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By Neal Berger
Much has been said regarding the impending decline of hedge fund fees, investor demands of greater transparency and liquidity, capacity rights, and the fear of rapid redemptions if managers fail to comply. This may hold true for early-stage, pedestrian strategies, or lesser-quality talent.
But make no mistake: Managers who are truly “best of breed” and able to produce “alpha” ultimately hold the power and the ability to dictate terms to investors. They hold all the cards.
As hedge fund industry assets double, triple, and quadruple in coming years, the opportunity for investors to hire experienced managers producing real value for investors will become increasingly difficult. Although capital has been flowing into the hedge fund industry largely unabated and at an incredibly rapid clip, it is our view that recent regulation, such as Dodd-Frank, will act as a catalyst to heighten the pace of inflows. Given the advantages that hedge funds possess, coupled with their risk-adjusted outperformance, there is no reason to expect that the substantial uptrend and growth of assets the industry has experienced will come to an end anytime soon.
Rather than begging for assets, the highest quality funds are instead increasingly closing to new capital. Some have already closed and/or returned capital.
For those funds that truly capture “alpha” and exploit inefficiencies in the market, they are by definition in a zero sum game with a finite amount of capacity. This is particularly true of various arbitrage-oriented strategies. The amount of capital chasing those opportunities is quickly becoming saturated and funds focusing on capturing these inefficiencies are increasingly unwilling to accept additional capital due to their reluctance to dilute their returns. In other words, the demand/supply equation for “edge” is rapidly becoming less favorable due to the continued massive inflow of capital into the hedge fund industry.
Those managers making concentrated and discrete bets in large/deep markets based upon specific market outcomes (usually, rising equities in one form or another) will always have capacity. However, one needn’t buy a hedge fund to make the same bet as they could make on their own by buying an index fund or an ETF.
Some investors may expect that new managers will open up down the road and will generate alpha similar to today’s top funds. However, the training ground for hedge fund managers of the future is largely nonexistent. The typical career path of bank/investment bank proprietary trader to hedge fund trader to hedge fund manager no longer exists. Due to the Volker Rule and other reasons, the banks are simply not hiring and training new proprietary traders only to see them leave to join hedge funds in a few years once they’ve honed their craft. Furthermore, hedge funds do not have training programs for future hedge fund managers. To be sure, there are assistants and junior traders, but hedge funds are simply not interested in training junior staff (and allowing them to lose money honing their craft), who will later launch their own competing shops or join with existing competitors.
Additionally, for those traders/portfolio managers who are currently qualified to run/work at hedge funds, they have largely done so already.
As such, the talent pool of future hedge fund managers who are open and available to take investor capital will degrade rather rapidly. As this degradation happens, I personally have a feeling that investors will become even more desperate and panicked to invest in hedge funds for fear of missing the last available talent.
Contrary to the view that transparency is king, future investors in successful hedge funds should actually be prepared to invest under more restrictive liquidity terms to allow for the stability of the assets under a variety of market conditions. They should expect limited transparency so as not to jeopardize the franchise value of the partnership. Finally, they should expect to pay market-based compensation so as to enable the partnership to compete and thrive with the best talent available.
There will certainly be managers who will chomp at the bit to meet all investor demands. However, are those really the ‘best of breed’ talent that we’re all seeking? If you’ve truly got the goods, people generally know it and will place a high value on it. A manager who cannot adequately assess his own value and sells himself short is generally not the type of manager who will be able to accurately assess value in the market for other assets.
Neal Berger is president of Eagle’s View Capital Management, a New York-based hedge fund advisory firm and manager to a variety of onshore and offshore funds of funds.