>Whilst there is a constituency within the hedge fund industry which have obtained the Hollywood version of the trappings of success in the financial sector – the cars, the ranches, and the (part-owned) private jet – there is also a very long tail of funds which have not been in performance fee nirvana for some years.
Barton Biggs gave a very good insight into the under-reported downside of running a hedge fund business in his book Hedgehogging. He told the story of an acquaintance who had put in a good year for performance, so collected a handsome performance fee for his added value. But as the manager’s style of investment wasn’t suited for subsequent market conditions, the following years were rough. The fund manager had to attend all his usual company meetings, read copious amounts of material, track stock market shifts, talk to his investors and put his ego on the line by selecting stocks. He had to put in long hours running his own small business as well as being a full-time professional investor – dealing with accountants, lawyers, budgets, planning, and hitting deadlines for regulatory filings and statutory reporting. All this while not making big money – in fact the big money of the fat year was ploughed back into the business for the subsequent lean years.
There are many challenges running a small business. In the hedge fund segment, in which the spoils go to the victors of the war of performance, not the least of the challenges is to retain (smart, professional, and mobile) staff who have no prospect of a bonus for some time. When the average hedge fund fell 19% in 2008 that presented the challenge of returning 23.4% to get back to the NAV of the start of that year. For most hedge funds that is two good years of returns. So staff could only get paid a meaningful bonus at the end of year three – that is, get paid at the start of year four! Hence staff defections from the hedge fund losers of 2008 was a theme of 2009 and into 2010.
The business school tenet for running a business like managing hedge funds is to build your expenses to be in line with your regular revenue, i.e. on the management fees. The performance fee is often characterised as the gravy in the meal, but if the base diet is thin gruel then gravy is not what a diner wants as a supplement.
And small gleanings are what have been available to many managers. It was reported here in a recent article that around half of Europe’s largest hedge fund manager groups had not gathered more assets in the middle six months of last year – so the base revenues of the businesses were not expanding. However, by the end of September last year only 5% of the assets of the largest managers in Europe were not qualified to pay performance fees because of the high water mark feature. So by extension, with a further five months of positive hedge fund returns, most of the world’s large hedge fund groups are now accruing performance fees. The well known names who run these businesses will be able to buy a larger house in the Hamptons if they choose. The more socially sensitive of them will be able to fund another urban academy in a deprived neighbourhood.
However, there are many dedicated hedge fund managers who will not be in a position to fund such largesse, or even take a house in Vail for the season. Eurekhedge reports that fully 42% of hedge funds are still below their end 2008 NAV at the end of February.