More Hedge Funds are finding that Smaller is Better

September 14, 2011

With the lessons of the financial crisis still fresh in their minds, hedge fund investors are, nevertheless, still pouring billions of dollars into the already swelled portfolios of the largest, high profile hedge funds, and their fund managers aren’t doing much to discourage them.  The lackluster performance of many of the top hedge funds doesn’t appear to deter large investors seeking competitive returns in an increasingly volatile market environment.  In stark contrast, several small to midsize funds are shutting off the inflows and closing their funds to new investors. After experiencing rapid asset growth in the last couple of years, these hedge fund managers have turned their focus to fund preservation and return maximization.

With back to back years of negative returns a real possibility, many hedge funds managers have all but given up on theSmaller hedge funds prospect of earning performance fees this year. With only management fees to generate their compensation, many hedge fund managers are inclined to collect as many assets that are willing to flow their way.  Many of the top hedge funds have grown to levels that approximate or even exceed their 2008 levels leading some large investors to wonder if their assets could suffer the same fate as those that were entangled in the ensuing liquidity crisis. Such may explain the attraction of some smaller firms which have actually turned in strong performances over the last couple of years.

At one time, these smaller firms were outliers that struggled to attract large investors. They were also thought to be endangered due to the increasing costs and pressures of mounting regulations. But, hedge funds, such as Anthony Bozza’s Lakewood Capital Management have flourished by attracting the spillover from larger, overweight funds. Bozza’s fund has more than quadrupled in size to $900 million in just the last 18 months.  But, that’s where he holds the line. Without regard to the cap on his management fee income, Bozza is now turning to risk management and investor returns.

A number of other recent startup funds have also curtailed new investment after experiencing rapid growth. RouteOne Partners, Jericho Capital and Brenner West have all capped their hedge funds at less than a billion dollars to focus on investor returns.

All of these hedge funds share a very critical element which is at the heart of their extraordinary growth, and that is they have all been started by seasoned and successful managers who gained their experience and wisdom during the raging financial storm of 2008 while working with some of the industry’s top hedge fund firms.  For example, Bozza hails from SAB Capital Management and Kohlberg Kravis Roberts. These managers experienced firsthand the toxic mix of accelerated growth and panic redemptions left many hedge funds in shambles.

Applying a more disciplined approach to growth gives the smaller hedge fund some additional advantages in navigating the volatile waters of today’s markets. Their size enables them to react more quickly and seize opportunities that would otherwise pass unnoticed.  Essentially, they have recaptured the entrepreneurial spirit that had one time enveloped the hedge fund industry but has since been lost to the pressure of gaining size at the expense of returns.  Bozza’s Lakewood Capital Management has turned his more disciplined approach into an average 20% annual return since the fund was launched in 2007.

The success of these small and nimble firms has spurred several top tier hedge fund firms to spin off smaller versions of themselves captained by top tier management talent – a welcomed trend that should breathe a new life into the struggling hedge fund industry.

 

 

 

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