Hedge Fund Exit Requests Hit 2012 High in September

 

Client demands to pull money out of hedge funds rose to their highest level this year in September 2012, industry data showed, as investors reacted to lackluster performance.

Hedge fund administrator SS&C GlobeOp’s forward redemption indicator, a monthly snapshot of clients giving notice to withdraw their cash as a percentage of its assets under administration, measured 3.76 percent in September.

That was up from 3.34 percent in August and higher than the 3.11 percent seen a year ago.

Hedge funds have gained 3.49 percent in performance terms in the first eight months of this year, according to Hedge Fund Research, which is well below the 13.5 percent return from the S&P 500 with dividends.

Many managers have been nervous about macro-economic conditions this year as the euro zone battles to contain its debt crisis and China’s economy slows and have consequently missed out on rallies in equity markets. However, the SS&C GlobeOp index is still well below levels seen during the 2008 credit crisis.

The GlobeOp Forward Redemption Indicator hit an all-time high of 19.27 percent in November 2008 in the wake of the collapse of U.S. investment bank Lehman Brothers but has not risen above 10 percent since September 2009.

“Forward redemptions slightly increased in September which is typical as we approach quarter-end but redemption notices still remained at moderate levels, indicating that alternative investments continue to hold their attraction,” said Bill Stone, chairman and chief executive of SS&C Technologies.

SS&C GlobeOp’s data covers around $187 billion of hedge fund assets under administration, or around 8 to 10 percent of the global hedge fund industry.
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Hedge Funds Stars Ponder

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Tucked into corners of Monaco’s plush Meridien hotel and on lonely tables in sun-kissed bars overlooking the Mediterranean, anxious hedge fund managers contemplate the next six months that could make or break their careers.

Behind the glitz of the annual hedge fund shindig, the 500 or so financiers who made the trip privately confess their struggle to find winning strategies given unpredictable markets, fretting clients will lose faith and snatch back their money.

Successful money-making ideas are in short supply and as many as one-fifth of last year’s delegates opted to stay at home, eschewing visits to the world-famous Monte Carlo casino for more hours in front of a computer screen, hunting for the trade that brings them back into the black.

“It is not the time when you can just say to someone, ‘come to Monaco for four days,’ when there are so many issues to deal with back home,” said Roberto Giuffrida, head of global business development at Permal, one of the world’s largest fund of hedge funds.

One delegate at the Global Alternatives Investment Management meeting said it was the smallest attendance she had seen in 10 years at the conference, Europe’s main venue for executives to tout their expertise, press the flesh and make contacts.

But as pressure mounts, presenting an image of control and confidence has never been more important for an industry whose raison d’être is a supposed ability to deliver strong returns regardless of broader market conditions.

Many managers refused to give up the trappings of yesteryear’s success, enjoying Louis Constant champagne at €140 ($180) a pop and hosting lavish client dinners—as many as three per night. Attendees’ sported designer handbags from the likes of Karl Lagerfeld and Celine and many forked out €260 a night to stay at the luxury Fairmont hotel, on the famous hairpin bend in the Monte Carlo Grand Prix course.

But this year’s conference had a different tone from usual, with British historian Niall Ferguson making bold predictions including another major war, potentially in the Middle East.

GLG’s Jamil Baz reckoned the current financial crisis had “not even started.”

Relatively Modest

“Off-duty” delegates were more careful with their own money, opting for the relatively modest McCarthy’s Irish pub to watch games in the Euro 2012 soccer tournament, although some could not resist a visit to old haunt the Sass bar, a favorite among jet-setters and where U2 frontman Bono once held his birthday party.

After the second year of losses in four for the sector as a whole, managers are earnestly comparing how bad their situation is against their peers, sometimes straying into gallows humor at just how hard it was to survive current markets.

Far fewer fund administrators bothered to pitch their services to executives in the main hall this year, while bank delegations, who splashed the cash in previous years, cut back or stayed away.

One U.S.-based manager, who arrived midway through the conference to take the pulse of the European hedge fund community, was quickly struck by the mood. “It is so gloomy,” he said, asking not to be named.

With the exception of some big-name funds such as Winton Capital and Brevan Howard, managers almost across the board admitted they were fearful of the future.

“Raising assets is very difficult,” said one manager, speaking on condition of anonymity. “Everyone is tired, everyone is scared.”

‘Not the Time to Party’

Investor resentment about hedge fund losses—on average 5.3 percent last year—against gains in the S&P 500 Index cast a pall over the event.

