Trevor Ganshaw is a partner at a multistrategyhedge fund in New York City.His articles have been published inthe Journal of Applied Corporate Finance.

HEDGE FUNDS HUMBLED

The Seven Mistakes That Brought Hedge Funds to Their Knees and How They Will Rise Again

By Trevor Ganshaw

The McGraw-Hill Companies, Inc.

Copyright © 2010 Trevor Ganshaw
All rights reserved.
ISBN: 978-0-07-163712-1

Contents

Introduction: The Tale of a Sharkone The True Evil in Hedge Fund Compensation (No, It’s Not Greed)two Excessive Leverage: Gorging at the Buffetthree Narcissistic Risk Managementfour Hedge Fund Correlationfive The Hedge Fund Peter Principlesix Capital Instability and Illiquidity: A Toxic Combinationseven FraudConclusion: The Road to RedemptionEndnotesIndex

Excerpt

CHAPTER 1

THE TRUE EVIL IN HEDGE FUND COMPENSATION(NO, IT’S NOT GREED)

For the past several years, Alpha magazine has provided an annualranking of the top earners in the hedge fund industry. Each year, the numbers atthe top of the heap grew more astonishing. By 2007, the top 25 individuals hadearned a combined $20 billion—including five managers who made more than$1.5 billion each in a single year. Even the list’s bottom feederswalked away with more than $200 million apiece. Many entrepreneurs in otherindustries have attained such wealth, but there are few outside the hedge fundindustry who became so rich so quickly.

Predictably, the recipients of this bonanza were not afraid to spend theirnewfound wealth. Reports of the inevitable excess proliferated: private jets,mansions, longer-than-yours yachts, weddings at Versailles, $8 million pickledsharks, and so on. Even the horrendous investment performance of 2008 turned outto be nothing more than a speed bump to the hedge fund Brinks truck; nine- andten-figure paychecks continued to be cut.

With the world mired in a deep recession in 2009, it was hardly surprising thataccusations of greed were being thrown about daily by national leaders,editorial boards, talk show hosts—anyone, really, looking to score easypoints. President Obama called Wall Street bonuses “shameful” within his firsthundred days. French president Nicolas Sarkozy declared that he was “shocked” bythe “system of bonuses for traders.” “That’s what we need to change,” he said.

Terrific sound bites, perhaps, but the true evil of hedge fund bonuses has lessto do with greed than with the inherent flaws embedded in many compensationschemes—flaws that can encourage excessive risk taking and promote anarray of other unintended incentives.

To begin with, any investor seeking to place capital with a hedge fund mustagree to the predetermined fee structure. This typically includes the managementfee, which is paid quarterly and derived from the amount of assets managed. Italso includes an annual performance fee that gives the manager a percentage ofany gains that are produced and, in many cases, an expense pass-through oncertain costs the fund incurs. Although the levels most frequently cited for theindustry involve a 2% management fee and a 20% performance fee, there arecountless variations ranging from 1% and 10% to 3% and 30%. The particularstructure a manager chooses is derived from the strength of the fund’s trackrecord, the investor lockup period, performance hurdles, and so on.

Given these percentages and the amounts of money being handled, it’s quitesimple to determine how such enormous compensation levels are reached. If ahedge fund with a 2% and 20% fee structure is managing assets totaling $5billion, gross fees of $300 million can be generated by the good (but notspectacular!) return of 20% in a year (2% management fee plus a 4% performancefee).

The issue at hand is not one of “fairness.” These fees are the simple, directresult of a contract entered into by a group of experienced investors and amanager. Everyone reads the fine print and signs; if a manager then delivers onthe agreement and generates positive performance, she has earned hercompensation, however high it may be.

Rather than bemoaning greed, it’s far more productive to determine if hedge fundcompensation formulas create proper manager incentives. That is, do they fosteralignment between the manager’s interests and the risk-return objectives of theinvestors? Or do they instead create adverse incentives that divert a fund fromits longer-term investment objectives and lead to increased risk or evencatastrophic loss?

A Free Call Option

One aspect of hedge fund compensation that seems to invite excessive risk is theinherent asymmetry of the compensation formula. By design, these formulas createa “call option” payoff with a huge upside for good returns and a very restricteddownside for poor ones. For instance, if a hedge fund is particularlysuccessful, gaining 20% to 40% in a year, the payoff can be enormous, totaling4% to 8% of AUM in incentive fees on top of a 2% management fee. If the hedgefund loses the same amount in a year, the fund still receives its 2% managementfee but no incentive fee. Despite this optionality, it has been very rare for afund to allow fee “clawbacks”—the return of fees from a prior year if thecurrent year is substantially down, even if the underlying assets are the sameor similar. So not only is the fee structure a win–win for hedge funds inany given year, it is a win–win from year to year.

The only downside for the manager is the existence of a “high water mark” (HWM)in many funds. An HWM is a stipulation that requires the manager to make backany previous year’s losses before new future performance fees can be paid. Forsmall losses, this can be an effective mechanism for aligning a manager’sinterests with those of the fund’s investors, but in the event of largelosses—such as those accrued throughout the industry in 2008—the HWMis problematic. The managers, unlikely to recoup the HWM in the near term, facethe prospect of several years without performance fees. This in turn makes theattraction and retention of top talent much more challenging, which furtherreduces the likelihood of attractive future returns.

A small number of funds have attempted to mitigate these difficulties bycreating modified HWMs that allow for a reduced performance fee, typically 10%,to be paid after posting a down year, with the provision that this lower feewill remain in effect until some greater percentage (often 130%) of the lossesare recovered. This kind of fee structure helps to minimize the problems oftalent retention and operation. However, for any fund facing deep performancelosses without such a modification to its fee structure, the HWM can prove to bea death knell, forcing the manager to close the fund and attempt to start a newone. Given the high cost of asset liquidation, closing a fund is no picnic foreither the fund or the investors.

However you slice it, though, each of these provisions helps to ensure that thehedge fund manager always shares in the upside while the investor always eatsthe downside.

Fool Me Twice?

Some argue that the counterbalance to asymmetric hedge fund economics is theloss of a manager’s reputation after a fund has failed. According to thisargument, a poorly performing or failed fund will so damage the manager’s mostvaluable asset—his reputation—as to end his career in the industry.Thus, the manager’s innate desire to remain in the club of unimaginable wealthwill always curb any urge he may have to exploit the advantages of the imbeddedcall option.

It’s a nice argument, and it would be nicer if it were true, but the recentsuccess of failed hedge fund managers blows this argument full of holes. Infact, managers have jumped clear of some of the biggest flameouts on record andinto new positions where they quickly attracted new capital. John Meriwether’sfund, Long-Term Capital Management, infamously collapsed in 1998. The next year,he launched JWM Partners LLC, which flaunted close to $2 billion in AUM by early2008; Geoff Grant, cofounder and CIO of Peloton Partners, launched a new fund,Grant Capital Partners, only months after his former $2 billion firm collapsedunder the weight of steep losses and lost financing. Nick Maounis, founder ofAmaranth Advisors LLC, who oversaw the largest hedge fund collapse in history,also has a new venture in the works. The list goes on and on.

In the end, the call option embedded in the hedge fund fee structure results inunfathomable riches for the manager if things go well and “getting by” onmanagement fees if they don’t. In a worst-case scenario, if the fund failsaltogether, the manager can simply close it and reboot with a new fund.

The dangers of this asymmetry are pretty clear. In an effort to maximize thevalue of the call option, a fund might take on excessive leverage, engage inhigh position concentration (that is, bet the ranch), adopt inadequately hedgedpositions, or take other big risks.

Unfortunately, the incentives created by the compensation call option are notlimited to senior managers. The same type of asymmetric payout exists for theportfolio managers of most funds as well. Many funds separate portfolio managersinto separate strategies, or “silos,” and give them a percentage of the upsidein their investments for the year, typically equaling 50% to 75% of the fund’s~20% performance fee, or 10% to 15% of their profits.

Smarter funds also incorporate some portion of overall fund performance intoportfolio manager compensation formulas as a way to better align traderincentives and mitigate the temptation to bet big in any one portfolio. Evenwith these modifications, though, most portfolio manager pay models remainentrenched in a call option mentality: big gains generate big compensation,while losses net you a salary and one or more chances to shoot for the moonagain.

