Report Predicts Bloodletting In Hedge Fund Industry

by Phillip Morton, Investors Offshore.com

26 November 2008

Many hedge funds will be forced to close and there will be significant consolidation because of market conditions and unprecedented changes to the regulatory landscape according to a new report by Watson Wyatt, a leading global consulting firm.

However, the firm believes the best managers in the industry will emerge in a better position to exploit investment opportunities characterised by greater market dislocations and lower prices and this will be made easier by the absence of proprietary trading desks.

In a recent note to its clients, Watson Wyatt asserts that long-term investors are likely to be the beneficiaries of this evolution, mainly through improved fee structures that better align interests. In addition, it suggests there will be certain hedge fund strategies that will struggle in future, given a fundamentally changed investment environment.

Craig Baker, global head of manager research at Watson Wyatt, said: “In absolute terms, general hedge fund returns do not look good this year, but it is likely that they would have performed better than some other strategies, long-only equity funds for example. This has come about despite the well-publicised headwinds facing the industry in the last year. Notwithstanding, it is our belief that the current crisis will expose those that are not structured to add value for investors and will provide the most skilled with attractive opportunities and potential for substantial returns in the future.”

According to the firm there are early signs that increasing numbers of skilled hedge fund managers are becoming more flexible in the negotiation of fees having been persuaded of the benefits of receiving long-term capital, provided by the likes of pension funds, rather than ‘hotter money’ which comes from other investors.

Craig Baker said: “While we strongly believe skilled managers should be fairly compensated, fees are generally still too high for the value they deliver, particularly as we enter a lower-return environment. Also, performance fees introduced to align interests have been less than effective because they are generally poorly designed and tipped in managers’ favour. For a number of years we have been trying to rectify this situation and negotiate a fairer deal on fees, but only now we are seeing real progress.”

In the note, the firm refers to a number of factors that should help certain hedge funds in the future including: increased opportunities as a result of recent market dislocations; lower competition as the number of hedge funds declines; a reduction in the overall level of leverage; fewer competitive proprietary trading desks; and lower fees making them more attractive to investors. Accordingly, it asserts that these factors will impact differently on the range of strategies resulting in some winners and losers.

The report finds:

• The outlook for average fund of hedge funds (FoHFs) is impaired, in part due to significant redemptions at the end of the year and high overall costs. However, high-quality FoHFs should be able to capitalise on opportunity sets when they become available.
• Multi-strategy managers are well placed to capitalise on opportunities and are arguably less affected by legislative changes, although some have very illiquid assets which combined with large redemptions could cause problems.
• Macro managers should be largely unaffected although highly leveraged funds, concentrated in a small number of bets, could struggle.
• Equity long-short managers should be also largely unaffected, on the understanding that the availability and cost of borrowing stock has not materially changed. However these strategies may suffer if regulation forces them to disclose short positions.
• Fixed income managers that use high levels of leverage will be adversely affected, particularly those that rely on a limited range of financing options.
• Credit focused managers that do not rely heavily on leverage are likely to benefit, although it will be important to distinguish between those opportunities that require hedge fund skill (e.g. distressed debt) and those that are more long-only in nature (e.g. bank loans) and should be accessed more cheaply.

Baker said: “With such a rapidly changing and uncertain environment we think it is sensible that those pension funds looking to invest in hedge funds should hold off until there is greater stability and current redemptions play their way through the system. But for those already invested we would not recommend any action, although there may be fund and manager-specific considerations that require extra vigilance.”

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