Steven Drobny, Co-Founder and Partner, Drobny Global Advisors
The issues facing hedge funds of negative average industry performance, increased redemptions from limited partners, and fund terminations are not new. In fact, the industry faced similar issues in the 1970s. The question now is how the hedge fund industry will adapt and evolve in the current environment.
Through the first quarter of 2009, hedge funds overall were down an average of 20 percent, but one in three realized positive returns over the same period. At approximately 2 percent, hedge funds account for a relatively small percentage of global assets under management. However, hedge funds have accounted for a disproportionate share of attention from the financial media due a handful of high-profile implosions. The panel of two fund managers, two pension fund limited partners and an industry consultant were largely in agreement on how the industry got to where it is today.
Jason Cummins said hedge funds got into trouble simply by taking on excessive risk with high leverage levels. Managers have historically been incentivized to "reach for yield," necessitating a move to riskier assets. As a result, Joseph Dear said, the compensation structure for hedge fund managers needs to be modified. "A serious misalignment of interests exists in the current model," Dear said, and a move toward pay for performance, increased transparency and an institutional model is needed.
Orin Kramer, also on the limited partner side, agreed with Dear's assessment and suggested that hedge fund managers adopt characteristics of a private equity fund structure with preferred returns for LPs and clawback provisions. Marc Lasry said increased transparency is necessary and not an unrealistic expectation from investors.
The panel agreed that screening from managers simply based on low fee schedules would lead to a negative selection bias. However, the LP representatives were emphatic that regardless of the fee structure adopted by a hedge fund, interests must be aligned with their investors and compensation should be based on performance.
When discussing the near future of asset allocation and fund flows to hedge funds, Stephen Nesbitt was optimistic about growth in hedge fund assets for multiple reasons. First, large institutions need to take calculated investment risks because depressed asset valuations across their portfolios mean that pensions are significantly underfunded. In addition, other asset classes are not terribly attractive on a risk-adjusted basis relative to hedge funds. Nesbitt expects to see more movement of money into hedge funds in the last quarter of 2009 and continuing into 2010.
Looking forward, Cummins said the macro economic environment will experience materially more volatility than historical levels. After the shakeout of the past 12 months, best-in-class managers will emerge and will be well-positioned to capitalize on an environment of decreased competition and increase volatility. Lasry described potential government regulation of the hedge fund industry with the simple statement, "It's not if but when."
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