Like scores of hedge fund managers this year, Richard Brennan has fallen victim to the global credit crisis and market meltdown. Brennan is the founder of Camulos Capital, a $2.5 billion Stamford, Connecticut–based firm that specializes in credit strategies. By early September his long-biased Camulos Master Fund had plunged 20 percent, to $1.8 billion, and Brennan, anticipating a wave of redemption requests before the September 30 deadline, swung into action. Instead of erecting a gate — which would have prevented investors from bailing out by limiting withdrawals but could have been seen as a death knell — he offered a different solution: Agree to stick around for at least one more year, and Camulos would cut its fees.
The initial reaction was cool. But as Camulos investors saw the U.S. government step in to bail out Fannie Mae, Freddie Mac and other large financial institutions, they warmed to the proposal to reduce the fund’s management fee from 2 percent to 1.25 percent and its incentive fee from 20 percent to 10 percent in exchange for locking up their money until September 30, 2009. Eventually, more than 85 percent of the fund’s investors agreed to the proposal.
Camulos is hardly alone. Through the first nine months of this year, roughly 90 percent of hedge funds were underwater and hundreds were down well into the double digits, including funds run by some of the industry’s best-known managers: Lee Ainslie of Maverick Capital, Timothy Barakett of Atticus Capital, Noam Gottesman of GLG Partners, Kenneth Griffin of Citadel Investment Group, Christopher Hohn of the Children’s Investment Fund Management (UK) and Stephen Mandel of Lone Pine Capital.
Barring a miraculous reversal in the global markets, 2008 is shaping up to be the worst year for hedge funds since Chicago-based Hedge Fund Research began tracking their performance in 1990. In September, as Congress was arguing over the Treasury Department’s $700 billion bailout of the troubled financial services industry, the HFRI composite index plunged 5.42 percent, its worst month in more than a decade. For the first nine months of the year, it was down 10.11 percent.
The hedge fund industry is operating on very shaky ground. The rush of institutional money into hedge funds for the better part of this decade is a distant memory. Spooked by the growing global crisis, investors are looking to raise cash wherever they can, and hedge funds — which for the most part have held up better than long-only investments — are one of the most liquid alternatives. A wave of 90-day redemption notices began to flood firms in late September. By some estimates as much as $500 billion could flee the $1.9 trillion industry by early 2009.
For some the losses and redemptions are simply too great to overcome. In early September, New York–based Ospraie Management began liquidating its flagship Ospraie Fund, which had lost nearly 40 percent this year because of bad bets on commodity stocks, according to a letter sent to investors by founder Dwight Anderson. Ospraie planned to distribute 40 percent of the fund’s assets by September 30, an additional 40 percent by year-end and the balance — which figures to consist mostly of illiquid investments — over the next three years.
Meanwhile, longtime manager Daniel Benton said he would close Andor Capital Management, the $2 billion hedge fund firm that split off from Arthur Samberg’s Pequot Capital Management in 2001. Earlier, in one of this year’s most ignominious closings, Citigroup announced it would shut down Old Lane Partners, which had been co-founded by Vikram Pandit, now Citi’s CEO, and bought by the bank in April 2007 for $800 million.
This year is likely to be a record one for hedge fund closings. During the first six months of 2008, HFR reported 350 hedge fund liquidations, an increase of 15 percent over the first half of last year. Given that most of the devastation from the escalating crisis didn’t hit hedge funds until the third quarter, the final number could be as high as 1,000 — or 10 percent of the industry’s 10,000 funds, according to HFR president Kenneth Heinz. That would easily surpass the record 850 hedge fund liquidations in 2005.
The funds that survive despite suffering big losses have a long slog ahead of them. They must first earn back what they lost — to get to their high-water marks — before they can start collecting performance fees again. Many funds could be living exclusively off management fees until at least 2010, which will make it difficult for them to retain top talent, as the bulk of analysts’ and portfolio managers’ compensation comes from year-end bonuses built around the industry’s rich 20 to 25 percent performance fees.
“If you are working at a firm well below its high-water mark, you can expect to work for a year or two with disappointing compensation,” warns Byron Wien, chief investment strategist for Westport, Connecticut–based Pequot.
“We will definitely see a shift of top talent if a fund is underwater by 20 percent or more,” adds Jonathan Kanterman, a managing director at New York–based Stillwater Capital Partners, which has $900 million under management in single-manager funds and funds of hedge funds specializing in asset-based lending.
The inevitable shake-up — and shakeout — will create opportunities for hedge fund firms with large asset bases that have managed to avoid the carnage. Those in the black — like $26 billion Brevan Howard Asset Management, whose flagship macro fund was up nearly 15 percent through September — are especially well positioned. London-based Brevan Howard is one of several firms that have been aggressively hunting for new talent, hiring portfolio managers, traders and other executives from banks, hedge funds and money management businesses. But big firms that have suffered sizable losses are also staffing up opportunistically. Citadel, whose two main funds were down more than 20 percent through September, recently hired four senior people to boost the $20 billion firm’s mortgage and securitized-products business.
“This is not all bad,” says Elizabeth Hilpman, a partner and chief investment officer at Barlow Partners, a New York–based firm that advises hedge fund investors. “A lot of stuff needs to be cleaned up. In the hedge fund business, it is survival of the fittest. Even good funds go out of business.”
In this quickly evolving world, small firms are at a disadvantage. Unlike bigger rivals, whose management fees and retained earnings help offset the prospect of life without performance fees, many are struggling to pay the bills. Even small firms that have managed to make money this year may have to look for merger partners to gain the necessary heft to compete. Financing in general has become much more difficult to get in the wake of the credit crisis (see “Good-Bye, Easy Money”).
