Managers’ future looks less bright
Falling prices and unstable markets mean money has to be handled in a different way from five years ago
The world has changed for the thousands of hedge fund managers who went into business in the past five years, and not in a way many of them like.
The expansion that characterised the environment when they launched, with rising equity markets and investors queuing to give them capital, has been replaced by falling asset prices, unstable markets and investors asking for their money back. For the first time in their careers as hedge fund managers, they are trying to manage a contraction.
A partner at a long-standing UK hedge fund manager said: “The risk of substantial redemptions has stopped managers being confident about buying assets that look cheap, but which may get cheaper. Long/short equity managers could be net long when markets were going up and capital was flowing into their funds, but we are now in a risk management and trading environment.”
Hedge funds have not been immune to falling prices in the equity and bond markets, despite being able to take short positions that investors assumed would give hedge funds an edge over traditional, long-only asset managers.
The industry as a whole lost 2.1% of its value in the first four months of the year, according to estimates published by US data provider Hedge Fund Research, the worst start to a year since its records began in 1990.
Jacob Schmidt, chief executive of independent hedge fund research firm Schmidt Research Partners, said: “Performance has been poor. Not many managers seem able to read these markets and it shows. There is a lack of investment talent. Are the markets so irrational that rational people cannot make money out of them?”
Financing has become a problem for many funds, particularly those trading in the credit markets, which a year ago were typically borrowing about five times the value of their funds to gear up their returns. The investment banks whose repo desks were financing credit hedge funds’ positions have reined in their lending, fearful of taking a risk on a counterparty’s creditworthiness and liquidity, by demanding more collateral, known as haircuts.
Hedge funds investing in asset-backed securities, notably a listed fund run by US alternative manager Carlyle and a fund run by UK manager Peloton, were devastated by a combination of falling asset prices and the refusal of repo desks to extend them more credit. Carlyle’s fund had borrowed more than 30 times its capital, Peloton had borrowed about four times; both have been shut.
Most credit hedge funds and the proprietary trading desks of investment banks have reduced their leverage in response to repo desks’ tightening terms, typically to a level of about twice the value of their fund. This has led to asset sales that in turn have depressed prices and generally not helped investment returns.
Few hedge fund managers globally have managed to obtain a long-term source of debt finance for their funds to rely on. Funds managed by US firm Citadel and UK firms Man Group and GLG Partners have issued bonds and about a dozen others have secured financing, but these are exceptions.
Gary Vaughan-Smith, founding partner of UK fund of hedge funds SilverStreet Capital, said: “Prime brokerage terms are tightening and will continue to tighten. Strategies that rely on large leverage are in deep trouble and will remain unattractive for some time.”
Managers are also facing redemption requests from the investors in their funds. Capital flow figures for the first three months of this year showed a net inflow of $16bn (€10.3bn) into hedge funds globally, according to Hedge Fund Research, countering fears that the industry would suffer net outflows, but still 75% lower than the net inflow figure recorded a year earlier.
Investors withdrew $30bn from long/short equity funds in the first three months of the year, although they enjoyed a net inflow of $8bn. Global macro hedge funds suffered $1bn of net outflows.
Managers face redemption requests for the end of June – many of these requests will probably be cancelled at the last minute, since they have been made by investors who merely want the option of taking their money out. However, a manager cannot be certain the requests will not be withdrawn, and therefore has to ensure the portfolio is ready to pay out, a challenge at a time of illiquidity in some markets, especially credit markets.
Hedge fund managers and banks’ proprietary trading desks have been selling their holdings of convertible bonds because this market has been relatively liquid. This has hurt managers that follow a convertible arbitrage strategy, which takes partially offsetting positions in a company’s convertible bonds and its shares. By the end of April they had registered six months of losses in a row, adding up to a loss of almost 10%. This is a longer run of losses than convertible arbitrageurs suffered in 2005, when many went out of business, and investors have begun taking their money away again.
