Tuesday, May 19, 2015

The Real Reason is Never Expressed: Why Hedge Funds Close

The Real Reason is Never Expressed:  Why Hedge Funds Close

Over the past several months a series of hedge funds created by managers with historic ties to the famous investor Julian Robertson have closed their funds.  Alexandra Stephenson of The New York Times summarized this development yesterday.[1]  Ms. Stephenson focuses on JAT Capital, managed by John Thaler, who worked for Chris Shumway, who worked for Mr. Robertson.  JAT got off to a great start in 2008 by avoiding the worst of the stock market collapse and then put in a few strong years of performance.  However, his overall record was uneven and is estimated to have been 4.6% after fees.

As Ms. Stephenson points out, TigerShark and Tiger Consumer, two more offshoots of Mr. Robertson’s original Tiger Fund, are closing their doors.  As is customary in the hedge fund industry, managers are continuously closing funds, just as mutual funds are constantly merging or closing.   Over the years, hedge fund managers have been giving the same reasons for shutting down funds.  However, they’ve never been entirely forthcoming.  I’ll list a few of the managers’ reasons cited in the Times article before explaining what’s really going on.

Mr. Thaler cites one of the usual reasons for a fund’s closure.  He says, “It is the right moment to take a break, spend time with my young family, and determine which path to pursue next.”  His spokesperson said that the shutdown was not performance-related.

In announcing the closing of Loeb King Capital earlier this year, Gideon King said, “Controlling capital and engaging intellectually is good work if one can get it. The business, on the other hand, has changed dramatically. As the endless quest for becoming institutional continues on, the soul of investing might get lost, as the unmitigated compliance processes become cumbersome and interfere with the purity of speculative contemplation.”[2] (emphasis added)

Alan Teh of Kamunting Street Capital Management told his investors “In a zero interest-rate environment, it’s much more difficult to make money without taking more risk.”[3] (Quick aside: interest rates have been zero for seven years: why did it take Mr. Teh so long to figure his strategy doesn’t work?)

Taken together, these are the three most common reasons given for shuttering a hedge fund: (i) I need a break; (ii) regulation is crushing my business; (iii) the strategy isn’t working.  Moreover, these managers are joining a long list of hedge fund managers who have also told their clients that they’ll spend time managing their own money.

What’s really going on?  In almost every case, the hedge fund manager isn’t earning carried interest or a performance bonus.  Since the fund hasn’t done well in recently, the manager doesn’t have any prospect of earning a bonus for several years.  When hedge funds perform poorly, they must first recover lost performance before that can start paying out 15% to 30% of the profits (known as a reaching the “high water mark”).  In other words, the manager isn’t hugely interested in managing money for a mere fee.  Moreover if he closes the hedge fund, he can start a new hedge fund that will immediately be eligible to earn bonuses (the historic record is expunged).  Hedge fund performance bonuses are wonderful for hedge fund managers because the managers don’t have to return the payments when funds perform poorly.

In addition, the hedge fund managers cited in Ms. Alexandra’s article have piled up tidy little nest eggs.   The management fees and occasional bonuses have created some serious wealth, and these managers are in no danger of starving.  I’d guess that JAT made at least $500 million in fees over the seven year’s of its existence.  With only 35 employees, Mr. Thaler certainly made a lot of money for himself from fees, and he wasn’t poor when he launched the hedge fund in 2007.  His investment account also did quite nicely even if it was invested in the hedge fund, since he didn’t have to pay himself management fees or bonuses.  Thus, the 4.6% earned by his investors was probably closer to 7% in Mr. Thaler’s account.

Mr. Thaler, Mr. King, and Mr. Teh have options.  They now have more than enough money (thanks to fees) to simply manage their own account.  And as I just mentioned, their investment performance doesn’t have to be great in order for their money to continue to grow.  Nonetheless, I’ll bet that most of these guys will be marketing another hedge fund within two years.  When you have a great deal of money and money is the only object of the game, the lure of fees and carried interest will compel you to launch another hedge fund.  Amazingly, plenty of investors will be willing to play their game.

[1] http://www.nytimes.com/2015/05/18/business/dealbook/facing-low-returns-and-balky-investors-more-hedge-funds-close-doors.html?ref=dealbook&_r=0
[2] http://www.bloomberg.com/news/articles/2015-01-15/loeb-king-says-its-closing-as-hedge-funds-rules-too-cumbersome
[3] http://www.bloomberg.com/news/articles/2015-04-09/hedge-fund-kamunting-to-become-family-office-founder-teh-says

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