The hedge fund arena is currently undergoing a tremendous amount of change.  As the size of the industry has shrunk over the past year, numerous funds have been forced out of business.  Meanwhile, investors have become much more discerning with their capital when compared to the boom years of earlier this decade.  Lastly, increased scrutiny from Washington and beyond threatens to change the way managers approach their marketing and operating strategies.  In today’s Darwinian investor landscape, funds are judged by how they respond to these issues, adapt, and position themselves for future success.

On Thursday, September 24 Eze Castle Integration will be hosting a free, one hour webinar at 11 AM ET.  It will feature three accomplished industry veterans sharing their wisdom on a variety of trends affecting the current hedge fund landscape:

Marketing Evan Rapoport, Co-founder, HedgeCo Networks

Due Diligence John Budzyna, Global Head of Hedge Fund Consulting, Deutshe Bank Securities Inc.

Technology Vinod Paul, Managing Director, Eze Castle Integration

By the end of the conference, listeners should walk away with a series of recommendations and best practices aimed at helping their funds to adapt to the changing hedge fund environment.  To sign up for this free event, please register here.

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In the wake of one of the most severe liquidity crises in recent memory, the vast majority of hedge fund managers have seen their assets under management shrink considerably over the past twelve months.  Whether in the name of paring back on risk, exiting losing positions, reducing portfolio volatility, or simply rebalancing portfolios, investors have used a litany of reasons to withdraw several hundred billion dollars in capital from their hedge fund accounts.  This, in turn, has drastically shrunken managers’ ability to generate fees on these accounts.  As a result, hedge funds are increasingly reworking their fee structures in order to satisfy existing investors, as well as attract new capital to their funds.

Let’s start out with a primer on the basics of hedge fund fees structures.   Hedge funds typically earn their income through a variety of fee structures charged to their clients.  These fees are not only meant to cover fund administrative and operating costs, but also to reward employees and managers for providing positive returns to investors.  The most common and well-known hedge fund fee structure combines both management and performance-based fees.

First, the “management” fee represents an annual, base fee levied on the amount of assets managed by a firm.  This fee can represent anywhere from 1-4% of net assets, however 1-2% is the most common range.  Thus, as an example, if a hedge fund has a management fee of 2%, then investors are charged $2,000 for every $100,000 invested in the fund, per year.  However, rather than being levied on the investor as one flat charge, management fees are usually deducted incrementally, on a monthly or quarterly basis.  These fees are traditionally used to cover fund administrative and operating costs, which may range from paying a full-time staff or third party administrator, to renting office space or attending conferences.

The second common fee structure within the hedge fund industry is a “performance,” or incentive-based fee.  Performance-based fees, on an ideological level, are intended to properly align the interests of the fund manager with investors.  The fee, which represents a percentage of the year’s profits, is thus only awarded to the manager in the event that he provides positive returns to his clients.  Performance fees typically range from 10-40%, however 20% appears to be the accepted industry norm.  Often, these fees are allotted to firm employees and managers in the form of bonuses, used as a way to reward positive performance by managers on behalf of their clients.  Hence, when a hedge fund’s fee structure is referred to as “2 and 20,” this means that it charges a 2% management fee and a 20% performance fee.

Increasingly in the past year, hedge fund managers have moved to reduce these fees in order to appease investors (after all, fees generally reduce investor returns).  Some managers, such as Bill Ackman, have vowed to halt the charging of fees to existing investors until previous fund losses have been reversed.  Oftentimes referred to as the implementation of a “high water mark,” this is typically done to appease existing investors who may feel jilted due to excessive fund losses.  It essentially prevents managers from charging double layers of fees.

Meanwhile, support is mounting for funds to abandon the traditional “2 and 20″ fee structure.  A recent report by Barclays Capital suggests that a growing number of investors favor the implementation of “hurdle rates,” which prevent managers from levying annual performance fees until they have met and passed a predisclosed benchmark performance rate.  This would hold managers more accountable, as they would only be rewarded for posting returns in excess of, say, the risk free rate.  Additionally, some managers are facing pressure to lower all fees in order to attract new investors.    For example, investors, particularly in the pension fund industry, are beginning to seek out funds with lower expense ratios, such as a “1 and 10″ structure.   These lower fee funds help to better-preserve investor capital, especially during years of negative fund performance.

The combination of charging both management and performance fees should continue as an industry-accepted standard.  While the management fee is used to cover basic fund expenses, the performance or “incentive” fee properly aligns the interests of the manager with his investors.  Furthermore, while hedge fund assets under management have fallen considerably over the past year (recent estimates put the value at about $1.3 trillion under management, down from an estimated $2.5 trillion), potential investors actually wield a considerable amount of power.  As investors reenter the hedge fund arena, managers may be forced to make concessions in order to win back their hard-earned capital, not to mention their trust.

In the coming years, it will be interesting to gauge whether investors, indeed, pressure the entire industry into lowering its fees.  In my opinion, managers will be willing to make concessions on fees in the near term.  In fact, investors would be wise to make these demands while the hedge fund industry is scaling back, and perhaps in its most vulnerable state.  If investors demand incentives to return to hedge funds, retooling fee structures represents a logical starting point.

That being said, investors need to make those demands right now.  If they fail to act now, then several years down the road, as industry-wide returns stabilize and improve, investor uproar over fees will likely evaporate.  As a result, investors seeking concessions would be wise to strike while the proverbial iron is hot.  If not now, then when?

Tags: Ackman, assets, Barclays, concessions, hedge fund, hedge fund fee structures, hedge fund managers, Investors, liquidity, Management Fee, performance-based fees, portfolio volatility, third party administrator

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David Einhorn is not afraid to call a bluff when he sees it.  The President of Greenlight Capital has built a reputation within hedge fund circles as a fiercely independent, critical-thinking manager with a knack for making bearish bets on established, generally well-respected companies.  No stranger to the public eye, previously publicized campaigns against the likes of Allied Capital and Lehman Brothers have aided his fund to post outsized returns for more than a decade, helping his fund grow from a lowly $1 million in assets under management in 1996 to its roughly $5 billion size of today.  One of his current fixations, the debt rating agencies, offers investors an additional glimpse into his investing philosophy.

During a speech at this spring’s Ira W. Sohn Investment Research Conference, “The Curse of the Triple A,” Einhorn made a compelling claim against the debt rating agencies.  Much of these firms’ success ties itself to the enormous fees they reaped during the earlier stages of this decade, rating structured debt products on behalf of institutional clients.  As the housing market ballooned, in particular, Wall Street licked its fingers in anticipation of the arrival of new tranches of mortgages which would be quickly packaged and resold to investors.  By law, many financial institutions are required to invest in assets based upon the underlying investment’s rating.  Hence, the likes of Moody’s, Standard and Poor’s, A.M. Best, and Fitch’s labeled the vast majority of subprime loans as AAA or investment grade, thus fueling more demand for these presumably low risk, “safe” products that banks and money managers clamored for.

However, the recent failures of several of these products, representing billions of dollars, suggests that the agencies may have misjudged or even ignored the risk of default.  As Einhorn has stated, many of these investors “…thought they were buying safety, but instead bought disaster.”  Under regulation FD, the ratings agencies are allowed to receive confidential information from underwriters that is not made available to other market players.  Hence, the investor should logically expect that these assigned ratings truly reflect the underlying product’s risk characteristics.  Yet, the widening discrepancy between these products’ losses and their lofty risk-based ratings has led many on Wall Street to question the validity of the debt rating process.

Just last week, a US District Court Judge in New York dismissed claims by Moody’s and McGraw-Hill Cos. (Standard & Poor’s parent company) that investors cannot sue them over ratings.  The ratings firms had claimed that their ratings are protected under free speech laws.  Einhorn clearly believes that the decision will open up the possibility for investors to file class-action suits, under the premise that the ratings firms hid the existence of risk.  Einhorn referred to the decision as “Landmark,” and went on to compare it to when tobacco victims were finally permitted to sue cigarette manufacturers.  If found liable, these suits could, in fact, threaten their survival.

