The Broken Hedge Fund Model

It's becoming increasingly clear that the standard hedge fund incentive model breaks when a fund plunges in value.

If the value of a hedge fund is rising, then 2-and-20 works as intended: the fund manager gets paid more the more that the value of the fund goes up. And if the value of the fund falls a little, then the high-water-mark system stops the fund manager from being paid twice for getting to the same spot. But if the value of the fund falls a lot, then suddenly the fund manager loses pretty much all of his incentives, things start going rather pear-shaped, and there's a good chance that fund investors will end up getting shafted by their fund manager.

Consider the fight between Carl Icahn and fund manager Warren Lichtenstein. Lichtenstein had a bright idea when his hedge fund -- full of illiquid assets -- faced a lot of redemption requests: he'd take it public, and investors could then sell their investments at whatever price the market put on them, without the fund itself having to liquidate. Investors might have to take a very low price -- but Lichtenstein himself would continue to collect his management fee in perpetuity.

And there's no shortage of fund managers with underperforming funds who have announced that they're going to set up new funds: both John Meriwether and Michael Zimmerman are in the news today planning to do just that, following the lead of Jeffrey Gendell.

In all these cases, investors in the old flagship funds end up getting either liquidated or ignored, while the fund manager concentrates on the new fund where he has a much greater chance of earning a performance fee.

What's more, hedge-fund investors are well aware of this dynamic, and that's one reason why they tend to issue redemption requests when a hedge fund falls more than about 10%, even if that fund has significantly outperformed something like the S&P 500. They know that the high-water mark means their fund manager has lost a lot of his incentive, and/or is now incentivized to take reckless risks in order to get back to the high-water point. So they bail.

I'm not sure how to fix this broken system, but there's clearly something very wrong with the way that things are set up right now. Most likely the total amount of money invested in hedge funds is simply going to shrink dramatically: it was an experiment which didn't work out very well. Which is fine. But anybody interested in seeing the system live on indefinitely will need to come up with some way of ensuring that investors don't get doubly shafted when a fund falls sharply in value.

Comments

[alpha24seven:]

This is a derivation on the same "kill the hedgies" argument making the rounds. I'm not sure you've ever seen an actual offer memorandum to invest in a hedge fund. The majority of the hedge funds out there have two very important items that you seem to have missed.

1) Hurdle. That means the manager must make a certain amount tied to a benchmark before the manager collects any fees. This is in addition to and not the same thing as high water.

2) Manager participation. The majority of most hedge funds will have very strong participation from the general partner, md, principal, etc. This means a very high percentage or a very large dollar amount of the managers personal net worth will be invested in the same fund and strategy.

The reason many managers are starting new funds is is simple. When an investor makes an investment in a hedge fund, the offer memorandum will describe in general terms what the strategy is. Perhaps merger arbitrage, long/short, commodities etc. There is a legal issue when the manager engages in "strategy creep" to chase new profitable strategies outside the offer. The manager then must either recalibrate with all investors -- or -- start a new fund to pursue the new strategy. It's much easier to start a new fund. The markets (especially these days) move at hyper velocity. The old strategies go and the new ones show up and you need to be able to take advantage of the current market, ergo you start new funds.

Hedge funds aren't black holes of information. What they have become is just another whipping boy and outlet for rage because of the financial mess we are in. Look closely at what has caused this and you will see it isn't the hedgies. It was the financial engineering from the banks re tier 3 assets. This is not the domain of hedge funds. In fact, many hedge funds have been screaming about this prior to it blowing up.

Feb 03 01:25 PM

[Pent up demand:]

I don't see that hurdle rate or participation by the manager do much to deal with the incentive problems when a fund is deep underwater. When funds go underwater they are heavily incented to go for the Hail Mary because they typically cannot retain their talent on management fees alone.

That said, hedge funds will exist as long a people believe that there are certain golden boys who "know how to make money." Some investors will always be willing to take that bet regardless of the high fee structure, lockups, etc. ad nauseum.

Feb 03 01:36 PM

[Harry Tuttle:]

The problem is not with hedge funds but with people who do dedicate less time researching their investments than they dedicate to their choice of dishwasher detergent.

The fund industry is all about marketing. You fall for the marketing, you deserve to lose money.

For instance, Meriwether, has not only blown-up, by my count, 3 times, but doesn't seem to make ANY risk-adjusted money for anyone but himself. Yet, I think it is safe to say that he will get another $100 million for his new fund.

Feb 03 01:43 PM

[levin70:]

Solution?

Don't put your investment $ in a hedge fund.

Kind Regards

Feb 03 02:40 PM

[Daniel Moser:]

The hurdle rate and manager participation are linked quite nicely to the discussion at hand. As the commentor was stating, many hedge fund managers have millions of dollars (if not the majority of their own personal networth) thus when they are down 10-15% they won't necessarily just start throwing hail mary's hoping for the best. If I have 20 million invested in my own fund, lose 50%, leaving 10 million of my own money in my fund. Surely I wouldn't want to diliberately roll the dice on the remaining 10 million. With respect to the hurdle rate, the reason that is important is that everyone whines about how expensive hedge funds are....but the comment about hurdles rates shows how many funds don't actually receive the 20% performance fee until they beat their benchmark. Thus, if I have a 10% benchmark return and I manage to earn a return of 15%, as I understand it the hurdle rate implies that I will only get a performance fee of 20% of the 5% excess return over the benchmark hurdle rate. Correct me if I am wrong?

People need to layoff hedge funds. I really think it is an envious hatred that stems from poor mutual fund performance and choices. Quite frankly if everyone is so convinced that hedge funds are too expensive why were market forces not forcing them to lower their fees during the good times? I am yet to see a decent argument that hedge funds caused all of these problems that we are involved in. I wonder, if the vast majority of hedge funds and private equity companies are bad investments, why is there so much talk about them? It seems like no one would ever talk about them. People wouldn't care, because they are all bad investments. I don't ever see anyone post negative things about slot machines. Slot machines are certainly a bad investment. Could it be that the majority of hedge funds and private equity funds are decent investments for certain people? What is all the hating about?

Feb 03 03:37 PM

[Fozzie:]

Agreed. All those drinking the "Kill the Hedgie" Haterade are simply ignorant. Granted, from a metric point of view, some traditional form alts are catching up, so market and competitive forces will force hedge funds to 1. lower fees 2. increase transparency and liquidity. Anyone deriding them as derivative casinos simply don't know what they are talking about. I'm in the fund-of-fund business and the level of risk exposure management in our firms is world-class; also, had the banks been on the same level they could have avoided this mess.

Mar 04 09:35 AM