The New Hedge Fund Landscape

Over the past year many changes have occurred within the Hedge Fund Landscape and these changes have created many new business guidelines for the space.  Some investors have even stated that the hedge fund business was dead and that hedge funds were no longer going to be an instrumental part of a proper asset allocation model. Although changes have occurred and fees are being challenged, the hedge fund business is surviving with these new rules and guidelines.  Here are a few of the new rules; we will continue to add some to our blog and newsletters in the coming weeks.

Start up Hedge Fund Size – Can most Survive

Depending on who you ask somewhere between 1500 and 2300 hedge funds have closed their doors in the past year, a number equivalent to at least 20% of the size of the industry back in 2007.  But at the same time there continues to be new funds rising from the ashes.   Most of the new funds have had a hard time raising assets although there have been a few funds opening with a significant asset base north of $500 million such as Roc Capital Management which opened with $1 Billion.   But realistically most funds in today’s marketplace are opening with a much smaller assets base, many under $25 million.

The problem with this small asset base ($25M or less) is that the economics of a fund with this asset base are very inefficient and unless the fund has set aside a substantial amount of working capital the fund  literally lives on its performance and even then every penny must be accounted for.  A fund of this size can usually last for only 12 to 18 months unless working capital has been set aside or performance is stellar.

Additionally a fund of this size can not provide the infrastructure an institutional client now demands and thus these funds will not be able to count on institutional assets until they reinvest in their growing business and build out their infrastructure.  Hopefully with the contraction that the hedge fund industry has experienced in the last year many institutional investors will lower their investment guidelines allowing these smaller funds to be an attractive investment product for the institutional investor but this is doubtful.

As has historically been the case there will be a few funds in this asset size that will excel and perform significantly better than their peers and become the next multi million if not billion dollar fund but this will be the exception rather than rule.  Thankfully there are high net worth individuals who have seen tremendous returns in this category before and will continue to invest in this category.

Fee’s challenged

In today’s economy everything is negotiable and this includes the fees investors pay their investment partners. There is no question that fees are being challenged, but top funds are still able to receive very attractive fee structures.  For less experienced funds or those funds with a less than stellar track record fees are being challenged and in many cases being changed to terms such as 1 and 15 or 1.5 and 12.5.

In the past few weeks we have heard of some very interesting new fee structures but the norm would be a smaller performance fee and in some cases a larger management fee to accommodate a much smaller performance fee.  Will these fees stay, I doubt it, once a firm has proven itself, it will be able to renegotiate the fees and return to the 1 and 20 or 2 and 20 of past years.  Only funds with top performance are not having their fees challenged, but otherwise no matter your size fees are being challenged. Even funds with top performance are experiencing a push back from their investors because in many cases their investors have large losses in their other investments and thus are very hesitate to pay the same fee they paid 18 month ago.

Cost of running a Hedge Fund Increases

Unfortunately even thou the fee structure and therefore revenue structure of a hedge fund is being challenged downward by investors other investor demands are making the actual cost of running a hedge fund increase.  Hence hedge fund managers in today’s marketplace are feeling a pinch from both directions.

Investors today demand better infrastructure, on top of that infrastructure they are demanding more detailed transparency and more layers of safeguards. Both of these demands come with an additional cost whether it be having two hedge fund administrators reviewing your books or two prime brokers helping execute and clear your trades, redundancy has a price.

These higher cost compounded by the lower revenue created by the lower asset bases will make the success rate of these smaller funds drop even further.  Furthermore for many larger billion dollar funds running numerous strategies, their cost will continue to rise because they will need not one or two vendors per category but 3 or more and for some specific categories they will need a whole new group of vendors.

The future of the Hedge Fund Business

The new rules and guidelines will not kill the Hedge Fund business but they will make it not as profitable for most funds and will provide funds with less of a safety margin in regards to their business.  But as we have seen since the 2nd quarter market low, the hedge fund business is still a very exciting and an attractive business for many professionals and investors - it is here to stay.

© 2008 NyamiNyami Holdings, LLC