in the favour of investors last year (too much supply relative to demand), in the first half of this year, the balance has become more even. Net capital flows to the industry have gone from being extremely negative in the later months of 2008 to very negative early in 2009, through mild outflows in the middle of this year to some positive inflows more recently. This is shown in the flow of capital in Fig.7, which uses data up to the end of May. In the three months since then there have been net outflows in two months and net inflows last month, according to estimates from TrimTabs. Anecdotal evidence from managers with positive returns also suggests that net inflows commenced about three months ago.

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So where managers have had to change their terms of business, such as on redemption terms and lock-ups, they have. Even SAC has moved there. But Steve Cohen still has assets under management of $11 billion or more, so his business model is not at risk at this point. His funds are up this year, so SAC still commands management fees of 3% and the eye-watering performance fee level of 50%.

Another factor in the area of newly dynamic hedge fund fee levels is manager location. Information provider Preqin surveyed hedge fund managers (single and multi-manager hedge funds) in April and May, and broke down fee levels by geography (see Table 2). US management fees are clearly lower in this survey, consistent with the HFR database analysis for management fees across the industry. One interpretation of the research is that US managers operate in the most mature market for hedge funds in terms of supply – that is where the majority of the industry assets are invested and managed, and it is the only territory where there are thousands of hedge funds. From the demand side it is also a market which contains end investors with ongoing appetite for the investment strategy, some of whom have sought to improve the terms on which they do business with hedge funds. So we should not be surprised that fee pressures seem to have had an impact there, of all regions.

stateofplaytable2Conditional resistance
However, to return to the starting point, the hedge fund business is all about performance. So within the universe of hedge funds, evidence so far suggests that single manager hedge funds that have performed as well or better than the average hedge fund and have a business with tenure and still have a robust business model have resisted pressures to cut their management and performance fees.

Can the same be said of funds of hedge funds? Along with the investment strategies used by hedge funds in the last year, and the impact of recent events on concepts such as managed accounts and hedge fund replication, this will be looked at next month when we continue our appraisal of the industry.