Hedge Funds Wilting under Weight of Poor Returns, New Regulations

August 31, 2011

In a year when expectations ran high for the beleaguered hedge fund industry, unspectacular returns and a tightening net of new regulations seems to portend an unhappy end for many small hedge funds. Coming off of disappointing performance in 2008, hedge funds have been experiencing increasing pressure from investors who have watched their alternative investments consistently underperform the S&P 500. In the spring it was a wave of new regulations spawned from the Dodd-Frank bill that weighed heavily on the outlook for small hedge funds, and then it was the August drubbing of long-short equity funds that may have been their crushing blow.

Of course, it wasn’t just the smaller or weaker hedge funds that have underperformed. High-profile funds, such as John Paulson’s Advantage Plus, have suffered steep declines on the year through the end of August. Unless they stage some sort of miraculous turn around between now and the year-end, it wouldn’t be any stretch of the imagination to foresee substantial fund redemptions as demoralized investors look for any kind of refuge for their battered investments. This is likely to spell the end of many smaller or weaker funds that have yet to fully recover from the hit they took in 2008.

Before the August decline, small funds were already feeling the squeeze on their bottom lines with the unleashing of Dodd-Frank induced SEC requirements that will add a whole layer of regulatory burdens on the once unfettered industry. The larger funds are equally targeted for regulation; however, they are better positioned to absorb the costs of increased compliance.

But, until their performance improves, most hedge funds are relying heavily on management fees which may not be enough to carry smaller funds very long into the future. Even the larger funds will find their management fee revenue fall as investors pull their funds.  And, in their weakened condition, many hedge funds may need to succumb to the growing demands of investors to negotiate lower fees, or a shift to performance fees which will stunt cash flow and reinvestment capital.

Some industry observers don’t believe that there will be a rush to the exits by investors, especially since there are not a lot of attractive alternatives.  But those who do predict investor fallout think that the industry may benefit in the long run as excess supply is shaken out. At $2 trillion, assets under management are at a peak level, and the number existing hedge funds have crested at their pre-crisis level. What may turn out to be an unhappy end for many funds may be just the medicine to return the industry to health.

 

Previous post:

Next post: