One of the hallmarks of a hedge fund is the performance fee. Along with a 1% to 2% management fee levied on assets, hedge funds typically keep 20% of the profits generated each year as payment. That fee structure creates serious incentive for portfolio managers to generate positive returns. If they can't, investors only have to pay the management fee until the fund's returns are back in the black
That's the theory, anyway. But in practice, hedge funds have an easy way out of the arrangement if it looks like they won't be able to earn positive returns above a pre-set "high-water mark" in the coming year. They simply shut down the fund. Assets are liquidated, the money returned to investors.
"If all they get is the management fee, why work?" observes Tom Taulli, an author and investment banker with Instream Partners in San Francisco. "What's the motivation?"
The managers are then free to spend some time "on the beach" (as the industry describes such downtime). Or, better yet, from their perspective, they can open a new flavor of hedge fund and invite the former investors to sign on. By doing so, they effectively set the clock back to zero and can start collecting performance fees on gains without having to work their way back up to break-even.
But it's not such a great deal for investors. "In some instances, after investors have paid a performance fee on the upside, they don't get the benefit of not having to pay one in the get-back-to-even mode," says Lee Schultheis, chief investment strategist of Alpha Hedged Strategies (ALPHX ), a mutual fund that uses investment plays typical of hedge funds. Even worse, they may pay the steep fee one year only to see all those gains erased and the fund shut down the next year.
This dynamic has always been part of the hedge-fund world but is more in evidence this year as more hedge funds close down operations. That doesn't mean every hedge fund that shuts down is engaging in this behavior. In fact, it's impossible to know who's doing it and who isn't. But as more institutional investors look to hedge funds to goose the puny returns available elsewhere, the interest in hedge-fund activity continues to increase.
READY FOR STORMS. Marin Capital Partners in San Rafael, Calif., and London-based Bailey Coates generated headlines in June by closing billion-dollar hedge funds. Many more smaller funds, particularly in the first and second quarter of this year, liquidated after certain strategies (such as convertible-bond arbitrage) stopped working, says Peter Rajsingh, executive vice-president at vFinance Investments, which operates several portfolios made up of hedge funds.
Some hedge funds are now modifying the incentive fee and high-water mark so that they earn a reduced incentive fee during the time they make back the money they lost, says Ron Geffner, an attorney for hedge funds at Sadis & Goldberg in New York. For example, the fund manager would get 10% of recouped losses, and 20% above the high-water mark. That would theoretically provide enough income and incentive to keep the fund going.
This new fee structure is an improvement for investors, says Geffner. But ideally, the firm should have enough capital so that it can afford to weather a temporary drawdown in returns.
MANY NEWBIES. "This is a normal metamorphosis among new funds," says Bradley Ziff, a director at risk-management firm Mercer Oliver Wyman in New York. At the large, established hedge funds with which he deals, Ziff says, he does not see fund managers closing up shop following a poor performance only to resurface at a new fund soon afterward.
But because more than 6,000 hedge funds exist today, up from 2,500 10 years ago, the customary weeding-out process -- an estimated 10% to 15% of new funds each year -- means more funds are closing this year than in the past, says Adam Zoia, managing partner of Glocap Search, a hedge-fund recruiting firm in New York. Hennessee Group LLC, an adviser to hedge-fund investors, found in its annual survey of 800 of the largest funds that in 2004 the attrition rate was 5.3%, higher than the 4.96% six-year average. The firm doesn't have figures for this year.
Hedge funds that close usually have little choice, says Rajsingh. Negative results can trigger massive redemptions. Management fees should cover the firm's operating costs, giving it breathing room while it improves performance. But if the asset base shrinks enough, there may not be enough cash left to run the firm.
PAY HEED. Funds that are "under water" face the added risk that their best traders and analysts will be plucked to go work for another firm where they stand a chance of earning performance fees, says Zoia. That could leave a hedge fund bereft of talent.
In such cases, shutting down a poorly performing fund and returning assets is often the best outcome for investors, since they can then invest their capital in a more promising venue, says Schultheis. In the worst case, the manager of a money-losing hedge fund may be tempted to change strategies midstream or take much more risk in hopes of getting returns back above water. "Shutting down the fund may be better than having that happen," he notes.
The bottom line is that investors need to pay close attention to fee structures before investing in a hedge fund. Even more important: Seek out experienced managers who have not only a strong track record but who "have proven their ability to manage in volatile times," says Ziff. In the high-fee, low-oversight world of hedge funds, caveat emptor applies now more than ever.