Taking the first point, if the hedge fund industry truly is about alpha, we expect more investors to question whether incentive fees should be paid on outperformance, not just performance. Unlike private equity managers, hedge funds pay themselves incentive fee compensation on unrealised appreciation – paper profits – as well as realised gains.There is a frequent misalignment between the annual cycle for the manager’s incentive compensation and both the investment time horizon and the period over which investors must commit their assets.Hedge fund managers receive an incentive fee on any positive performance, not just performance above the market (ie for all the talk of alpha, hedge fund managers get paid on beta as well).It can be argued that the current hedge fund fee model has multiple flaws:
In the New World, investors will ask whether a 2% management fee and 20% incentive fee remains a valid compensation structure.
We have distilled these themes into five questions which, we believe, are of relevance to both investors and managers in this New World. Operational risk will also become a greater concern as investors grapple with a multitude of non-investment issues ranging from counterparty risk management to the use of withdrawal gates and provisions to suspend redemptions.Ĭurrent events prompted us to review our posts over the past year and, while we have touched on numerous issues, several common themes emerge. Irrespective of the manager under consideration, it will no longer be possible to rely primarily on manager reputation and historical track record. Going forward, investors will be more rigorous and systematic in their hedge fund selection and due diligence process. Indeed, a period of retrenchment may be helpful: after the astonishing growth of hedge fund assets over the past five years, the current environment gives the opportunity to adjust, refine, and over time create a stronger and more stable industry. This is not to say that hedge funds will not remain integral to diversified, institutional portfolios, and we expect investors to retain confidence in the long-term validity of alternative investment strategies. Current market events will unavoidably lead to a re-evaluation of the hedge fund model and, in the short term, a contraction of industry capital.
The hedge fund industry will not be immune: while some hedge funds have performed well, many have faltered and some have failed spectacularly. It goes without saying that, after the events of the past 18 months, markets will not be the same: both investors and money managers will face a “ New World“. The credit crisis which first began in mid-2007 – with the failure of a hedge fund managed by Bear Stearns – has now accelerated to create the most severe financial market dislocation since the Great Depression.
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