S&P Downgrade May Force Many Emerging Fund Managers To Close Shop

Aug 10 2011 | 12:04pm ET

By Steven Simmons, Head of Prime Services, Maxim Group -- As the fallout continues from Friday’s downgrading of the U.S. debt by Standard and Poor’s, the pundits have begun the guessing game as to which “too big to fail” hedge funds are actually failing, or at the very least, being forced to exit positions in order to reduce their extensive leverage. Meanwhile, the gasping sounds you hear at the other end of the spectrum are the collective last breathes being drawn at numerous emerging and midlevel hedge funds. For those lucky few funds that were able to survive 2008, 2011 may end up being the year written on their tombstones for several reasons.

The first reason is very simple – the inflows that had been on the rise in 2011 (roughly $75 billion according to Barclay Hedge and Trim Tabs, which is the heaviest first half inflow since 2007) will not only stop, but reverse.  Human nature has shown time and again that when you have calamitous market moving events like this, the natural first move for investors lacking the intestinal fortitude is to sell (if possible) and to bury the money under the mattress. For most hedge funds, $100 million dollars is the barest minimum required to truly create and maintain a thriving business. To the layman, this may seem like a staggering number, but once the actual costs of running the business of a hedge fund are taken into account, that $100 million is chump change, and also the reason why the funds with the top 10% funds in assets under management continue to take in 90% of the new money. It is simply too expensive to run a small fund based on the fee structure of 2 and 20 – if they can even get that these days. After building out an institutional caliber infrastructure including legal fees, auditors, administrators, real estate and equipment, salaries, execution costs and research, there is little, if any, leftover for actual marketing and fund growth. 

The old adage of “it takes money to make money” rings true. At a recent Family Office conference in Newport, numerous developing managers paid a respectable fee for the opportunity to pitch themselves to a relatively captive (and moderately receptive) audience of family offices and endowments. For budgetary reasons for many of these funds, this was the only true marketing opportunity of the year for them – failure to capitalize and deliver a resounding message could mean failure, period. Paradoxically, many of the successful funds will suffer the same ignoble fate of successful funds in 2008 and be used like ATM’s for investors seeking redemptions. Many of these funds will not be able to survive the withdrawals.

Secondly, performance is once again going to take the spotlight. Qualified institutional investors reviewing potential hedge fund candidates for allocations typically look for performance dating back to 2008.  Slight underperformance in giddy years like 2009 and 2010 can be overlooked if the funds performed well in 2008. Typically one of the first questions I hear from investors regarding 2008, is “What did they learn?” And more important, “How have they protected themselves moving forward?”

For many of the developing managers that were toddlers in 2008, 2011 was going to be the make or break year for them. A meandering, non directional market would be their opportunity to shine and show their ability to truly create alpha—anything less than outperformance is simply inexcusable, and a mediocre to negative performance is more or less the kiss of death. There are simply too many other funds out there who are significantly outperforming both their peers and their benchmarks, particularly among the emerging and developing manager subset.

Lastly, there is the flight to quality issue. In this case, I am referring to the talented employees at the underlying developing funds. While many of these folks have made the move from the larger, well established hedge funds or sell side-shops, the very palpable fear of going another year with a reduced or nonexistent paycheck is going to be too much to stand. This is especially the case for the folks in the investor relations and capital development positions. Many of these talented individuals may have the greatest rolodexes and relationships with the key check writers, but unfortunately they are not magicians, and their hands are tied if the fund is underperforming. Loyalty may be an admirable quality, but it does not pay the mortgage. For many of the funds that were already on life support, they will not have the capital to retain or attract the potential talent required to resuscitate the dying patient.

Being in sales it is my nature to be an optimist, and even as dismal as the picture may be, a few glimmers of hope remain. First and foremost, for institutional investors, the inevitable shakeup within the hedge fund industry is a much needed separation of the wheat form the chafe that was not completed in 2008. There are too many mediocre to poor funds creating unnecessary noise and static, often overshadowing the numerous undiscovered, developing funds that are not only surviving, but thriving in this current tape. The essential combination of shear talent, a nimble touch in the market, and highly tested and utilized risk measures are key factors for those prescient investors looking for true diamonds in the rough. Additionally, talent will attract talent. For many of the funds that do survive the impending carnage, there will be many talented individuals who will leave sinking ships and further bolster the ranks of those funds that are out performing and well positioned to grow. And naturally, there will be a spate of new startups and emerging managers consisting of very talented teams who will bring more to the table than their predecessors, thus regenerating the cycle of fund development and growth. 

Steven Simmons is the Head of Prime Services for Maxim Group, an independent, full-service broker dealer and investment bank catering to the needs of emerging and established hedge fund managers.

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