By Eric Jackson
03/06/09 - 11:05 AM EST
Last November, fund-of-hedge-funds manager Sandra Manzke of Maxam Capital Management sent out a Jerry Maguire-esque letter to her investors in which she stated that she was "appalled and disgusted" by the behavior of hedge fund managers today.
They no longer acted with investors' interests in mind, she said, as they did 25 years ago when she founded Tremont Capital. Managers today followed questionable practices like "gating, side pocketing, suspension of redemptions ... attempting to get their money out ahead of investors, [and] eliminate[ing] high water marks".
At first, Manzke was portrayed as a whistle-blower trying to get the rest of her greedy industry in line. Then, Bernie Madoff happened. In the fallout, it came to light that both Tremont and Maxam were heavy Madoff investors. Earlier this month, both firms separately announced they would have to shut down as a result of Madoff-related losses. Ironically, the firms (like many Madoff investors) did little to no meaningful due diligence and were content to play middlemen for a performing product and collect their fees. The would-be reformer should have started her efforts in her own backyard.
Hedge funds are much maligned in the press and by politicians these days. They do have some failings which need correcting, which I plainly see as a hedge fund manager myself. However, the industry will continue to attract talent, innovative strategy, and capital as a result in the coming years. Here are some of the problems with hedge funds but reasons why the industry is still an attractive place for your money.
Gating While Charging Fees is Unacceptable
A number of funds -- large and small, including ones with formerly sterling reputations such as Citadel, Farallon, and DE Shaw -- have exercised their rights to enforce a gate in the last few months, reducing how quickly investors can redeem out of the fund. The intent of a gate is to prevent a panicked run on the fund, requiring forced selling, which can be very difficult for funds holding illiquid assets, and which further lowers the value of the remaining investors' assets in the fund.
John Paulson, whose fund was up 38% in 2008, has criticized fellow managers for invoking gates, and Leon Cooperman, who runs Omega Advisers, told The New York Times "you'd have to lower me into the ground before I'd put up a gate."
In my view, erecting gates is not ideal but defensible for a manager, since the possibility is fully disclosed to investors up front. However, it's deplorable that so many hedge fund managers have recently put up gates and then continued to charge fees after doing so. That certainly hasn't engendered goodwill with investors.
Among the funds still charging full or partial management and performance fees after erecting a gate, according to several industry participants I've spoken with: Citadel, Cerberus, and Highbridge Capital Management. One fellow manager expressed deep frustration at this practice of charging fees post-gate: "It's almost criminal. It gives all of us in the industry a bad name." Some funds are doing the right thing: Farallon is not charging fees to its investors kept in by their decision to use a gate last fall.
And, of course, just as no one is paying attention to the consumers who never got themselves into a loan they couldn't afford, let's not forget the many funds that had down years in 2008 and yet imposed no gates. They've given up fees on capital that left but could have been forced to stay. Some of the funds taking the high road are Atticus, Clarium, Harbinger, Maverick, and Tremblant. These funds faced the same "unprecedented" or "Perfect Storm" market conditions and yet were still able to maintain adequate liquidity and confidence in the marks on their positions in order to pay out requested capital to their investors. These funds are taking the long-view on this issue and will benefit in future fund-raising when this current down cycle turns.
Pay for Performance Works
Hedge fund critics are quick to jump on the issue of manager compensation. Critics say hedge fund managers should always make money, no matter the market or the strategy being followed. But not every hedge fund manager is following an absolute return strategy. One of the great things about hedge funds is that there is such a diverse choice of strategies and exposure levels.
Sadly, some hedge fund managers don't help themselves in the court of public opinion -- call it John Thain-itis. Most profiles of hedge fund managers include references to private jets, homes in the Hamptons, and flashy lifestyles. Discussions about managers giving to the Robin Hood Foundation are less common. A fund-of-hedge-fund manager recently told The Wall Street Journal: "I was definitely overpaid in the good times and now I'm definitely being underpaid in the bad times."
Those comments don't put anyone in the industry in a good light (especially that manager) but, at the end of the day, these comments or whether some manager buys a flashy car, has no predictive value on whether a hedge fund is a good investment. The truth is that hedge fund managers basically will only survive as a firm if they perform. If not, they'll be out of business (as many will in the next six months) and going into a different industry.
Most investors I know don't mind paying fees, as long as they get acceptable performance. When they don't, they redeem -- as they are in spades at the moment in the industry.
Don't Tinker With High-Water Marks
Hedge funds typically have high-water marks, which require managers to make their investors whole before resuming paying themselves performance fees. These high-water marks are going to cast a large shadow in the industry for the next few years. Ken Griffin of Citadel, which dropped 55% in 2008, said recently that he and others at his shop would only be working for "psychic income" for the next few years, as they crawl out of their negative performance hole.
Some critics have said that high-water marks are not the panacea they seem. If you have a down year, these critics say, you can just shut down your fund to avoid the pain of making back past losses and open another shop up across the street. Although this can and does happen, it's equally common for hedge funds to honor their high water marks instead of taking the "easy" way out and shutting down, eliminating the high water mark, and re-opening later.
There are examples of shirking performance responsibility in smaller hedge funds. In early 2008, before the real stock market pain hit, Dan Zwirn was forced to shut his hedge fund DB Zwirn & Co. when it came to light that he had improperly paid for a jet with investors' money (amongst other back-office issues). His performance had been steady and successful prior to those revelations. Zwirn claimed the improprieties were the fault of poor back-office oversight by his CFO and wasn't linked at all to the strategy he had overseen successfully.
Because his strategy involved stakes in many illiquid assets, it will take time to fully wind down DB Zwirn. However, only a few months after the decision to shut down, rumors began to circulate that Zwirn would be launching ZLC Global -- a new fund following exactly the same strategy as DB Zwirn & Co. Many DB Zwirn & Co. investors were going to be investing in ZLC Global, according to reports. It is puzzling that some investors can be so forgiving, but this behavior is isolated and does not undermine the value investors' gain from high water marks.
Some hedge fund managers have tried to bend the rules in their favor to collect more in fees. For example, Steve Mandel of Lone Pine Capital abides by a high-water mark but can get some portion of a performance fee the next year, if he surpasses a hurdle. In other words, you don't always have to live off psychic income if you had a bad previous year.
Another bad practice that should be changed is when hedge funds insist on long lock-up periods -- say three years -- during which they still pay themselves management and performance fees annually. They don't typically claw-back their year one performance fees if they have a major performance drop in year three.
Investors will rightly have less tolerance for these "innovations" going forward. If managers screw up, they need to pay the consequences. It's that Darwinism which makes the industry strong and should give no investor qualms about having to pay performance -- or more correctly stated, revenue-sharing -- fees.
The hedge fund industry will work out its excesses carried over from the last five years and become a stronger collective of funds and fund managers. Most of the lemmings will leave, until the industry once again begins to experience excessive growth. Oversight must and will improve. Lessons should be learned. But in one, five, and 10 years from now -- no matter the macro environment -- investors will still flock to hedge funds because it attracts the best managers with the most creative strategies.
Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.
Friday, March 06, 2009