At most hedge funds, a risk management team exists that is tasked withmonitoring portfolio manager attempts to take outsized risks. Unfortunately, thetrack record of these efforts within the industry has been at best inconsistent.Consider the case of Brian Hunter of Amaranth Advisors. In 2005, he made a big,bullish bet on natural gas that paid off handsomely when Hurricane Rita hit theUnited States. His pay for the year was estimated to be approximately $75million. Fresh off this stunning success, he ramped up his risk in the naturalgas market, amassing more than $10 billion in trades and controlling an amountequal to, at one point, roughly 25% of the annual U.S. residential natural gasconsumption. This time, however, his luck wasn’t as good. Less than one yearafter his $75 million payday, his trades contributed to losses of more than $6billion and led to the collapse of the firm. Today, he is gainfully employed ata new fund and apparently still enjoying what is left of his $75 million fromAmaranth. (See Chapter 5 for a more detailed discussion of Amaranth andBrian Hunter.)

Recognizing the flaws in this compensation strategy, some funds have developednonformulaic, subjective “anti-silo” pay plans that incorporate individualportfolio manager P&L, overall firm performance, movement of capital fromunderperforming sectors or strategies, information sharing, etc. While these payplans do address many of the problems associated with the fee call option, theycan also drive exceptionally talented managers to seek potentially biggerpayoffs at funds with formulaic compensation.

Perhaps the best defense against imbalances and abuses will always be greaterownership of the downside risk by a fund’s partners. The best risk managementteams tend to be found at firms where partners have the majority of their ownwealth invested in the funds, such as Steve Cohen at SAC Capital and Jim Simonsat Renaissance Capital. Loss of reputation is one thing. Loss of one’s fortuneis quite another.

Realized Fees on Unrealized Gains

For many hedge funds, paying fees on investment gains produced by the fund is arelatively fair and simple matter. If the fund’s underlying investments areactively traded—as is the case with many long-short equity, global macro,and commodity funds—then the fund can easily respond to any loss of itsequity or debt capital by quickly selling (or buying, if short) assets atprevailing market prices and returning the capital. In these cases, investorsexit the fund having paid fees that accurately reflect the fund’s performancefrom initial allocation to redemption.

Other funds, however—particularly those that invest in long-dated and lessliquid assets—can sometimes create a much less balanced and more painfulfee outcome for investors. In these cases, many funds will finance these longer-dated assets with monthly or quarterly equity and debt capital. If this capitalis lost or redeemed, as it was for many funds in 2008, the fund can be forced tosell its illiquid assets at heavily discounted or fire sale prices. For aninvestor who has paid 20% performance fees year after year, a premature sale ofthese investments at deeply discounted prices can wipe out years of gains andleave the investor stuck with fees paid on gains that were never realized.

Consider the hypothetical $1 million hedge fund investment shown in Table 1-2. This simplified analysis assumes that a hedge fund generated 15% grossreturns per year for three years and received a 2% management fee and 20%performance fee each year. Assume that on the first day of the fourth year, thefund lost a substantial part of its debt and equity capital and recorded a 25%decline due to forced sales of illiquid assets (effectively, this is whathappened to scores of funds in 2008). At the end of year three, the $1 millioninvestment had generated a net compounded return of 34.5% after management feesof $66,456 and performance fees of $86,393. Not bad. However, the 25% loss earlythe next year is a killer. The fund’s three-year annualized return drops to0.9%, and yet the fund retains performance fees equal to 8.6% of the initialinvestment for performance that was never realized. Total fees for the threeyears exceeded 15%.

Prior to the credit crisis, very few hedge funds that trafficked in illiquidsecurities had a mechanism to deal with this problem. After 2008, however, manyinvestors, having been flogged by fees on unrealized gains, called for the useof clawback mechanisms in funds that invest in longer-dated assets. Clawbacksare a means to better match performance fees with the realization of theperformance. They allow investors to recover all or a portion of previously paidperformance fees after a period of negative performance. CalPERS (CaliforniaPublic Employees’ Retirement System), a California public pension fund and oneof the largest hedge fund investors, and the Utah Retirement Systems (URS) bothendorsed this approach in 2009.

