Transcript Hedge Fund Issues and Performance

Hedge Fund Issues and Performance
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L6: Hedge Fund Issues and Performance
Hedge Fund Performance
 2008 was a watershed year in the hedge fund industry
 Assets under management (AUM) by hedge funds dropped by unprecedented levels and
the concept of managing for absolute returns (positive returns) was, in part, invalidated
by significant losses
 As a result of these losses, investor withdrawals increased substantially
 This withdrawal activity, combined with reductions in asset values, resulted in a drop in
AUM by approximately 25%, from almost $1.9 trillion at the end of 2007 to just over
$1.4 trillion by the end of 2008
 Part of the problem during 2008 was that too many funds bought the same assets and as
markets fell, many hedge funds sold these assets to gain liquidity, pushing prices even
lower
 Compounding this problem was the need for some institutions to raise cash when the
equity market decline caused minimum equity allocation benchmarks to be breached,
triggering a need to take money out of hedge funds and reinvest directly in equity
instruments.
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L6: Hedge Fund Issues and Performance
Hedge Fund Performance
 The Fund Weighted Composite Index tracked by Hedge Fund Research (HFR)
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fell by 19.0% during the year compared to the drop in Standard & Poor’s 500
stock index of 38.5%, including dividends
Therefore, even though hedge fund losses were significant, they were
substantially less than the broader equity market
2008 marked only the second calendar year of negative returns for hedge funds
since 1990
Approximately two thirds of the decline in assets during 2008 was a result of
poor hedge fund performance and the remaining one-third came from clients
withdrawing their assets
Fund of hedge funds underperformed hedge funds, losing 21.3% for the year.
Despite the overall poor performance, however, it is important to reemphasize
that hedge funds (both in aggregate and across the major investment strategies)
still outperformed the broader market
L6: Hedge Fund Issues and Performance
2008 returns of the S&P 500, all hedge funds, all fund of funds and select strategies
While hedge funds outperformed the S&P in 2008, very few investment strategies offered investors escape from losses
HFRI EH: Short Bias Index
HFRI ED: Merger Arbitrage Index
Main indicies
Major strategy indices
Sub-strategy indices -5%
HFRI EH: Equity Market Neutral Index
-6%
HFRI Macro (Total) Index
HFRI Relative Value (Total) Index
-18%
HFRI Fund Weighted Composite Index
-19%
HFRI Fund of Funds Composite Index
-21%
HFRI Event-Driven (Total) Index
-22%
HFRI EH: Quantitative Directional
-23%
HFRI RV: Fixed Income-Corporate Index
-23%
HFRI ED: Distressed/Restructuring Index
-34%
-37%
S&P 500
-39%
-60%
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-27%
HFRI Emerging Markets (Total) Index
Source: Hedge Fund Research, Inc.
L6: Hedge Fund Issues and Performance
5%
-25%
HFRI Equity Hedge (Total) Index
HFRI RV: Fixed Income-Convertible Arbitrage Index
28%
-40%
-20%
0%
20%
40%
The Value of $1,000 Invested at January 1, 1990
The good, the ok, and the ugly
$14,000
$12,000
$10,000
HFRI Fund Weighted Composite Index
HFRI Fund of Funds Composite Index
HFRI Macro (Total) Index
HFRI EH: Short Bias Index
S&P 500
$8,000
$6,000
$4,000
$2,000
$89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
Source: Hedge Fund Research, Inc.
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L6: Hedge Fund Issues and Performance
Dispersion Between Top and Bottom Decile Median Fund Performances, 2002-20081
93%
100%
80%
60%
69%
57%
56%
40%
40%
42%
42%
2004
2005
2006
20%
0%
2002
2003
2007
2008
Note 1: Dispersion calculated as median fund performance of the top decile less the median fund performance of the bottom dec ile.
Source: Hedge Fund Research, Inc.