However, Einhorn still faces his share of skeptics.  While the ruling opens up the possibility of future lawsuits, investors must be able to prove that the firms deliberately misled investors, eventually causing them losses.  With little concrete evidence, this could be difficult to prove in court.  In fact, in addition to Berkshire Hathaway, the likes of Morgan Stanley, Vanguard, and T. Rowe Price still hold considerable stakes in Moody’s.  As a result, while Einhorn’s efforts may have contributed to Moody’s share price falling more than 35% over the past year, a slew of investors still view the firm’s discounted shares as a value opportunity.

Nonetheless, Einhorn stands by his claim.  Readers may recall that Einhorn feuded with lender Allied Capital earlier this decade, even outlining his criticisms of the firm in a book, Fooling Some of the People All of the Time.  Despite dodging an SEC investigation by Elliot Spitzer concerning market manipulation, Einhorn stuck to his guns, accusing the firm of fraudulent behavior and crooked accounting.  The SEC eventually found Allied guilty of breaking several securities laws.  That battle, which lasted six years, reflects his innate ability to persevere.  Indeed, that stick-to-itiveness has helped to produce annual investor returns of over 20% since the fund’s inception.

In 2006, Einhorn placed 18th out of nearly 9,000 competitors in the World Series of Poker Tournament in Las Vegas.  After bowing out to the eventual tourney winner, he pocketed a cool $660,000 in prize money (which he in turn gave to charity).  Admittedly only a part-time player, Einhorn displayed little hesitation when rubbing elbows with some of the most elite players in the world.  Similarly, his short positions in Moody’s and McGraw-Hill Cos. represent his latest challenge, an opportunity to prove his mettle against several of Wall Street’s titans.  In his first quarter letter to investors, he included a quote from the late President John F. Kennedy, “A nation that is afraid to let its people judge the truth and falsehood in an open market is a nation that is afraid of its people.” For Einhorn, to ‘judge the truth’ involves discrediting an entire industry, exposing the status quo for its alleged wrongdoings.  His current plight represents one of the most engaging investments of his relatively short career.  Yet, if his past serves as any indication, don’t expect Einhorn to “fold” any time soon.

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Early last week, real estate circles were sent abuzz by the release of the Standard and Poor’s/Case Schiller national home price index, which revealed that average home prices in the nation’s 20 largest markets experienced a 3% jump in valuations during the second quarter.  It marked the first quarterly increase in 3 years for the index, leading some prognosticators to suggest that housing has indeed bottomed out.  In fact, CNBC’s Jim Cramer has panned for some time now that housing is bottoming out.  However, Cramerica & friends could not be more wrong.  Despite this hurried optimism, a variety of factors suggest that the darkest days still loom ahead for the US housing sector.

1.  First, we have that pesky figure called “unemployment.” According to the US Department of Labor, 247,000 people lost their jobs in July.   While that figure may be beginning to taper down when compared to previous months, any realistic hope for positive job growth will likely wait until 2010, at best.  Meanwhile, an extra 200,000 people gave up looking for jobs, most likely as a result of frustration and a lack of hope.  While not an earth-shattering figure, bear in mind that millions of Americans, gainfully employed or otherwise, are still receiving mortgage statements in the mail every month. If the recession lingers on, we are likely to see more and more out-of-work homeowners falling behind on or simply walking away from their mortgages.

2.  The federal housing credit is due to expire. First-time home buyers are currently eligible for up to $8,000 in credits from the federal government to use towards the purchase of a new home.  However, the program ends abruptly on December 1.   Roughly 1/3 of all new home purchasers currently take advantage of the credit; thus, when this government subsidy expires, the housing market may find itself in a pickle. Consumers might ride the wave of buyer momentum and continue to scoop up houses, or, more likely, a considerable pool of price-conscious home buyers will decide to delay or abandon entry into the housing market.

3.  The effects of ARM resets have yet to be fully realized. As this schedule of adjustable rate mortgage resets illustrates, the US should still see a sizeable chunk of recently-originated ARM mortgages reset in the coming two years (Credit Suisse predicts the total amount could reach $1 trillion).  As more and more homeowners see their mortgage payments reset from initial, artificially low teaser rates, the serious threat of foreclosure will remain.  Ben Bernanke & Co. has pledged to do its best to keep interest rates low, which should help to mitigate the extent of upward rate resets.  Nonetheless, the threat of foreclosure could grow considerably for millions of additional ARM holders as their monthly housing payments rise.