In practice, however, it is difficult to implement clawbacks. After all, afuture promise to return fees is only as good as the creditworthiness of theobligor. Also, if a fund collapses, there may be little left to return. Oneoption that has gained backing from institutional investors involves escrowing aportion of annual performance fees in a segregated account for a term of severalyears. For other managers of illiquid assets, such as private equity funds,deferred performance fees are commonplace: a private equity “carried interest”performance fee is paid only when the investment is realized and investors havereceived repayment of their original capital. As the hedge fund industry looksforward, a clawback feature will most likely be part of many successful funds.

Artificial Alpha

A related but far less common problem with hedge fund fees involves, for lack ofa better term, “artificial” alpha. The term ITLαITL describes a manager’sability to generate returns in excess of a benchmark index or riskless interestrate. For the vast majority of managers, this alpha is achieved through deepfundamental research, superior market or industry knowledge, and strong tradingskills, among other advantages.

In some cases, however, managers can either knowingly or unwittingly generateexcess returns that appear to be real due to their size and consistency but areactually short-term gains created by leveraging small interest payments or otherconsistently paid premiums in exchange for taking on large downside exposures.Like many other dubious investment propositions, it worksbrilliantly—until the hurricane blows in. Only then is the fallacy of theventure uncovered.

An appropriate analogy for this type of strategy is a portfolio of short putoptions. For example, consider a hypothetical strategy of selling put options onthe S&P 500 (not a specific strategy that hedge funds employ but illustrativelysimilar to others that are utilized). For a given dollar amount of capital, youcould generate annual premiums equaling approximately 10% to 15% a year byselling 15% out-of-the-money S&P put options. In exchange for this premium, youwould be required to assume all of the downside risk in the index below adecline of 15% for the year. The probability that these put options will beexercised is somewhere between 20% and 25%. If the options are not exercised (a75% to 80% probability), then the manager will generate annual gross returns of10% to 15%. If leverage is used, the returns would easily exceed 20%.

In a bull market, this strategy could successfully generate this type of returnfor years. When the inevitable fall arrives, however, any decline in the indexgreater than 15% is fully borne by the investors in the fund, possibly leadingto large losses. For hedge fund managers with a 2% and 20% fee structure, thelack of a claw-back feature makes this type of strategy very attractive: theyenjoy both the 2% management fee and 20% performance fees on returns of 10% to15% or more for years. When the market tanks, they are under no obligation toreturn their previously earned performance fees.

Selling Subprime Puts

Granted, this S&P put option example is almost silly in its simplicity.Nonetheless, it is remarkably analogous to the return profile some hedge fundspursued in the boom years. And, as with our put option example, when the musicstopped, the outcome for investors in those funds was no laughing matter.

One example of artificial alpha involved the Bear Stearns hedge fund. The mainstrategy of Bear’s hedge fund was to invest in structured bonds backed bysubprime mortgages, which support the least creditworthy homeowners andtherefore tend to suffer significantly greater losses than higher-qualitymortgages during recessions or other times of economic pain. The Bear fund was aheavy buyer of these bonds, which paid less than 2% over the base interest rate.To amplify this small spread and create net returns of 10% to 12% after fees,the fund leveraged its assets by somewhere in the vicinity of ten times theamount of investor capital.

For years, while the housing bubble continued to expand, this strategy earnedconsistently strong returns, attracted more investor capital, and generated amountain of fees for the fund’s managers. Then, in late 2007, home prices beganto fall, many adjustable-rate mortgages began to reset higher, and the defaultrates on subprime mortgages began to skyrocket. Under the weight of hugeinvestment losses, high leverage, illiquid assets, and ineffective hedges, thefund collapsed, resulting in a near-total loss to shareholders.

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(Continues…)Excerpted from HEDGE FUNDS HUMBLED by Trevor Ganshaw. Copyright © 2010 by Trevor Ganshaw. Excerpted by permission of The McGraw-Hill Companies, Inc..
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