Hedge funds face ever-shrinking future

Bruised and battered by some of the most miserable months in living memory,
bankers are now drowning their sorrows with the free champagne that flows once
the Christmas season swings into gear. Parties are always filled with gossip and
intrigue. But there is one particular topic that is dominating the bubbly and
smoked salmon blini-fuelled discussions: just how tough are things going to get
for the hedge fund industry?

Despite being shrouded in secrecy, the financial pain suffered by the Mayfair
practitioners of these dark arts has leached out into the wider financial
community. Nick Evans, principal consultant in investment advisory at KPMG,
says, “A number of senior and well-respected people are saying that around a
third to a half of hedge funds will close next year.”

One London-based fund manager, who did not want to be named, thinks this is
too conservative a view and that an even larger number could close. According to
a report in November by International
Financial
Services
London, hedge funds are set for a major withdrawal of funds that
could substantially reduce the $2.25 trillion under management the funds have
played with previously. “This has less to do with investments in mortgage-backed
securities and more to do with loss of confidence among investors due to poor
returns in 2008,” it says.

Squeezed out
Evans agrees with this analysis. “The hedge fund industry is being squeezed from
various fronts,” he says. When the current crisis first broke, the hedge funds
looked to exploit this situation by looking for mispricing between different
types of financial assets. “The hedge funds put money into trading strategies to
make the money from the mispricing. The banks lent some hedge funds additional
money to add leverage to these positions,” explains Evans.

But then things started to go wrong. The market became more distressed so
that instead of generating profits, the hedge funds started to make losses. “The
banks started to get nervous about the amount of money they had lent them and
started demanding more collateral on their loans. “Hedge funds returns turned
negative. The private individuals, who are the principal investors in these
funds, became nervous about erosion of their capital and started to withdraw
their money,” he says.

Hedge funds were forced to raise funds quickly to pay off both the banks and
their investors. But so many assets have become highly illiquid, making this
difficult. As the hedge funds have been forced to sell at any price, this is
resulting in a fire sale of those assets that are still liquid, such as
equities.

It’s not only this squeeze by the banks and investors that will force hedge
funds to close. The way hedge funds are paid could also persuade many funds that
closing is the best option. “Hedge funds usually charge a performance fee of
around 20%. If, in the first year, the hedge fund generates returns of 10%, it
will be able to take two percentage points as fees. But if the value of the fund
falls by 15% in the following year, the company can’t charge anything until it
is above the so-called high water mark of the previous year’s performance. That
means they will probably not be able to charge fees for at least a year.” Hence,
many funds may decide that it makes more sense to close the fund and start all
over again when the market looks more favourable.

But these are not the only burdens on the hedge fund universe. Pressure is
growing for the authorities to impose stricter regulations and tighter controls
on short-selling. In such unpredictable times, one thing is certain: the hedge
fund industry will soon be a very different ­ – and smaller – ­ beast.