4.  Housing inventory data is misleading. Estimates suggest that the US currently has a 6-8 month inventory of homes available for sale, which equates to how long it takes for the average home sitting on the market to sell.  In actuality, that figure is much higher.  Millions of Americans who in rosier times would sell their homes have taken them temporarily off the market, either continuing to live in them or renting them out.  This has created a “shadow” surplus inventory, equating to a surplus backlog of condos and homes. When prices finally do begin to inch back upward, homeowners could very well look to unload their homes en masse, threatening to push prices further south.

5.  Pending budget deficits are forcing local governments to raise taxes. As Californians have been made well aware of, the recent recession has forced state, county, and local governments to reign in on spending as tax revenues have evaporated.  With continued government bailouts less likely, several states and municipalities are considering measures to recoup such losses, including raising taxes on everything from personal income to water usage and public transportation.  This increase in taxation, in the wake of our worst economic struggle since the Great Depression, could easily push even more homeowners beyond their means and out of their homes.

6.  Last, access to consumer credit has tightened considerably. Long gone are the days in which just about any John, Jane, or Alberto could lock in a mortgage with little or no down payment and attractive terms.  In fact, even if interest rates mimic the artificially low rates encouraged by Alan Greenspan earlier in the decade, home buyers must still navigate a much less-forgiving lending environment.  A majority of banks have both reigned in on lending practices and upped their underwriting standards.  These efforts, done in an attempt to both deleverage and build up capital reserves, have been passed directly on to the consumer.  As a result, home buyers are being forced to shell out larger down payments, undergo more stringent proof-of-income terms, and, in contrast to several years ago, convince the banks that they represent a healthy credit risk.  Oh, how  times have changed!

Although home prices have recently flirted with the notion of heading north, a multitude of risks still remain.  Unemployment, the expiration of home buyer subsidies, ARM resets, a bloated housing inventory, a heightened tax environment, and tightened lending standards should place continued downward pressure on the housing market.  While these trends admittedly will not affect all regions of the country equally, they cut to-the-core several of the major themes affecting municipalities across the US.  While the recent upswing in prices represents a welcoming change for homeowners, such a price movement is unsustainable.  Furthermore, the price weighted Case Schiller Index is disproportionately responsive to changes in prices amongst the most expensive homes in each market.  Hence, it is an unreliable indicator of broad market changes in home prices.  Lacking any fundamental changes in the consumer landscape, the media pundits and housing bulls will nonetheless pounce at any opportunity to grab the headlines with their ‘bold’ claims of a turnaround in the greater economy and housing.  However, taking a quick look around the housing landscape, it’s safe to assume that we aren’t out of the woods quite yet.

Tags: adjustable rate mortgage, federal housing credit, foreclosures, Great Depression, housing, mortgage crisis, Real estate, US Department of Labor

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While the debate rages on as to whether the economy is, indeed, displaying evidence of “green shoots,” numerous hedge fund firms appear to be taking matters into their own hands, repositioning themselves to benefit from any signs of improving investor sentiment.  In particular, several firms have gone on recent hiring sprees in an attempt to lock in the best and the brightest minds from the considerably large pool of unemployed hedge fund workers.

Recent struggles within the hedge fund industry are well documented.  In addition to the estimated 1,500 funds which were forced to close in 2008, a vast majority of funds experienced a significant fall in assets under management.  Unable to generate substantial profits from fee generation, this forced numerous firms to cut expenses and/or lay off workers.  However, a renewal in industry hiring could signify optimism amongst some of the industry’s major players.

As the markets rebound from their lows of the past year, once-wary investors are beginning to retest the markets.  Repositioning themselves for an impending rebound, many firms are actively raising capital, while adding staff to fill sales and marketing roles.  In fact, Citadel, RBC Capital Markets, Artradis and Tribridge have all announced recent hires.