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L6: Hedge Fund Issues and Performance
Searching For Returns
 Hedge funds have traditionally been associated with “alpha based” returns which are
independent of market conditions, but, increasingly, hedge funds participate in the
same investment activity as traditional fund managers
 To differentiate themselves, hedge fund managers have had to search for new
sources of returns in new markets, but this search has pushed them into less liquid
investments, including private equity investments and other private transactions
 This activity extends their investment horizon, requires longer lock-ups and results
in the need to hire new managers who have long-term investment expertise
 Hedge funds have become active participants in leveraged bank loans, mezzanine
financings, insurance-linked securities and in LBO transactions
 In other words, hedge funds have moved a significant amount of their investment
base from public transactions to private transactions in their search for alpha-based
returns
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L6: Hedge Fund Issues and Performance
Fund of Funds
 2008 ended on a bad note with the disclosure of over $20 billion in losses
experienced by those who invested in Bernard Madoff’s investment funds
 While Madoff wasn’t a hedge fund manager, a number of fund of funds that allocate
investor money to hedge funds also allocated money to Madoff through feeder funds
 This created concern about the quality of fund of funds due diligence processes and
the ensuing crisis of confidence in fund of funds resulted in many investors
withdrawing money from these funds, which in turn, caused money to be taken out
of hedge funds
 Fund of funds have sold themselves to investors on the basis that they offer three
key benefits: diversification, access to sought-after managers and due diligence
 The financial crisis weakened the first two benefits from the perspective of many
investors
 The Madoff scandal significantly undermined the third benefit
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L6: Hedge Fund Issues and Performance
Fund of Funds
 Compounding the difficulties of fund of funds was the leverage employed by these funds.
 Many fund of funds borrowed money to supplement investor money when they made
investments in various hedge funds
 Since most of the hedge funds they invested in were already leveraged, this doubling up
of leverage created enhanced losses beyond the losses of the underlying funds
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In part, because of this leverage, average losses from fund of hedge funds during 2008
were 21%, compared to average losses for hedge funds of 19%
 With lenders retracting credit, fund of funds were forced to dump assets, putting further
pressure on hedge funds and the markets in general
 As a result, a number of high profile hedge funds liquidated or froze redemptions during
2008, traumatizing the investor base and triggering additional requests for redemption
by some investors who sought liquidity wherever they could find it (even from hedge
funds that were generating positive returns)
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L6: Hedge Fund Issues and Performance
Benefits Revisited
 Historically, hedge fund managers have articulated the following benefits for
investors who place money in their funds
 Attractive risk-adjusted returns, focusing on positive returns, low volatility
and capital preservation
 Low correlation with major equity and bond markets
 Investment flexibility to invest long or short, using a variety of instruments,
investing in segments of the market that suffer from structural inefficiencies
and in smaller asset pools
 Focus on marketable securities
 Structural advantages including performance-based compensation, managers’
personal investment (which aligned interests) and the ability to attract the
“best and brightest”
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L6: Hedge Fund Issues and Performance
Benefits Revisited
 An analysis of these benefits in light of the major dislocations of the market
during 2007 and 2008 suggests the following about hedge funds
 Achievement of positive (absolute) returns has become a problematic
objective during periods of major market dislocation
 Achievement of low correlation with major equity and bond markets is
difficult to obtain during periods of major market dislocation
 Investment flexibility continues to be a major benefit of hedge funds
 Some hedge funds have invested a portion of their assets in nonmarketable
securities, creating a mismatch between asset maturities and investor
withdrawal requirements
 Structural advantages, including performance-based compensation and
aligned interests
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L6: Hedge Fund Issues and Performance
Transparency
 Hedge fund investors historically have not required a significant amount of
investment transparency from hedge fund managers
 Many investors are now pushing for greater position-level transparency, but some
managers resist this based on their concern that disclosure of strategies will benefit
competitors and cause arbitrage opportunities to disappear
 Managers are generally willing to provide organizational and process transparency
regarding assets under management, profit and loss attribution, key investment
themes, new product initiatives, and personnel
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In addition, risk transparency is usually provided through disclosure of credit
exposure, volatility exposure, long verses short positions, leverage, geographic
focus, portfolio concentration, industry focus and market capitalization focus