Just how much money will exit the hedge fund industry won’t be clear until later this year. Some managers don’t require redemption notification until mid-November. Others don’t have lockups but levy severe penalties on investors who redeem early. William von Mueffling’s Cantillon Capital Management, with $9 billion in assets, neither has a lockup nor imposes a penalty, allowing investors to pull out anytime, provided they give one month’s notice. Still, according to von Mueffling, the firm has had few redemptions this year.
“If your strategy is very liquid and you are confident in your ability to generate returns, there is no reason to have a lockup,” says von Mueffling. His two biggest funds, Cantillon World and Cantillon Europe, were down 8 percent and 11 percent, respectively, this year through September.
The run on hedge funds could be less than some are predicting if markets stabilize. A sizable percentage of the September redemption notices have come from funds of hedge funds to meet potential redemptions from their own investors. Typically referred to as protection redemptions, these requests could be withdrawn or canceled by fund-of-funds managers if their investors, who generally need to give only 30 days’ notice, decide not to redeem.
Where will all the money go? Don’t bet on it being plowed back into hedge funds anytime soon, says David Tepper, founder of $5.7 billion Appaloosa Management in Chatham, New Jersey. He thinks most investors will seek the safety of Treasuries: “People are scared to death.”
Firms down significantly this year that have high-water marks will need to find creative or unconventional methods to retain top talent. Some will distribute a larger than usual piece of their management fees. A hedge fund with $5 billion under management and a 2 percent management fee generates $100 million in revenues from these fees alone, typically far more than its expenses.
Maverick Capital’s Ainslie began making preparations for potential hard times about ten years ago, when he set up a reserve fund, putting aside a small percentage of profits that could be used to pay bonuses to top people during down years. Maverick, whose flagship fund was down about 21 percent through September, is likely to have to tap that fund both this year and next.
The handful of firms that went public in recent years — Och-Ziff Capital Management Group, Fortress Investment Group and GLG Partners — have the flexibility to give out additional stock, stock options and restricted stock to retain talent. Och-Ziff, for example, in 2007 granted its managing directors and all other employees class-A restricted share units, which may accrue dividends. Its managing directors subsequently entered into new agreements providing that a significant portion of their bonus compensation would be equity-based.
That’s unlikely to help London’s RAB Capital. The firm, which went public in 2004 and manages $4.2 billion in assets, has been hit hard this year. Its $790 million Special Situations fund was down 48 percent through early September and faced certain redemptions. Like Camulos, RAB persuaded investors to approve a long lockup — in its case, three years — in return for lower fees. (RAB halved its management fee, to 1 percent, and cut its performance fee, to 15 percent from 20 percent. Its shares, like those of Och-Ziff, have fallen more than 80 percent this year; Fortress’s shares have dropped nearly 70 percent.)
Hedge fund managers of privately held firms, who in recent years personally made hundreds of millions, or even billions, of dollars, may have to dip into their own pockets to pay their top people. “Everyone talks about this being an institutional business,” says Jane Buchan, CEO of Irvine, California–based fund-of-funds firm Pacific Alternative Asset Management Co. “It will be interesting how many senior guys step up.”
In general, employees at solid, reputable firms who are paid well during good times may be willing to stay around even if they don’t get a bonus this year. Tepper, whose Appaloosa Investment and Palomino funds ($4 billion in combined assets) were each down about 24 percent through September, notes that his people are used to his historically hair-raising, volatile performance. “This is not the first time on the roller coaster here,” says Tepper, whose funds were up 8 percent last year and about 25 percent in 2006. Earlier in the decade the funds were up 67 percent, down 25 percent and up nearly 150 percent in a three-year period. Tepper’s $1.7 billion Thoroughbred Fund, which invests in fixed-income securities and launched in July, was up about 4 percent through September.
Meanwhile, many funds that are losing money in 2008 may be willing to renegotiate their fees if they are allowed to earn a reduced performance fee until they hit the high-water mark. They will make the case that they need to charge some sort of incentive fee to retain and attract top talent. Lone Pine’s Mandel figures to implement his reduced performance fee next year under a plan worked out with investors early in the decade. Under the arrangement, Lone Pine will receive half of its usual 20 percent performance fee until it makes up 150 percent of this year’s losses. That could take a while: The firm’s flagship Lone Cypress fund was down 26.5 percent through September.
Adam Herz, founder of Hunter Advisors, a New York–based executive search firm that specializes in alternative investments, doesn’t expect to see an enormous amount of job-hopping. “In tough times the devil you know is better than the one you don’t,” he says. He notes that senior people at hedge funds often have some equity in their firms, which they lose if they leave.
One thing is certain: It is getting increasingly difficult to start a hedge fund. According to HFR, 487 funds were launched during the first six months of this year, down from 609 during the same period in 2007. Even if this pace were to continue, which is unlikely given the recent market turmoil, it would result in the lowest number of start-ups since 2001, when there were 673 new funds.
Heinz, the president of HFR, says the bar has been raised for the amount of capital needed to launch a hedge fund. Five years ago managers could start with as little as $10 million, he notes, but investors now are not likely to put money with a manager who doesn’t have a realistic opportunity to reach at least $100 million in assets in 12 to 18 months. “If you can’t get to that level in a reasonable amount of time, it is difficult to sustain a fund,” explains Heinz. In fact, given the difficulty these days of raising money, he says, the market is more welcoming of what he calls “experienced launches” — funds that have $500 million or more in assets on day one.
Ultimately, many of the changes that take place in the hedge fund business will be decided between now and the end of this year. During that period most redemption notices will have been submitted and losing funds will be scrambling simply to break even. After all, despite the huge declines so far this year, performance fees are still determined on December 31 — that’s when funds will know whether or not they have made money.
“It will be fun to watch,” says Herz. Maybe for him, but not for most in the hedge fund industry.
