Hedge funds: wounded but not sunk

Hedge funds have been under the spotlight recently and I believe there are consequently a few lessons for asset managers to be learnt from this turbulent period.

First, the facts. The first quarter of 2016, dominated by volatile and hesitant markets (Brexit, commodity prices, US elections etc. you know the story), has made many casualties, including flagship funds: Blackstone’s Senfina lost 15% of its value, a relatively good performance compared with Odey European Fund’s 31% loss. Add on top of that a high-flying regulatory investigation on a $11bn revenues company (Valeant) many hedge funds had bet on and you understand why investors have been fleeing, withdrawing $15bn from hedge funds over the period. This comes after a year (2015) that has seen the second-worst year in terms of investment performance (-1.1% on average over the year) and logically the worst in terms of number of closures since the financial crisis in 2008 – despite the fact that the 25 best paid hedge fund managers pocketed more than Namibia’s GDP.

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Nest-Egg-Retirement-Money-FinancialOn top of difficult market conditions, alternative investment has become a victim of its own success, with too much money chasing too few deals. In private equity markets this translates into exceptionally high valuation multiples by historical standards. In public markets, not only have some stock indexes (notably the S&P500) reached all-time highs over the last 12-18 months, but hedge fund managers’ risk-adverse bias has led some ‘beauty stocks’ to concentrate an abnormally high demand which may fly away at the earliest warning signal, creating significant instability – especially given the fact that volume of assets under hedge fund management has been multiplied by 6 since 2000. The shock would impact highly-levered hedge funds but portfolio managers as well, who wrongly believe that by putting their eggs into different baskets they have managed to create a ‘hedge’.

Private equity funds tend to be relatively more protected for now given that the capital they manage is committed for years and possibly by the fact that their added value is perceived to be higher than the one delivered by hedge funds. This, however, has not prevented listed private equity firms to see their share price drop – and none of the private ones has been boasting about its recent performance. I remain more reserved with regards to that asset class and I refuse to be alarmed for instance by Blackstone’s or Carlyle’s disappointing economic net income performance in Q1 this year, knowing how much this figure depends on exits performed over the period – and there were many across the industry in 2015.

Evolution of share price since IPO (rebased at 100) and since year start. Source: Yahoo Finance.
Evolution of share price since IPO (rebased at 100) and since year start. Source: Yahoo Finance.

Pressure also comes from the UK Government, which has targeted financiers in its latest budget. Although Mr. Osborne proved generous with many capital holders, private equity executives will still be taxed at 28% on their carried interest gains and possibly even more in the case of ‘quick flips’ – i.e. sale after less than 3 years of detention.

What does it tell us? Despite the rise of passive investment strategies (see my earlier post on the topic), alternative investment is definitely not dead, far from it. The $15bn outflow mentioned earlier in this article only accounts for 0.5% of hedge funds’ assets under management ($2.86tn as of April 2016) and, although it may seem paradoxical, private equity investing rose by 14% in Europe in 2015.

Divided on the attitude to adopt
Divided on the attitude to adopt

Moreover, the challenges faced by the alternative investment industry over the last 18 months should not occult the strong performance the same industry generated in the years before. Although some LPs, such as the New York City Employees’ Retirement System have decided to terminate its hedge fund investment programme as a whole, following the example set by Calpers, many, such as Metlife, have just decided to reduce their exposure in a move that could prove temporary.

Pierre-Lavallee-pic-e1432679343807-180x180“Hedge funds have added value to the total fund over the past several years.”

(Pierre Lavallée, Senior Managing Director at CPPIB)

Furthermore, markets are still desperate for investments with even barely positive net risk-adjusted returns, and so far the surprisingly high demand for negative-interest sovereign bonds proves that they have been largely unsuccessful in their quest. As a consequence, as soon as structural changes to the fee structure are made and the market tide turns, liquidity will flock back to alternative asset (including private equity and hedge) funds that have managed to through this crisis of confidence. Confident of the fact that this will happen, KKR bought back $388m of its own stock in April.

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What it means, however, is that hedge fund managers will need to adjust their pricing to the value they really provide to their customers. Otherwise, an increasing number of LPs will be tempted to in-source their trading operations or move away from the asset class as a whole. The historical ‘2 & 20‘ model with limited GP liability – i.e. GPs get carried interest if they make good investments but do not lose anything if they make bad ones -, initially designed for hands-on private equity investments, has become the norm in hedge fund investing, which arguably requires less effort and can be more easily substituted – even by computer systems. A few ‘long’ or ‘long-short’ hedge funds have thus decided to switch to lower management fees and/or to scrap the carried share of their compensation – although this latter fee structure could incentivise fund managers to maximise assets under management at the expense of performance.

Finally, it brings us back to the purpose of private equity and hedge funds. The former should benefit from the relative freedom of the private ownership structure to boost the development of companies – not just the level of debt on their balance sheet – while the latter should provide an effective market ‘hedge’ especially in downturns – something they failed to do earlier this year.

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Hedge funds will adapt and rise again as they have already done in the past. What may have happened in the meantime, though, is a (welcome) clean-up of the ‘battlefield’ and the subsequent extinction of under-performing entities. Getting rid of the wounds in order to stay afloat.

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