The Tide Is Going Out

The tide is going out and may not come back.

An already exacting business is getting even harder. Julian Robertson recently told Bloomberg, “It’s tougher to be a hedge fund investor than ever before.” Perry Capital and Nevsky Capital are closing. Brevan Howard and Tudor Investment Corporation are laying off staff and cutting fees. Other firms are also reportedly reducing their terms, including Caxton, Fir Tree and Och-Ziff. These are major firms losing assets, letting go of people and shutting down. The wild growth of the hedge fund industry is in the past. Now we will see a fight for survival.

The pressure on fees and wave of redemptions are driven by poor performance. Bloomberg reports that hedge funds have underperformed the S&P 500 every year since 2008. That’s stunning. As a result, hedge fund investors want lower management fees. Preqin says 73% of investors are pushing for less expensive terms. That’s staggering.

Luke Ellis, CEO of the Man Group, told a Bloomberg conference in London today, “We all face fee pressure.” This is striking as it comes from the leader of the largest publicly traded hedge fund in the world.

The confluence of all these factors is extending the phenomenon of fund closures outpacing openings. Hedge Fund Research says closures are on track to hit the second-largest total since HFR began tracking the data in 1996. The surviving funds may benefit from less competition, unless there are exogenous, systematic factors at work here. Observers cite the rise of systematic firms, passive vehicles, index funds, ETFs, low interest rates and an overvalued stock market.

How can hedge fund managers prepare to withstand the ongoing fallout and endure for the future? They need to build a robust firm with an outstanding team of professionals who are engaged and empowered.

You’re gonna need a bigger boat

In the 1970 film Jaws, when Roy Scheider first sees the shark, he tells the captain, “You’re gonna need a bigger boat.” That used to be the case in the hedge fund business. You needed a big boat to survive in the open ocean. Today, things are different. This environment benefits smaller firms that can be more flexible and nimble. That’s encouraging for new firms.

Ideally, a hedge fund is set up to enjoy the best of both worlds: The advantages of scale and the benefits of being small. To achieve this, several funds are managed by separate portfolio managers, allowing them to provide the performance that large funds struggle to generate. Together, these funds operate on a platform that provides shared accounting, tax, marketing, administration, technology and infrastructure. The goal is to take away all the things a fund manager shouldn’t have to worry about so they can focus on their paramount responsibility: Investing. This structure offers what some call “operational alpha,” though it also presents challenges, including reputational risk and cultural fit.

When the fall is all there is, it matters

It will be telling to see how the funds that are closing go about winding themselves down. The best will handle their affairs with grace, generosity, fairness and transparency. Champions don’t always win. When they lose, they are gracious.

In the 1966 play Lion in Winter, King Henry II of England seeks to appoint a successor among his three sons before deciding to imprison them and consider having them executed. Facing the prospect of death, Henry’s son Richard the Lionheart says, “When the fall is all there is, it matters.” How hedge funds treat their investors, employees, partners and counterparties matters a great deal, including, if not especially, when the firm is closing.

Of course, had King Henry II developed his sons as leaders, he wouldn’t have faced the dire consequences of losing his kingdom.

A real team

No one person can successfully lead a firm on their own. To build a leading, lasting business that generates responsible returns for investors over the long term, you have to create an outstanding team around you. These are not supporting roles; they’re leadership positions. The team must be engaged and empowered. In order to attract and retain the best people, give them real equity and a real voice in the portfolio and the firm. If you build a personal kingdom, it will fall one day.