Furthermore, the prime brokerage business, which offers fund managers a variety of services ranging from clearing to securities lending to financing services, is another area experiencing growth.  Firms such as Credit Suisse Group AG and BNP Paribas SA, in particular, have announced their plans to expand prime brokerage services.  This expansion is especially pronounced in Asia, where the region’s hedge fund industry is expected to resume its prolific growth.

Hedge fund hiring by some of Wall Street’s biggest players could also signify to makings of a turnaround for the hedge fund industry.  Citigroup Inc. and Bank of America Corp.’s Bank of America Merrill Lynch have also added new hires to their hedge fund businesses.  Meanwhile, in one of the largest hiring moves to date, Morgan Stanley announced late last week its intentions to add 400 new hedge fund hires in areas ranging from sales to trading.

Recent hiring patterns would suggest that hedge fund firms are retooling their infrastructure, positioning themselves to benefit as investors return to the industry.  In the process, this news perhaps offers a glimmer of hope to the throngs of idle and out-of-work former hedge fund employees.

Tags: hedge fund, hedge fund industry, infrastructure, investor, Not Categorized, prime brokerage, Wall Street

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Despite a series of ongoing challenges, a variety of environmental effects have recently swung in the activists’ favor.  First, as mentioned in my previous blog post, stock prices have taken a tremendous hit over the past year.  Yet while the news media tend to tout the market’s recent resurgence, in reality the S&P 500 still remains more than 25% below its level of one year ago.  This has unlocked a variety of value opportunities for investors, and activist hedge funds have taken notice.  In Ackman’s case, it has allowed him to add considerably to Pershing Square’s stake in Borders Group (its current economic interest consists of 40% of shares outstanding), as well as earn him a seat on the company’s board.  In doing so, he has lowered his investment’s average cost basis by purchasing shares at lower prices, thus setting the stage for a substantial profit opportunity if and when the book retailer’s shares rebound.

In addition, activist investors are benefiting from a recent groundswell of support for corporate governance reform, following a rise in publicity over corporate excesses.  Corporate carelessness and excess, which includes outrageous bonus payouts and golden parachute provisions paid out to management, as well as the stacking of corporate boards with the close friends of leadership, essentially robs shareholders of their right to share in a firm’s success.  In one more egregious example, Robert Nardelli received a $210 million severance package from Home Depot in 2007 as its departing CEO; yet, during his six years with the firm its share price failed to appreciate in any meaningful way.

In response to such corporate excess, a variety of changes are in the works.  In July, the SEC enacted a series of proposals aimed at corporate transparency, such as allowing shareholders of companies participating in the Troubled Asset Relief Program (TARP) to vote on executive pay.  In addition, the SEC is now considering reforms intended to “remove impediments so shareholders may more effectively exercise their rights under state law to nominate and elect directors at meetings of shareholders.”

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Tags: activist investor, Bill Ackman, hedge fund, Not Categorized

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Bill Ackman, the forty-three-year-old founder of hedge fund firm, Pershing Square Capital Management, has had a rough go of late. Readers may recall that in 2007 he raised $2 billion from private investors in order to start a new hedge fund, Pershing Square IV.   Employing a highly-leveraged mix of common stock and call options,  Ackman invested the proceeds in trendy discounter, Target Corp.  Since its launch, Ackman has pursued a public campaign against Target, pressuring it into not only selling off its credit cards division, but also spinning off the land underneath its stores into a separately-managed real estate investment trust.  However, his attempts to unlock value on behalf of Target shareholders have thus far proven to be a colossal bust, as evidenced by his failed attempt in May to nominate several fresh faces (including himself) to the company’s board of directors. The current poster boy of hedge fund activist investing, Ackman’s plight reflects, or at least resonates with several key themes currently affecting the activist landscape.

First, one major challenge affecting today’s activist investor involves access to capital and leverage.  As a primer, activist funds are typically considered longer-term, illiquid investments. This is because the average activist fund enforces a 2-3 year lock-up period to new investors when launching the fund. Managers do this so that they can more easily concentrate on building long term value for investors, and thus minimize short term distractions caused by fund maintenance, redemptions, and reporting monthly performance. After all, raising media attention, influencing corporate governance, and generating further value from a target company is no overnight project! In Ackman’s case, he was fortunate-enough to raise capital for the fund in 2007, when market conditions were much more favorable and investors were much more willing to part with their capital for long periods of time.

