Monday 26 January 2009
The Hedge Fund Mismatch
Unlike US banks, hedge funds haven’t been lining up for government bailouts in the wake of losses they can’t handle. But the funds do share one Wall Street problem: a massive mismatch between the short-term funds they take in and the long-term bets they make. Without a rethink of their business models, many in the hedge fund business risk going the way of the investment banking dodo.
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The Hedge Fund Mismatch
By ROB COX AND RICHARD BEALES
23 January 2009
Unlike US banks, hedge funds haven’t been lining up for government bailouts in the wake of losses they can’t handle. But the funds do share one Wall Street problem: a massive mismatch between the short-term funds they take in and the long-term bets they make. Without a rethink of their business models, many in the hedge fund business risk going the way of the investment banking dodo.
Recall the nightmare on Wall Street. Going into 2008, America’s five big investment banks held trillions of dollars in long-term and illiquid assets financed largely by short-term borrowings. That did not work out so well. Two of them disappeared. Another was swallowed by a traditional bank, and the last two had to don the sober garb of regulated, deposit-taking banks to survive.
In the hedge fund industry, which at its peak last year managed some US$2 trillion, the analogous problem runs like this: Investors hand their money over to hedge funds, which typically charge fees of about 2 per cent a year plus a fifth of any profits, on the basis they will, mostly, make some money even when pandemonium breaks loose. This promise of what the industry calls absolute return went unmet last year. The average hedge fund lost nearly 20 per cent of its value in 2008, according to Hedge Fund Research.
As a result, many investors understandably wanted their money back. The problem is, hedge funds have in many cases loaded up with investments they can’t easily sell - at least not without incurring a big loss. That’s not just bad for the investors who want out; it also creates collateral damage to those who want to stay in the funds.
For funds that want to continue letting investors pull their money out on relatively short notice, one answer is to cut out the adventurous stuff and stick to the most liquid markets, like those for stocks, government bonds and the like. Hedge fund grandee Paul Tudor Jones is doing just that with his BVI Global fund.
Some managers still want to place complex, illiquid bets. For them, the obvious solution is to look for longer-term capital, akin to the way Goldman Sachs and Morgan Stanley are pursuing low-cost, relatively stable deposits. Lately, many hedge funds have been managing this process on the fly by putting up so-called ‘gates’ that prevent investors from redeeming their money, at least temporarily, as Jones did with BVI Global.
But this approach is a stop-gap that comes at huge cost. For one thing, it enrages investors, who thought hedge funds presented a mostly liquid form of investment. And to mollify limited partners (market jargon for investors), some funds are voluntarily emasculating themselves by reducing, even eliminating, management fees and taking a smaller cut of profits, should there be any.
For the longer term, some funds are restructuring with a view to locking investors in for years rather than months. At least one is pushing this idea further still. Jeff Ubben, founder of San Francisco-based ValueAct Capital, is taking a page from the private equity business and applying it to his hedge fund. The idea is that the new investors in his next fund, which he’s targeting at US$3 billion, must commit their cash to him for five years, about even with the effective life of a leveraged buyout fund.
That’s a long time, especially in the hedge fund world. But here’s the carrot: In return, ValueAct promises not to take a penny out of the profits until the end of the period, when the final tally will be real, not just on paper. That’s not all. Breakingviews.com has learned that Ubben and his crew will not collect a cut of the gains unless they generate returns of at least 12.5 per cent a year, or about 80 per cent over the life of the fund.
ValueAct will charge a 2 per cent annual management fee. That will keep the firm going while it researches its stock picks and fights the occasional proxy battle, as is Ubben’s wont. But with a track record of 20 per cent-plus annual returns over the last nine years, he’s clearly confident he can make up the difference. In doing so, he may also be on to a new business model for a good portion of his industry.
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