Managers were forgiven mistakes in 2008 when the Lehman Brothers’ bankruptcy poleaxed global markets, but more recent failures have proved tougher to swallow.

“Hedge funds did let us down, particularly in August and September when equity markets were falling and hedge funds took a tumble,” Ian Prideaux, chief investment officer at Grosvenor Estate, which runs money for the Duke of Westminster’s family, said. “It is an experience they have to learn from. Hedge funds have got a bit to do to restore their reputation.”

Executives, wary that fresh redemptions could cripple smaller managers, are already realizing they have to raise their game. Some at the conference took part in a session where the content and delivery of their sales pitches were marked out of 10 by a panel of experts.

“As an industry … we have to perform this year,” said Anne-Sophie D’Andlau, co-founder of Paris-based hedge fund firm CIAM. “So far, so good—we are in positive territory…. It is not the time to party, it is the time to show we can deliver.”

Hedge funds have gained 2.54 percent on average in the first five months of this year, according to Hedge Fund Research. But stubborn worries over the stability of Italy and Spain are chipping away strong gains in January and February and hedge funds are finding it far tougher to prove their worth.

Unlike some previous crises, when some hedge funds earned a reputation for calling the bottom of the market, most are steering clear of trying to second-guess how policy makers will try to fix the euro-zone crisis.

Managers with conviction are hard to find and even those who believe their bets will eventually pay off have little idea how long they can ride out the storm.

Gavyn Davies, the ex-Goldman Sachs economist and co-founder of Fulcrum Asset Management, told an audience: “The worry I have is we won’t be in the market in the quarter (where we would have got) … 25 percent from our strategic positions.”

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Some Smaller Hedge Funds Outshine Their Bigger Rivals

A number of hedge fund industry spin-outs are showing up their bigger and better-known brethren by delivering eye-popping returns in a year marked mainly by lackluster performance.

After a horrible 2011, this year is not shaping up to be much better in the $2 trillion hedge fund industry, with the average fund up only 2.10 percent through June. But a handful of new funds, run by managers who had worked at some of the most prominent names on Wall Street and in the hedge fund industry in recent years, is doing very well with double-digit returns.

Mick McGuire is the founder of Marcato Capital Management in San Francisco, which specializes in selecting stocks. Only a short time after leaving William Ackman’s $10 billion Pershing Square Capital Management, Mr. McGuire is posting the kind of returns that would make any parent proud. Mr. Ackman has invested as has the Blackstone Group, one of the world’s most powerful hedge fund investors.

Since January, Marcato Capital Management has gained 17.6 percent, ranking it among the industry’s very best performing hedge funds this year, according to a person familiar with his numbers through the end of July.

For years, academic research has shown that smaller funds, often with younger and hungrier managers at the helm, have outperformed their bigger peers because they can be more nimble. Numbers from Marcato Capital Management and others seem to be underscoring those findings.

Some of Mr. McGuire’s fuel has surely come from the firm’s biggest position: Corrections Corp. of America, whose stock price has climbed 53 percent since January.

By comparison, Mr. McGuire’s former employer, Pershing Square Capital Management, is looking less dynamic with only a 3.3 percent gain for the first six months of the year. Pershing Square’s numbers through July are not yet known.

Mr. McGuire, whose assets under management hit $675 million on Aug. 1, also handily outpaced David Einhorn‘s Greenlight Capital, another closely followed and prominent fund with about $8 billion under management. Greenlight gained 2.7 percent in July and is up 6.4 percent for the year.

In July, when the Standard & Poor’s 500 stock index gained 1.3 percent, Mr. McGuire’s fund rose 4.4 percent. That puts him in lofty territory for a month in which the risk on/risk off environment likely hurt many managers.

Performance numbers are often highly guarded secrets in the hedge fund industry, and tracking groups that put together industry benchmarks are not expected to release their numbers until early next week.

“Part of the reason these smaller managers can do well is because of size,” said Charles Gradante, who co-founded the Hennessee Group, which invests with hedge funds. “You can make more concentrated bets while staying on the radar when you are small and you can unravel them better when you need to.”

Poker Player

Mr. McGuire is not the only newcomer hitting home runs. Murdock Capital, run by Jason Murdock, who spun out of Contrarian Capital and oversees some $250 million in assets, is up 12.99 percent for the first seven months of the year.

In July, Murdock Capital gained 2.85 percent, making it the strongest month this year, since a 4.14 percent rise in January. Mr. Murdock, who earned a law degree from Harvard and spends some evenings as a competitive poker player, makes long and short investments in distressed leveraged loans, distressed bonds and post-bankruptcy securities. He launched his fund with a few million dollars in July 2009.

