Why I'm Closing My Hedge Fund
Hedge funds are hot.
Forget recently soft returns and ignore the occasional scandalous headline. The most important as a measure of an industry's heat is the amount of money chasing it; on that count Hedge Funds have never been more hale. $16.9 billion flowed into hedge funds in the quarter ended September 30, an amount more than double the prior quarter.
With nearly $900 billion under management, hedge funds, once mutual funds' vaguely sinister little brother, will surpass One Trillion in assets under management sometime in the next 18-months.
All that Glimmers isn't Gold
When hedge funds pass the 1-trillion mark they'll be doing it without me and my fund. In August of last year I began my monthly note to partners with the sentence: "I have decided to close the Buckshot Capital partnership effective at the conclusion of November, 2004".
I'm sending the money back to our partners.
We didn't "blow-up", didn't have a "run on the bank" and neither me nor my firm are involved in any litigation or regulatory threat. What's more, I'm neither burned-out (at least any more so than is the normal level for fund managers), nor independently wealthy to the point that I'm seeking a life a jetting, golf and yachting in Cannes.
The reason I decided to close the fund boils down to my quite simple but strongly felt view that the traditional structure of a hedge fund at this point represents a bad deal for both the fund managers and their partners. The funds are increasingly unlikely to generate outsized returns, fees will come under pressure and the standard of "sticky money" will become any partner who doesn't switch funds after a manager has a bad week.
In other words, hedge funds are transmogrifying into mutual funds in all the worst ways.
Increased Regulations: Is this the Intended Consequence?
To be sure, the jumbo hedge funds of the world (call it "Those with greater than $500M in assets") are still a great business. As long as they have performed at least in the vicinity of the major averages (the bogey for all money managers), they have money coming in if they want it. They can cover the growing resource suck from complying with ever-changing regulations easily from upfront fees (traditionally 1-2%). Couple that with a large asset base and the 20% pay-out from the upside is still a large enough number to make staying in the game a no-brainer.
For smaller funds, however, the time and expense associated with complying with the increased requirements can nearly be a deal breaker on their own. It's not only the fact that auditing and legal fees are dramatically increased (some 4x in the 5 years I've been running my fund). The main rub is that the managers' time is increasingly spent dotting I's and crossing T's on paperwork that, for the most part, adds no element of safety to LPs. In terms of productivity it's akin to sending fund managers to the DMV for two weeks at the end of every quarter.
The effect of the growing regulations on hedge funds is similar to the effect Sarbanes Oxley is having on corporate America. For large cap companies Sarbanes Oxley simply adds some negligible number to their SG&A, makes it harder to get a good board and means the CEO has to sign a few more pieces of paper.
For small companies, organizations like $450M revenue retailer Duckwall Alco (DUCK: Nasdaq) on which I am a member of the Board of Directors, Sarbanes Oxley has taken a much more meaningful bite. In 2004 the company had net earnings of $6.5M. For a company that size the multiple 6-figures paid to legal and accounting firms in order to comply with Sarbanes Oxley matter quite a bit. Inasmuch as the organization, for all its faults was honest in the first place it's not at all clear that our shareholders are better off now than they were prior to the regulations.
We haven't exactly gone wanting for evidence of corporate malfeasance in the post-Sarbanes Oxley world and, at the risk of ruining some of the suspense for readers, whatever regulations the SEC finally settles on in regards to hedge funds they won't mark the end of criminal hedge fund enterprises.
While benefits to investors are theoretical, the effect on small funds is clear. A higher percentage of management fees goes to compliance (as opposed to "paying people to unearth good investments") and percentage of time managers spend trying to make money for their LPs (shooting for the "Incentive Fee" to offset rising fixed costs) goes down.
The problems with the obvious solutions to the above (raise more money and get cheaper lawyers and accountants) stem from the stampede of financial giants into the hedge fund game. As any first year business student will tell you, when more entrants come into a market margins for all existing players' contract.
Said more plainly, if you're running a fund I'd advise strongly against modeling "1.5% management, 20% performance" into your long-term financial plan. Those fees will be coming down at a speed that figures to be inversely correlated with average hedge fund returns.
In the post-bubble, post-crash rather trendless-tape world hedge funds are muddling around with the general tape (the average hedge fund is up roughly 3% ytd). Heat or no, LPs aren't going to give a fund manager ½ of a single digit return in fees.
As the juggernaut's sink their teeth into the hedge fund business (either through sponsoring fund's run by ex-employees or buying/ creating their own funds in house) the coveted sticky clients (those who give money and go away for years at a time) are inundated with the same type of glossy, high-budget thinly-veiled business pitches that still have investors chasing returns by dumping money into "hot-hand" mutual funds every month.
The relationship between managers and LPs is becoming the relationship of fighters to Don King; "I'll stick with you win or tie; lose a single fight (read: month) and you're on your own".
Hedge funds, particularly those of "boutique" size, don't have the time or set-up to market competitively and they don't have deep enough pockets to fight the giants.
Making the Hard Choice While there's still any choice.
None of the above has yet made running a small hedge fund an impossibility. Hey, there are even arguments to be made that it's never been easier to start a boutique hedge fund. For one thing, unlike what I faced 5 years ago, new managers aren't likely to spend the bulk of any meetings with qualified investors explaining what a hedge fund actually is.
I started a hedge fund with the simple belief that the best way to manage money is to have someone trustworthy working full-time to protect and grow that money as aggressively as possible without taking on excessive risk. While I still believe that, the changes in the marketplace over the last 5 years have reduced the time I can actually spend trading, doing research and investing dramatically. In their place have come administrative time sucks (explaining Black-Scholes to a first year accounting worker, for instance) and a losing marketing war against much larger concerns.
I remain passionate about the markets and will continue to trade and invest my own money. I'll also continue to write and comment about the markets to the extent that readers and viewers will have me.
But I won't be doing those things from the perspective of a hedge fund manager. That's an industry I'll steer clear from for the foreseeable future, both as an investor and a manager. Unless I miss my guess, there will be floods of people joining me on the hedge fund sidelines very soon.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Daily Recap Newsletter