Keeping Fear in the Hedge Fund Equation

by: Veryan Allen

Hedge funds "work" because of monetary incentives and checks and balances on managers that closely align their interests with clients. The often cited "heads I win, tails you lose" compensation scheme is a myth. The possibility of investors redeeming for poor performance, high water marks, no lockups and the principals' wealth at risk assures clients of shared downside exposure and motivates managers to try to minimize drawdowns.

Fees for failure have impacted shareholders of corporations where senior management was neither competent nor motivated to prepare for difficult times. While proper hedge funds are structured in ways that provide upside and downside alignment, this is now not always the case with some funds.

Investing in a hedge fund should be about replacing market risk with manager risk. If, like me, you believe in alpha not beta, that makes sense as "the market" is unhedged and notoriously volatile. Hiring a true hedge fund manager means you are paying 2 and 20 to someone who is incentivized to make money while hedging risk. Managers provide the skill and some capital and limited partners then provide more capital to leverage that skill.

A Win-Win Business Model

It is a business model that has proven a win-win for both parties for over 50 years despite much criticism from commentators who have never invested in a hedge fund themselves. A new source of return and keeping 80% of gross alpha is a great deal for investors provided the manager is motivated to keep on performing, managing risk, restricting AUM to the size they can perform well with and continue working 100 hour weeks. Redemption fears, high water marks, personal wealth in harm's way and non-permanent capital if you don't do your job well are protective covenants for investors, though, of course, nothing is guaranteed. We have seen the dangers of covenant-lite loans and there are possibly similar issues with covenant-lite fund capital.

Necessity is not the mother of invention. Motivation is the real mother of invention. Lots of things weren't considered necessary until long after they were invented. Life went on before wheels, electricity, cars, computers, internet or mobile phones and few said beforehand that we needed any of them. Hedge funds got invented because some were motivated to find safer, better ways of growing capital than simply owning assets. Incentive fees ensure managers keep working hard and figuring out even more ways to make money for investors. If, and only if, clients make money then you make money. "Cheaper" management fees mostly result in index hugging and asset gathering often at the cost of performance.

Mutual Funds: A Comparison

Actively managed mutual funds and other relative return products have fees that are often higher than hedge fund fees. Most mutual fund returns are at least 90% driven by the beta of whatever asset class they are investing in. Since beta fees are effectively zero (the holdings can be lent out to cover the indexation cost), that means a mutual fund charging 1% could be considered to be charging 10%(!) since it is actively managing only a small part of the portfolio and indexing the rest. Mutual funds get paid that fee whether they make or lose money.

In contrast, good hedge funds that can make money whether the market is up or down are a bargain. Hedge funds mostly charge that infamous 2% to cover much higher fixed costs on a generally smaller AUM; usually they only get paid if they produce new profits. But in some cases now the 2% is also becoming a profit center and some hedge funds are sadly morphing from hunter gatherers into asset gatherers. Permanent capital reduces the fear of redemptions, falling too far below your high water mark and the many alignment benefits of all senior managers having most of the wealth at risk in the fund.

The Meaning of IPOs for Hedge Funds

Recently I was asked by an investor whether they should automatically redeem from an alternative asset manager that tries to IPO. Good question. After all, the IPO process, before and after, is a major management distraction away from focusing on portfolio and risk management, while the monetization of what are effectively future management fees may reduce motivation in subsequent years and the interests of public shareholders and fund investors are not necessarily the same. Worse, it tends to transfer the emphasis to the 2 rather than the 20, leading to more marketing- and less performance-driven fee dependence.

Why buy an investment banking stock when the CEOs can still parachute out no matter how poor a job they do? Why buy an AAA rated CPDO when the ratings agency won't be financially damaged if it drops to a C rating? Why purchase a "Strong Buy" equity pushed by an analyst who won't be financially punished for being wrong? Why buy into hedge fund or private equity IPOs when the founders are selling? Why provide permanent capital and allow net present value monetization of fee cash flows far into the future when the possibility of having that capital taken away is such a powerful incentive to keep performing?

Permanent returns guarantee permanent capital. Hedge fund managers have always been able to monetize their skills through the performance fee. The more money investors make the more the manager gets paid. Jim Simons, George Soros, Michael Steinhardt, Julian Robertson or Bruce Kovner among others never went or have never expressed an intention to go public, yet seem to have monetized their businesses fairly well and attracted talented employees. For a quality hedge fund there is no need to IPO. Selling a stake to a strategic investor might make sense, listing a fund might make sense but the manager itself going public is a clear short sale signal.