 However, hedge fund managers will attempt to keep specific investment strategies,
ideas, and short positions confidential, so investors must decide whether the level of
overall transparency provided is adequate in the context of the risks and benefits
associated with investing in hedge funds
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L6: Hedge Fund Issues and Performance
Fees
 Following the poor industry performance during 2008, some hedge funds decided
to reduce fees from 2% to 1%
 Renaissance Technologies, one of the largest and most successful hedge funds,
waived all management fees for 2009 for its Renaissance Institutional Futures fund
and the fund agreed to not receive any performance fees until 2008 losses of 12%
were recovered
 Other funds, including Highbridge Capital Management, launched new share classes
with lower fees in exchange for longer lock-up periods
 At the end of 2008, Citadel Investment Group gave back about $300 million in fees
it had previously collected, after completing a money-losing year and other firms
also gave back fees and remained committed to not receiving performance fees until
they reached their high water marks
 At some funds, fee cuts came principally from performance fees, rather than
management fees, based on the view that management fees are essential to keeping
the funds operational
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L6: Hedge Fund Issues and Performance
High Water Mark
 A hedge fund high water mark is a mechanism that is implemented to make sure
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that managers do not take a performance fee in the current period when the
fund has had negative performance over previous performance fee periods
The high water mark is the colloquial term for a “cumulative loss account”
A cumulative loss account starts with a zero balance at the beginning of any
performance period (monthly, quarterly, or yearly, as determined by the firm)
and it records net losses during that period
It was estimated that only one in 10 hedge funds received performance fees
during 2008 because of losses and application of high water marks
This created significant compensation pressures for many funds since their
management fees were insufficient to keep the business going, which resulted in
significant downsizing of headcount and office space
L6: Hedge Fund Issues and Performance
High Water Mark
 The high water mark may create a perverse incentive for the hedge fund
manager to either take extra risk to generate returns high enough to deplete the
cumulative loss account so that a performance fee will be paid, or to close down
the fund and start again
 Both of these actions could be damaging to investors, forcing them to either
make a redemption at an inopportune time, or continue with their investment
with a potentially higher risk profile
 If a hedge fund manager shuts down a fund, the investor might suffer
disproportionate losses as assets are sold in a fire sale environment
 However, to keep money invested in the fund under a higher risk profile may
also not be in the investor’s best interest and taking money out to invest with
another manager might subject the investor to the same high water mark issue
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L6: Hedge Fund Issues and Performance
High Water Mark
 As a result of this conundrum, in some cases, it might make sense for investors
to consider modification of the high water mark
 An alternative to the standard hedge fund high water mark is a modified high
water mark: resetting the high water mark to the current fund level under
circumstances where to do so better aligns everyone’s interest, amortizing
losses over a several year period to enable some modest level of performance
fees during this period, or rolling the high water mark over a more extended
period
 A modified high water mark may create value for investors by keeping a
manager in the game and reducing the incentive of the manager to take
excessive risk
 As a quid pro quo, some hedge fund managers may be willing to accept lower
performance fees
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L6: Hedge Fund Issues and Performance
High Water Mark
High Water Mark Example
An example of the mechanical application of the cumulative loss account and high water mark calculation is
below:
Hedge fund NAV 01/01/06: $1,000,000
Hedge fund NAV 12/31/06:
$1,200,000 (total after expenses, including the management fee expense)
Gain: $200,000
Less Performance fee: $40,000 [20% of $200,000]
Cumulative loss account: $0
Hedge fund NAV 01/01/07: $1,160,000
Hedge fund NAV 12/31/07:
$1,000,000 (total after expenses, including the management fee expense)
Gain: ($160,000)
Less Performance fee: $0
Cumulative loss account: $160,000
Hedge fund NAV 01/01/08: $1,000,000
Hedge fund NAV 12/31/08
$1,100,000 (total after expenses, including the management fee expense)
Gain: $100,000
Less Performance fee: $0
Cumulative loss account: $60,000
Hedge fund NAV 01/01/09: $1,100,000
Hedge fund NAV 12/31/09
$1,300,000 (total after expenses, including the management fee expense)
Gain: $200,000
Less Performance fee: $28,000 [20% of $140,000]
Cumulative loss account: $0
The concept of the high water mark is theoretically similar to the "claw-back" provision found in many private
equity funds in that its purpose is to make sure the manager is not overcompensated for underperformance.
However, the high water mark is distinctly different in that it is prospective in nature (whereas the claw-back
is retrospective in nature). The high water mark is applied to a hedge fund manager on a going forward basis
and so the manager will need to get the fund's account back up to the high water mark before a performance
fee can be taken.