In contrast, in today’s environment activist hedge funds face a tougher time raising large sums of cash from investors. Unwilling to part with their capital for the long term, risk averse investors are resorting to placing funds in liquid investments.  On top of this, banks and other lending firms are increasingly refusing to lend to hedge funds.  This is the combined result of new heightened lending standards, as well as need by these institutions to shore up cash reserves.  As a result, many activist managers, or raiders, are putting to use smaller sums of capital.  With capital so difficult to access, most new players are either waiting on the sidelines for now, or picking their battles with much smaller-sized corporations.

Another challenge faced by activist managers involves the exit strategy.  Obviously, the goal of any activist investor is to acquire a stake in an undervalued company, force it into implementing changes which unlock value for its shareholders, and then exit out of the position.  However, the stock market selloff of late 2008 left many activist investors in a precarious position.  Due to the declining markets, their positions have lost a considerable amount of value.  In the case of Ackman, he started acquiring shares in Target during 2007 when it was priced in the 60′s.  Yet, by this past spring, his levered investment had lost over 90 percent of its value as Target (TGT) shares plummeted.  Since that time, Target’s share price has rebounded into the mid-$40 range, and Ackman has pledged more capital to his investment (including $25 million of his own).  Nonetheless, while plummeting share prices can momentarily aid an activist investor in his attempt to drum up opposition to corporate boards or policies, it also renders him and his investors helpless in realizing any near-term profits.  What Ackman may have intended to be a quick profiting opportunity is slowly developing into a potentially long and drawn-out battle.

To be continued…

Tags: hedge fund, Not Categorized, start a new hedge fund

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If the actions of some of the hedge fund industry’s leading managers is any indication, the attractiveness of gold as an asset class is on the rise.  Several recent disclosures support such a conclusion.  First, a recent survey performed by London-based researcher, Moonraker, found that 20 out of 22 hedge funds had added exposure to gold bullion to their portfolios.

In addition, well known managers John Paulson of Paulson & Company, Inc. and David Einhorn of Greenlight Capital have upped their stakes in gold this past year.  Paulson, who will soon start a hedge fund aimed specifically at gold investments, has swallowed up shares in mining groups AngloGold Ashanti and Gabriel Resources.  AngloGold currently represents his fourth-largest holding at $108 million, while SPDR Gold Trust represents his largest holding, at $2.87 billion.  Likewise, Einhorn has reportedly resorted to purchasing and physically storing a sizeable position in gold, citing the cost effectiveness stemming from reduced fee exposure.

What, if anything, can investors glean from such information?  For starters, it is safe to assume that money managers are using gold investments as a hedge against the fluctuating value of the dollar.  Recent actions by the Federal Reserve to inject liquidity into the monetary system, as well as the funding of massive bailout and stimulus projects supported by the Obama Administration will likely place future downward pressure on the value of the US Dollar.  However, predicting the timing of such a drop in value is difficult, and depends upon a wide range of economic variables.  If one thing is for certain, the aggressive moves of Paulson and Einhorn suggest that the time to move into gold is right now.

Second, by claiming such massive stakes in gold, hedge fund managers may be steering clear of traditional equities.  As Market Folly reports, Einhorn claims “almost no net long exposure to equities.”  Such a position does not represent a vote of confidence for the broader stock market indices, and his comment may even hint that equities are currently overbought.  Moving into such a liquid investment as gold may hint a belief that we are in for a bout of market volatility in the near future.   Equities investors, particularly those with shorter time constraints, may want to take heed.

If the actions of some of the world’s leading investors is any indication, it may be worthwhile to reexamine your portfolio’s exposure to gold.  Given the enormity of our current fiscal, monetary, and economic concerns, such a position could add a safe and effective hedging option to your investment mix.

Tags: gold investments, hedge fund, Not Categorized, start a hedge fund

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