Greed Is Good but Fear Is Fabulous

There are a few funds now more motivated by the 2 than the 20. Shareholders like the 2 while obviously limited partners should like the 20 since the more fees they pay the higher the returns. Asset size is usually the enemy of performance. Surely the best motivator is that if you don't perform then the money will desert you. Lockups and redemption penalties reduce this fear but are only appropriate for some strategies. With permanent capital, the fear of losing the assets is taken away. As we have seen with subprime mortgages, SIVs or executive compensation, take fear out of the equation and greed alone must lead to problems. There is nothing wrong with greed per se provided it is not a free call option with no downside. Greed is good but fear is fabulous.

Almost every quality hedge fund operating today began with less than $100 million under management. Every one of those funds was motivated primarily by the performance fee. So the argument that the biggest funds will win ignores factors that have underscored the success of the industry since inception. There is strong empirical evidence that newer and smaller hedge funds perform better. Yet currently more money is flowing to the biggest funds by besotted investors operating under the delusion that large AUM equals large future returns. There seems a strange dichotomy here. Isn't money supposed to go the funds likeliest to perform better? Whether a firm has $500 billion or $500,000 under management gives little indication of its abilities. People should have learned that expensive lesson from the traditional financial world by now.

Does Size Matter?

It is true a large proportion of new assets into hedge funds have recently gone to more established funds. With most investors it made sense to enter the space through funds of funds but as their familiarity has grown, direct investment into larger funds is the stage we are in now. But with the superiority of early performance and higher returns on smaller asset sizes there is always going to be capital for niche managers with new ideas and strategies. With the industry still so tiny compared to future demand, there will be plenty of space for large and small hedge funds.

Core-satellite is how the traditional world evolved and is how the hedge fund space will evolve: A core of fund of funds and multistrategy behemoths enhanced with specialist managers filling a specific portfolio gap. Lots of room for good hedge funds of all sizes as long as the people in charge are incentivized and feel fear. Motivation and incentives are the fuel of any functioning economic model. Fees for failure threaten that system. There is surprisingly little correlation between how hard someone works and their net worth. There are plenty of billionaires working just as hard as when they started out. But there is a danger that some managers might lose their motivation if the worst case scenario isn't that bad and when shareholders prefer AUM more than performance fees. Will the Och-Ziff partners burn the midnight oil in 2008 as much as when starting out in 1994 even if the IPO proceeds have been reinvested in the fund? Hopefully they will but it is yet another question investors will have to ask themselves. Nomura and the China and Dubai sovereign wealth funds can't be very impressed with the post IPO performance of Fortress (NYSE:FIG), Blackstone (NYSE:BX) and now Och-Ziff (NYSE:OZM).

Finding a Performer

It is not often such obvious short sells come along but when someone stands on a street corner throwing out $100 bills you try to grab all you can. Some shorts this year like credit or the dollar weren't completely obvious unless you did your homework, but shorting those IPOs was blindingly obvious. If the principals are selling it makes sense to sell alongside. Since there was previously no easy way to short hedge funds it makes sense to short OZM even if you think Och-Ziff is a good firm. OZM now serves as hedging instrument in the same way the FIG and BX IPOs enabled a way to short private equity.

When a hedge fund manager "takes home" a billion it is great news for their clients since it is fair compensation for strong performance. Any management team should be incentivized to do a good job. But if you IPO then you become similar to a CEO of Merrill Lynch (MER) or Citigroup (NYSE:C) as it does not align shareholder or client interests with management. Those properly incentivized to work don't play bridge or golf when their firms are taking massive losses either. Any hedge fund manager worthy of the name was available 24/7 during the recent problems. Non-permanent capital and easy redemption forces managers to work hard especially if their net worth is at risk.

As in any industry, if you want cheap you can get cheap. "Cheap" hedge fund clones and replicators are out there as are so-called "hedge fund" style mutual funds. As usual you get what you pay for. While proper hedge fund fees remain stable there has been some fee reduction in the funds of funds arena. An investor may be proud of getting "lower" fees instead of the former 1% and 10% second layer, but the chances are they are being penny-wise, dollar-foolish. There are costs to due diligence, infrastructure, monitoring and attracting the quality of staff able to identify good hedge funds. It is easy enough to just pick names that had a good recent performance and charge 70 bp and skimp on the massive due diligence you claimed in your powerpoint presentation. It is much harder and expensive to do a good job picking quality hedge funds that will perform.

Someone asked me what I expected to be the best performing strategy over the next 10 years. I answered that considering financial incentives and innovation, the chances are the top returning strategy over 2008-2018 probably hasn't been invented yet and that the managing firm is likely not yet established. They responded that they figured "China short only" would be the best performer which was interesting. They might be right, they might be wrong, but if they do find such a manager, they need to make sure anyone to whom they provide non-permanent capital is properly incentivized to 1) make money 2) not lose most of it.

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