Similarly, some five years after the so-called quant quake when many quantitative funds stumbled badly, Mark Carhart is back with a fund of his own and strong numbers. Mr. Carhart formerly co-managed Goldman Sachs’ vaunted $10 billion Global Alpha fund, which ran into big trouble during the August 2007 turmoil.

Mr. Carhart’s Kepos Capital, which relies on computer-driven trading models to make macroeconomic bets on currencies and other instruments, climbed 5.2 percent in July. The fund, which now has some $750 million in assets under management, is up 11.2 percent for the year.

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Want To Make Risky Trades with No Brakes? Go To London

Pop quiz time. Which U.S.-based financial services firm used the U.K. to make losing trades that caused embarrassment, regulatory scrutiny and much worse: MF Global, AIG, Lehman Brothers, or JPMorgan?

Answer: All of the above.  

JPMorgan Chase’s chief investment office was set up bi-nationally, with traders in the U.S. and the U.K. It looks like that was the only smart thing Jamie Dimon did here. This business unit put on huge positions in credit derivatives that were rationalized as a “portfolio hedge” but grew unmanageable under minimal supervision and lax controls. The bank’s risk appetite grew out of sight of U.S. regulators and out of the mind of U.K. watchdogs.

AIG’s Financial Products Group, a PricewaterhouseCoopers audit client along with JPMorgan, made the bets on credit derivatives that caused the insurance company’s own liquidity choking fit (and takeover by the U.S. Treasury) in London, too.

Lehman Brothers’ Repo 105 transactions, used to window-dress the balance sheet each quarter, began with an exchange of $105 of collateral for a $100 loan. Because the repo was structured with excess collateral, Lehman could call it a “sale” and, therefore, did not record the loan on its books. The excess collateral was a necessary condition for treating the transaction as a “sale” but not a sufficient condition for any U.S. law firm to bless it. Lehman went to the U.K. to get a “true sale” legal opinion.

A U.K. legal opinion in 2009 revealed that Lehman’s local management team had also failed to segregate “vast sums” of client money “on a truly spectacular scale.” After Lehman went bankrupt, this commingling sadly reduced clients’ claims to the status of unsecured creditors.

When Jon Corzine decided to use repo-to-maturity trades to juice corporate profits, MF Global’s subsidiary in the U.K made it happen, for a cut of the action. The risky bets instead caused what MF Global bankruptcy trustee James Giddens called “liquidity asphyxiation” in his June 4 investigation report. Large sums were needed every day to fund the margin calls on the European sovereign debt behind the trades, debt that was rapidly losing value. MF Global allegedly funded the margin calls by re-characterizing customer assets as house assets.

The illegal act of commingling customer funds with company money had already been committed in London by MF Global’s main bank, JPMorgan, and by another bank, Barclays. PwC, the auditor of all three firms – MF Global, JPMorgan and Barclay – had neglected to catch them doing it for several years. The banks and the auditor were fined recently for the lapses. Yet PwC and regulators on either side of the Atlantic missed the red flags when MF Global seemed to be breaking the same laws all over again.

As a result, MF Global customers are also waiting more than seven months for the return of some of their funds from the U.K., where they were allegedly used to fund Corzine’s unsuccessful outsized bet to return the firm to profitability.

It’s not clear if the Dodd-Frank Act’s Volcker rule, intended to restrict proprietary trading and hedge fund-like activities for deposit-taking institutions, will apply to overseas affiliates of American banks. We need stronger cross-border regulatory enforcement and U.K. cooperation with U.S. regulators to spot U.S firms going to London for looser rules.

It looks like we have regulatory capture instead: Margaret Cole, the U.K. regulator at the Financial Services Authority who presided over the fines for commingling customer funds at JP Morgan, Barclays and PwC, is now general counsel for PwC U.K.

 

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BulldogBillionaire

Seed Capital for Hedge Funds

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Seed Capital for Hedge Funds

Time and again, studies on hedge fund performance indicate that smaller, emerging funds outperform their larger brethren because they are more nimble, being able to get in and out of positions without moving prices; and have the ability to build focused portfolios.  Even with this evidence, emerging managers are finding it difficult to raise money.   The situation has been exacerbated by Dodd-Frank legislation, causing proprietary traders at banks to spin-off into hedge funds and prohibiting banks from investing in funds.  More funds are chasing less investment capital.  Also, the HFRI Fund Weighted Composite Index returned negative 4.8% in 2011.  Investors want access to the higher returns of emerging managers. These pressures are causing managers and investors to turn to an alternative:  seed capital.

