Nouriel Roubini, not too long ago considered an alarmist by many, has been so right (while so many were wrong) that his missives are quickly becoming must reads by anyone even tangentially involved in the capital markets.
...The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken excessive risks with high leverage and are poorly managed may collapse. A massive shake-out of the bloated hedge fund industry is likely in the next two years.
A Global Process of Deleveraging
Easy money. At the heart of our current financial crisis is a systemic disregard for risk which in turn fueled an asinine bubble in worldwide liquidity. The availability of easy money stemmed every rung of the economic ladder. Consumers got easy car loans, homeowners got easy mortgages, corporations fueled M&A and buybacks with easy debt, MEW was plentiful, historic LBOs, unprecedented money growth in emerging and developed sovereign nations. You name it, the liquidity was there. The notion of "what goes up must come down" is more than a truism in this case. While we're beginning to understand the significance of the mess we've collectively made, anyone that thinks the Paulson Plan magically gets us through the normalization process needs to revisit their statistics textbooks from university.
Felix Zulauf explained the situation succinctly in this week's Barron's [sub required]:
The leveraging-up in this cycle is reversing, and we are now deleveraging. When a huge system -- that is, the global credit system dominated by the investment-bank giants that have been the major creators of credit in the last cycle -- turns down, the fallout is going to be terrible. Deleveraging is a very painful process, and will run longer and deeper than anybody can imagine.
Quantifying Hedge Fund Leverage
The hedge fund industry has grown up during the liquidity bubble. That's no coincidence. I've had a number of people ask me what the "typical" leverage profile is within the industry. A recent study by the ECB puts the average hedge fund leverage at 1.4x-1.5x in its most recent analysis; with the caveat that leverage was declining in the face of tighter credit conditions. Unfortunately, even if this number proved accurate, knowing the Mean for our industry isn't very helpful in estimating the potential fallout that Roubini predicts.
- Hedge funds are fluid instruments and a snapshot is just that, a snapshot. Industry leverage can change dramatically in a matter of weeks. Quarter to quarter is anyone's guess
- The mean isn't predictive given the dispersion of styles and risk characteristics within our industry. There are funds that use little to no leverage, and there are firms that use 10-12x leverage [think Bear Stearns Enhanced Leverage Fund]
- The majority of funds are unregistered and unregulated, creating an opacity of disclosure
But Wait, There's More...
1.5x leverage doesn't seem as bad as you thought, right? Well that only accounts for a component of the unwinding Roubini is hinting at. A good chunk of hedge fund capital comes from fund of funds; which use leverage to generate their returns. Still not enough for you? Then remember that lots of hedge funds used that capital to invest in highly leveraged debt instruments (i.e., CDOs).
Way back in January 2007, Gillian Tett of the Financial Times [sub required] relayed a story from an anonymous emailer who expressed disbelief at the ease by which hedge funds have been able to lever up as much at 50:1 [admittedly an extreme example]:
He then relates the case of a typical hedge fund, two times levered. That looks modest until you realise it is partly backed by fund of funds' money (which is three times levered) and investing in deeply subordinated tranches of collateralised debt obligations, which are nine times levered. "Thus every €1m of CDO bonds [acquired] is effectively supported by less than €20,000 of end investors' capital - a 2% price decline in the CDO paper wipes out the capital supporting it.
"The degree of leverage at work . . . is quite frankly frightening," he concludes. "Very few hedge funds I talk to have got a prayer in the next downturn. Even more worryingly, most of them don't even expect one."
Don't Cry for Me Argentina
Right now the "Main Street vs. Wall Street" sentiment is at a fever pitch and, for as little sympathy the average citzen has for the travails of Lehman, AIG, Goldman, Morgan Stanley, et al...you can be sure they have less sympathy for the hedge fund industry. We're big boys (and girls) and the rational among us can't reasonably expect the kind of blank check bail outs being afforded the investment banks, insurers and traditional lenders.
- Unregulated = Unprotected -- The pound of flesh the government is demanding for this monster bail out is HEAVY REGULATION; and as an industry we've fought continuously against oversight. Ironically, if the HF fallout is severe enough, we're probably facing increased regulation when all is said and done anyway.
- Easy Political Targets -- The blame game is already underway. While I personally think it's counter productive to spend cycles figuring out who to blame [especially b/c just about everyone is culpable in a mess of this magnitude], it's an ELECTION YEAR and politicians need someone to rally against. Since they can't blame over-leveraged consumers [they need those votes] and assuredly won't blame themselves [how can they win re-election that way?], hedge funds are an easy target.
- Short-selling criticism is a harbinger -- I've already said my piece on the silliness of the short-selling ban; but that isn't stopping the politicians from beating the "short selling = evil" drum.
Drowning in High Water
Deleveraging and public criticism are just two of the issues at play right now. The proverbial other shoe to drop is the incentive allocation model. For those who aren't familiar with how hedge funds are structured, typically we collect a management fee (based on a percentage of assets under management) and a performance fee (based on a defined percentage of the net profits during a given fiscal period). But what happens when a fund manager fails to generate a positive return? We're subject to a high water mark:
Where a hedge fund applies a high water mark to an investor's money, this means that the manager will only receive performance fees, on that particular pool of invested money, when its value is greater than its previous greatest value. Should the investment drop in value then the manager must bring it back above the previous greatest value before they can receive performance fees again.
In other words, if a fund loses 10% in Year N, it has to make back that 10% in Year N+1 before it can begin accruing performance fees.
Nine of out Ten Hedge Funds are Under Water
According to a recent survey by EurekaHedge, 97% of the 4,000 funds it surveyed were under their high water mark as of July 31st. That shouldn't be a surprise given where the equity indices currently sit, but it does raise the question of what the resulting impact will be. Barring a major turnaround in the capital markets between now and year end, the majority of the world's hedge funds won't receive performance fees.
Thoughts on the potential fallout:
- Large, multi-strategy mega funds will weather the storm better than most -- The mega funds are diversified and well capitalized to weather a down year or two. Presuming the aggrerate returns aren't significantly below the high water mark, the potential to quickly get back above water in 2009 will be incentive. Furthermore, top performers at smaller funds will likely look upon the relative safety of working for a mega firm in a new light
- Hundreds, if not thousands of funds will shut down, merge or recapitalize -- Some fund managers will simply close their doors and move onto other initiatives; returning capital to LPs and living off their past proceeds. Others will look to "get big quickly." Expect many funds that fall significantly under water to lose top performers who would have otherwise generated performance fees on their own portion of the portfolio
- Capital raising will become more difficult -- This is already happening but capital raising will become more difficult; particularly as fund of funds and large institutions struggle to justify past investments in toxic CDOs and other leveraged, non-performing assets
- Investors will demand more transparency -- This is self explanatory, and inevitable
- Aggregate returns will moderate -- Systemic deleveraging means more muted aggregate returns. For funds that have made their way using little to no leverage [full disclosure: we are one of those entities], this hopefully brings opportunity
Tumultuous times are ahead, for every portion of the financial world. Roubini's prediction that hedge funds have a period of rationalization ahead is both logical and highly likely. There will be pain; much of it necessary. But those who stay focused on the task at hand, execute within their stated investment parameters, and balance the need for absolute returns with the need to service and protect their partners against undue risk will not only survive, but flourish. Changes are inevitable, but I for one don't necessarily think that's a bad thing -- longer term, of course.
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