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L6: Hedge Fund Issues and Performance
Merging of Functions
 Hedge funds, private equity funds and investment banks compete against each other and
are, at the same time, major sources of revenue for each other
 Each of the largest participants in these three industries conducts business activities in all
three areas
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Goldman Sachs has an industry leading sales and trading business, providing trading and
lending services to hedge funds and a large investment banking business that provides
services to private equity funds
 In fact, private equity funds and hedge funds are the two most important clients of
Goldman Sachs’ investment banking division and trading division, respectively
 In addition, Goldman Sachs historically conducted one of the world’s largest hedge fund
businesses between their proprietary trading desk and their Asset Management Division
and one of the world’s largest private equity businesses between their principal
investment area and their Asset Management Division
 As a result, Goldman Sachs is both an important provider of services to hedge funds and
private equity funds, as well as one of their principal competitors
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L6: Hedge Fund Issues and Performance
Merging of Functions
Goldman Sachs
The chart below highlights segments of Goldman Sachs’ business that pertains to the hedge fund, private
equity and alternative investment segments
Goldman Sachs
Investment
Banking
Corporate advisory
Trading and
Principal
Investments
Asset Mgmt and
Securities Services
Trading:
Fixed Income,
Currency &
Commodities, and
Equities
Asset Mgmt:
Alternative
investment funds
Principal
Investments
Securities Services:
Prime brokerage,
financing and
securities lending
services
Underwriting
Key:
Services used by Goldman’s private equity clients
Services used by Goldman’s hedge fund clients
Services that compete with Goldman’s hedge fund and private equity clients
Source: Based on Goldman Sachs 2008 10-K
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L6: Hedge Fund Issues and Performance
Merging of Functions
Fortress Investment Group Business Overview
Fortress
Investment Group
$29.5 bln AUM
Private Equity
$15.8 bln AUM
Hedge Fund
$13.7 bln AUM
Funds
$12.6 bln AUM
Castles
$3.2 bln AUM
Liquid
$7.2 bln AUM
Funds focused on controloriented investments in
North American and
Western European
companies. Active sectors
include financial services,
residential and
commercial real estate,
senior living,
transportation and
media/telecom
Real estate investments
including securities, loans
and property assets
Seeks to exploit
opportunities in global
currency, interest rate,
equity and commodity
markets and their related
derivatives
Newcastle
Investment Corp
(NYSE:NCT)
 Drawbridge Global
US REIT that owns
Macro Funds
portfolio of debt secured
by commercial and
residential real estate
Eurocastle
Investment Ltd.
(AMS:ECT)
Euro denominated
company. Owns a
portfolio of properties
and debt
Note: AUM as of December 31, 2008
Source: Based on Fortress Investment Group LLC 2008 10-K
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L6: Hedge Fund Issues and Performance
Hybrid
$6.5 bln AUM
Seeks to exploit pricing
anomalies that exist
between the public and
private finance markets
 Drawbridge Special
Opportunities Funds
 Fortress Partners
Funds
Merging of Functions
Overview of The Blackstone Group
Blackstone Group
Corporate
Private Equity
Private equity
investment arm; has
managed 5 generalist
funds and 1 media &
communications fund
• $23.9 bln AUM
Real Estate
Real estate investment
arm; has 6 general, 2
international, 1
European and 1 special
situations funds
• $24.2 bln AUM
Marketable
Alternative Assets
Mgmt.
Alternative asset arm:
• Fund of funds mgmt
• GSO Capital (hedge
fund)
• Closed-end mutual
funds (The India Fund
and The Asia Tigers
Fund)
• $46.5 bln AUM
Financial Advisory
Corporate advisory arm:
• Corporate and M&A
advisory
• Restructuring and
reorganization advisory
• Fund placement
advisory (The Park Hill
Group)
Due to market related losses across all investment arms, the Financial Advisory division became
the highest revenue-producing division in 2008, bringing in $411 million in fees
Source: Based on The Blackstone Group 2008 10-K
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L6: Hedge Fund Issues and Performance
Future Developments
 Hedge funds suffered significant pain during 2007-2009: redemptions created loss of
income and forced sales of assets that compounded losses, fees were reduced as
performance waned, regulators reached toward greater regulation and more taxes, and
many investors became concerned with the hedge fund model. As a result, a number of
significant, lasting developments have occurred:
 Hedge funds have more limited access to leveraged financing, which, in particular,
impacts convertible arbitrage, fixed income arbitrage and statistical arbitrage
investment strategies
 The ability to maintain confidentiality over investment strategies has been reduced as
investors demand more transparency and liquidity
 Losses, gates and fraud have forced hedge funds to become more open in their
activities and more willing to share details of their business and associated risks with
investors
 Fees have been reduced from the typical 2/20 schedule to a lesser fee system that
allows greater returns to investors and acknowledges the lower return environment
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L6: Hedge Fund Issues and Performance
Future Developments (continued)
 The decline in alpha is well documented and many hedge funds are now viewed as creating
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diversified beta instead of finding significant returns from market inefficiencies
This still represents value added, but differentiation from many well-managed traditional
investment funds is more difficult
Hedge funds are subject to additional regulatory constraints, which limit somewhat their
flexibility, especially in long/short equity, event driven and other equity based strategies
A less favorable tax environment will result in reduction in after-tax compensation
received by hedge fund managers
As hedge funds adjust to the new realities of the market they are developing longer lockup arrangements that better match the lengthening maturity profile of their investments,
enabling them, in turn, to expand long-term investment activity to take advantage of
higher yields available for patient capital
The balance of power has shifted from general partners to limited partners
The result is that limited partners have been successful in obtaining better transparency,
improved liquidity and the other benefits described above
L6: Hedge Fund Issues and Performance