Seed capital is a multi-year commitment in emerging hedge funds.  Larch Lane has been a provider of seed capital since its inception in 1999.  It has seeded twenty-five hedge funds.  Seeders (either from an investor or a hedge fund seeding vehicle) give small funds a stable asset base that will not be withdrawn at the first sign of a drawdown.  This helps attract other investors.  Fund managers may receive assistance in operations, risk management, marketing and business development.  Seeders can receive a share in the fund’s management and performance fees, full transparency, risk control and ability to monetize their investment.

The three main seeding arrangements are equity ownership, revenue sharing and hedge fund platform.  In equity ownership, the investor actively helps manage the hedge fund from a business point of view only.  Investment decisions are still made by the manager.  Seeders can profit by being bought out by the manager or another investor or the manager may grow large enough to be brought to the public markets.  The Tiger Cubs are the most prominent funds in this category.  They were seeded by the famous investor Julian Robertson of Tiger Management.  He invested $25 million for a 25% equity stake.   The Dutch firm IMQubator is another investor using this type of transaction.  In January, they announced a joint venture with Synergy Asset Management to source emerging managers in Asia.

In revenue sharing, the arrangements are variable but they all have one goal – to enhance returns.  A seeder’s investment is improved by the fund’s revenues.  As the fund attracts more assets under management, the seeder’s returns increase.  Additionally, the manager pays a percentage of the revenues (usually around 20-25%) to offset the “2 and 20” fees paid by a regular investor.  Below is an example of how the return on investment increases as the assets grow.

Illustration of Seed Economics
	Non-Strategic Investor	Seed Capital Provider
		$200m AUM Growth	$400m AUM Growth	$900m AUM Growth
Capital invested	$5,000,000	$100,000,000	$100,000,000	$100,000,000
Current Fund AUM	$300,000,000	$300,000,000	$500,000,000	$1,000,000,000
Seed Capital Provider’s Share of Gross Revenues	N/A	25%	25%	25%
Management Fee	1.50%	1.50%	1.50%	1.50%
Incentive Fee	20%	20%	20%	20%
Gross Fund Return	14%	14%	14%	14%
Less Management Fee	12.50%	12.50%	12.50%	12.50%
Net Fund Return	10%	10%	10%	10%
Return on Capital Invested	$500,000	$10,000,000	$10,000,000	$10,000,000
Management Fee Share (25% * 1.5% * AUM)	N/A	$1,125,000	$1,875,000	$3,750,000
Incentive Fee Share (25% * 2.5% * AUM)	N/A	$1,875,000	$3,125,000	$6,250,000
Total Return on Investment $	$500,000	$13,000,000	$15,000,000	$20,000,000
Total Return on Investment %	10%	13%	15%	20%

Terms of the agreement between seeder and hedge fund may include a limit on the amount of fees shared with the investor or the investor may pull out its capital after the seeding arrangement is completed and still retain the revenue flows.  FRM Capital Advisors has used revenue sharing agreements in seeding funds such as WestSpring Advisors and Beechbrook Capital. FRM Capital Advisors’ parent is Financial Risk Management, a fund of funds with more than twenty years of experience.

Hedge fund platforms are offered by large hedge funds and financial institutions.  They provide a platform with marketing and operational expertise.  The investor has control over the manager’s business and investment process.

A hedge fund seeding vehicle specializes in investing in emerging funds.  According to one source, the number of seeders has dropped from 100 to 20-30 in third quarter 2011.  They close two to four deals annually and the average size of an investment is $10-30 million.  In addition to the advantages of direct investing (share in fund growth, higher return potential, transparency and risk controls), a vehicle gives investors manager diversification, access to co-investment opportunities and returns equivalent to private equity but with better liquidity.  The 800 pound gorilla is the Blackstone Group.  It raised $2.4 billion for the Strategic Alliance Fund (SAF) II in 2011.  Other large firms include Reservoir Capital ($1 billion), Protégé Partners ($750 million) and Goldman Sachs Asset Management ($500 million).

Current investing conditions are favorable to the growth of seeding arrangements.  They allow investors to participate in the fee structure of managers and the on-going growth of the hedge fund sector.  A seeded fund attracts other investors and allows the seeder to benefit greatly by the increase in assets under management.   In addition, investors gain exposure to the higher returns of emerging managers.   Anyone with a longer time horizon will find this an attractive investment as three years is the standard lockup period.

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