Most hedge funds may have weathered so far the gales blowing through the financial markets following last summer’s implosion of the US sub-prime mortgage sector, but the crisis is far from over.
Most hedge funds may have weathered so far the gales blowing through the financial markets following last summer’s implosion of the US sub-prime mortgage sector, but the crisis is far from over.
The sub-prime meltdown has since upended credit markets across the globe and jolted equities as well. Add leverage, and you have all the ingredients for worldwide financial contagion, one that has sounded the death knell for hedge funds big and small. Notable casualties include funds run by high-fliers such as Bear Stearns, Citigroup, Focus Capital, Peloton Partners and Sailfish Capital Partners.
Is there a wider shakeout coming? With serious macroeconomic problems looming, investors surely have reason to pause. Hedge funds rang up an average loss of nearly 3 per cent in January, their worst-ever monthly decline since 2000, according to index providers, and after a mixed February, managers are reporting a fresh round of losses for March.
A lingering problem is that the underlying real estate linked to troubled paper remains in the doldrums, which means that deflation of the credit bubble still has some way to go. Asset valuations, meanwhile, remain hard to determine in a market that has to a large extent seized up, resulting in longer redemption terms. Finally, equity markets are also weakening, despite the US Federal Reserve’s attempts to revive the economy by repeatedly slashing interest rates.
‘There’ll be more hedge fund blow-ups this year than ever,’ says Michael Hennessy, managing director of investments at Morgan Creek Capital Management, which was established in 2004 by Paul Yusko, former investment chief and a colleague of Hennessy at the endowment of the University of North Carolina at Chapel Hill.
‘Price discovery, when it occurs, will likely threaten if not devastate hedge funds and even financial institutions. There’ll be month-to-month hits and then, in the case of hedge funds, redemptions which, combined with tighter lending, will cause the classic death spiral.’
That makes the job of managing money that much harder. Recent losses are creating real liquidity problems at some funds of funds, according to Virginia Parker, founder and chief investment officer of USD600m Stamford, Connecticut-based fund of hedge funds manager Parker Global Strategies.
Hedge funds are imposing longer lock-ups and gates, Parker says, and there is nothing a fund of funds manager can do other than hope to have redeemed before the underlying manager triggers this move. This means manager due diligence has to be rigorous in order to ‘pick managers that know how to keep their powder dry’, she says.
The bar for due diligence and risk management is being raised, industry participants say. An effort is being made to improve disclosure and transparency via initiatives such as the President’s Working Group on Financial Markets, which has nearly completed drafting a report designed to address key investor concerns.
Separately, two industry bodies, the Alternative Investment Management Association and the Chartered Alternative Investment Analysts’ Association, are co-operating on a guide for hedge fund investors, written by Alexander Ineichen, senior investment officer at UBS Asset Management, with help from California Public Employees’ Retirement System portfolio manager Kurt Silberstein. The guide is due to be published during the second quarter of this year.
Among the issues that are expected to be addressed by the various reports and publications are the overuse of long lock-ups, side-pockets and illiquid investments, over which experts have already raised red flags.
Current market conditions call for even greater manager scrutiny, according to Gary Witt, a managing director of ratings agency Moody’s in New York. Ensuring the manager has sound funding is more important today than it was a year ago, says Witt, who leads the agency’s unit that gives ratings to hedge funds.
In turbulent times, funds should not have a single source of funding, and operational risks need to be vetted. ‘Hedge funds are usually started by traders coming out of large institutions and haven’t run businesses before,’ he says. ‘They are focused on generating returns, not taking care of mundane business issues.’
One likely result will be a slowdown in new entrants coming in to the market. Institutions now want to see longer performance records and larger volumes of assets under management, criteria that have become particularly difficult to meet in current market conditions.
Industry data on new launches is starting to indicate a slowdown from the record pace of recent years. According to a survey by Absolute Return, 30 funds were launched in the second half of 2007, compared with 51 in the six months to June. In total, USD31.5bn was raised last year, compared with USD40bn in 2004 and USD35bn the following year, albeit slightly ahead of the USD30bn total in 2006.
According to BarclayHedge and TrimTabs, investors added USD2.5bn in net new capital to hedge funds in January, which was USD200m more than in December but far short of the USD21.8bn figure for November.
‘As the market matures, you’re going to see fewer wannabes joining the market,’ says Michael Caccese, head of the financial services practice at law firm Kirkpatrick & Lockhart Preston Gates. ‘Those who are having difficulties surviving will exit. The successful ones will expand and will find it easier and cheaper to acquire new strategies through acquisitions rather than training talent.’
Cases in point are the acquisition of London-based Castlegrove Capital by Israel Englander’s Millennium Capital, and Blackstone Group’s purchase of GSO Capital in New York. There have been plenty of similar deals and more are on the way, according to Karim Leguel, investment chief at New York-based financial advisory firm Rasini & Co.
‘I expect more M&A in the industry as bigger hedge fund managers acquire smaller ones, given the increased costs of running a hedge fund and the economies of scale and the reach and talent of bigger managers,’ Leguel says. ‘I also believe that institutional investors will be buying more stakes in hedge fund managers, allowing them more sustainability and potential access to capital in tough times.’
The good news is that hedge funds still enjoy institutional support. Darien, Connecticut-based consultancy Casey, Quirk & Associates forecasts that institutional capital invested in hedge funds will rise to USD1trn by 2010, almost triple the USD360bn the firm recorded in 2006.
Inflows might not pour in as a straight upward line on a graph, but they will continue to grow, according to Casey Quirk chairman John Casey. All told, institutions allocated a record USD66bn to hedge funds in 2007, of which an estimated USD52bn is still waiting to be deployed.
Hedge fund investment is now a normal part of the institutional allocation process, according to Patrick Keane, a managing director in New York with third-party placement agent Liability Solutions.
‘Despite spectacular headlines of some hedge fund disasters, institutional investors are increasing their use of hedge funds as part of their portfolio diversification strategy,’ Keane says. ‘They are no longer considered an exotic part of a typical, diversified institutional portfolio.’
Where’s the new money going? Managers say the possibility of bargain-hunting has drawn investors to credit strategies, while managed futures, global macro and selective commodities have drawn strong investor interest since late last year. By contrast, equity long/short, certain emerging markets, event-driven and merger arbitrage in general have lost some lustre.
The temporarily debilitating forces notwithstanding, Hennessy says, hedge funds as a whole will again prove their worth this year in terms of portfolio diversification, defensiveness and superior risk-adjusted returns.