However, convertible arbitrage managers said this was not a return to 2005. The problem then was that volatility, on which convertible arbitrage relies heavily to make money, was at a 10-year low. Volatility is now near a 10-year high, and managers anticipate that, once the sell-off has eased, they will make money. One UK convertible arbitrage manager said his fund was up 3% in April, though still down 6% for the first four months of the year.
All these pressures have led a few hedge funds to shut, and in some cases their managers too. The list of defunct funds includes credit-focused investment vehicles run by US managers Carlyle and Drake Management, while US firm Sailfish Capital Partners, UK manager Peloton Partners and Swiss firm Focus Capital have shut their entire operations as a result of losses sustained by their funds. Meanwhile, would-be managers have changed their minds about going it alone.
Peter Harrison, chief executive of MPC Investors, a UK hedge fund manager, said: “I just had calls from three people on one day, saying they had been trying to raise a fund but had changed their minds and asking, was there a place for them here? A year ago, people of this calibre would have been able to raise money for themselves.”
The largest firms have generally fared better than their smaller rivals in terms of financing and attracting investors’ capital (see chart below). This builds on a trend that has become established in the hedge fund industry, and in the fund of hedge funds industry, whereby the biggest firms have generally grown fastest.
Large managers report that prime brokers, a profitable division for investment banks that primarily finance hedge funds’ equity positions, have been seeking to retain their biggest hedge fund clients by improving their lending terms by waiving their right to vary terms and instead agreeing terms for a fixed period, such as 90 days.
The upshot of this has been a change of heart towards mergers. Hedge fund managers that were once proud of their independence are now favourably disposed to being taken over by a larger rival, with all the security that offers.
Peter Clarke, chief executive of UK-quoted alternative asset manager Man Group, said the environment was “one of significant opportunity”. He plans to build a global credit business around a joint venture Man Group entered into in March with US credit hedge fund manager Ore Hill, paying $195m cash, $40m in shares and a 50% stake in another credit hedge fund subsidiary in return for a 50% stake in Ore Hill, which has $4bn of assets under management.
This month, Japanese financial services company Mitsubishi Corporation spent $40m buying a 19.5% stake in US credit hedge fund manager Aladdin Capital Holdings, which has $20bn of assets under management. Toscafund, CQS and RAB Capital have made small acquisitions. However, hedge fund managers and bankers said they were surprised so few such transactions have taken place.
Large European managers report receiving calls from bankers and hedge fund managers with acquisition proposals, yet the list of Europe’s 20 largest managers reveals only a few that are likely to buy.
UK partnerships Lansdowne, Brevan Howard, Marshall Wace, Sloane Robinson, The Children’s Investment Fund, Cheyne Capital, Atticus, Winton, Polygon, Spinnaker and Egerton Capital are all unlikely to get involved with consolidation because of the effect it might have on their ownership structure, according to the chief executive of a large UK hedge fund manager and an investment consultant, who added Franco-Belgian manager Dexia and French HSBC subsidiary Sinopia to the list of reticent buyers.
BlueCrest Capital Management might buy, and Gartmore’s private equity owners Hellman & Friedman may use the firm as an acquisition platform, but no such plans are public. Man Group and GLG Partners are theoretically the most likely acquirers because they are public companies, with shares to offer instead of cash and, if necessary, access to the capital market.
GLG, however, has its hands full managing a situation unconnected with the credit crisis. Last month, Greg Coffey, the manager of four emerging markets funds comprising $7.2bn of assets at the end of last year, which is more than a quarter of GLG’s total, resigned. GLG accepts investors will redeem capital. Its shares, which traded at more than $13 when it became a public company last November fell to below $8 a share on the news.
Managers will feel the effects of the credit crisis for some time yet. One UK manager said: “Some will find the way they have to manage money is very different from the way they have done over the past few years and some will not emerge intact.”
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