Managers hungry for cash infusion

Some hedge funds long closed to new investment have thrown their doors wide open, seeking new cash in order to keep the lights on.

In the face of their worst collective performance in years — compounded by a 76% drop in net inflows in the first half of the year and redemptions from high-net-worth investors — hedge fund managers anxious to replenish their coffers are visiting institutional investors and their proxies, institutionally oriented fund-of-funds managers, with caps in hands, sources said.

Even managers who performed better during the past year of turbulent markets are seeking new investor capital to take advantage of abundant investment opportunities they anticipate in coming months. Sources said managers of global macro, fixed-income arbitrage and multistrategy hedge funds have been especially active fundraisers in recent months.

But whether from desperation or opportunity, most hedge fund managers and strategies are open, some for the first time in years.

Brevan Howard Asset Management LLC, Caxton Associates LLC, D.E. Shaw & Co., Och-Ziff Capital Management Group LLC, Farallon Capital Management LLC, London Diversified Fund Management LLP and Capula Investment Management LLP are among the highly sought-after hedge funds that have been closed or have tightly limited new investment that are now reportedly accepting new capital into their hedge funds.

“Hedge fund capacity is at an all-time high. ... Hedge fund managers have the best investment opportunities they've had for years,” said David E. Gold, manager research consultant in Watson Wyatt Worldwide's New York office.

Hedge fund-of-funds managers, who keep a close watch on available capacity, broadly agreed that 50% or more of hedge funds that historically have been closed or kept a very tight lid on new investment now are fundraising.

“Hedge funds that are tightly closed to new investments definitely are in the minority now,” said Deepak Gurnani, managing director and co-head of the approximately $7 billion hedge fund and fund-of-funds business of Investcorp International Inc., New York.

One big factor contributing to the pop in capacity is a massive drop in collective net inflows into hedge funds this year. Net inflows in the first two quarters totaled just $29 billion, down an astonishing 75.6% from $118.9 billion in the first half of 2007, according to data from Hedge Fund Research Inc., Chicago.

And with year-to-date performance through July 31 of -3.08% for the Morningstar 1000 Hedge Fund index and -2.52% for the Morningstar Hedge Fund of Funds index, sources said only the crème de la crème of hedge fund managers will be able to generate the fabled 20% performance fees they have in past years. Hedge fund performance fees typically depend on the fund exceeding an agreed target by a set margin.

That means many hedge fund firms will have to rely on the 2% management fee to “keep the lights on,” quipped Ernest Boles, chief executive officer, Auda Hedge LLC. Auda Hedge manages about $1.7 billion in funds of funds.

Mr. Boles noted that “there's been a general contraction in asset levels for many hedge funds and because performance certainly will be lower than it has been, there's a lot of potential pressure (on these firms) to raise assets by going out and marketing.”

Hedge fund-of-funds executive Antonio Muñoz-Suñé said good hedge fund managers should be capable of managing their businesses on what they make from management fees. He noted that in the absence of incentive fees, “hedge fund managers will want to maintain what they have and to rebuild their asset bases. If you were a $5 billion fund and now are at $3 billion, of course you want to go back to where you were.”

Mr. Muñoz-Suñé is chief executive officer of EIM Management (USA) Inc., New York, a subsidiary of EIM Group, Nyon, Switzerland, which manages $15 billion in hedge fund of funds.

Another reason for cranking up marketing efforts is employee retention, according to Sol Waksman, president of hedge fund database and index developer BarclayHedge, Fairfield, Iowa. Mr. Waksman said that when performance is less than terrific, employees won't get much in the way of performance pay, which might make them more susceptible to offers from other hedge fund managers. He explained that by raising new capital, hedge fund managers will not only have enough to keep the electricity and heat on, but also might have enough left over for a bonus pool.

“Employee retention is a factor, although in reality many heads of funds make up the difference for their employees' bonuses out of their own pocket during these extreme performance events,” said Aoifin Devitt, principal of alternative investment consultant Clontarf Capital in an e-mail response from her London office.

But Ms. Devitt echoed many other sources in sounding a note of caution: “As the current losses and redemptions may signal trouble at the underlying funds ... even the performance fee on a bit of marginal capital won't be enough to retain top portfolio managers if the bulk of existing capital is under a high watermark for the year. The opportunity cost of leaving has dropped, so I expect to see more departures — and possibly a wave of interesting new fund launches over the next 12 months. So investors should revisit whether that "must-have' fund is a "must have' after all.”

Regardless of the motivation for fundraising, the hedge fund niche has become a buyer's market for the first time in many years, sources said, and the biggest beneficiaries are institutional investors.

Courting institutional investors has become the number-one priority for hedge fund managers who are seeking to substantially shift their client mix to favor more long-term institutional investors and to reduce the amount they manage for trigger-happy high-net-worth individuals, private wealth management intermediaries and retail-oriented funds of funds.

“The risk in the retail space is that so many investors tend to chase performance, looking for the funds that will really outperform. It's a faulty premise on which to invest and because they go in with the wrong expectations, retail investors tend to be quick to leave,” Auda's Mr. Boles said.

Eric Weinstein, managing director and chief investment officer, Lehman Brothers Alternative Investment Management, New York, agreed. “Bad markets put the investor in the controlling position,” he said. “This is much more of an investor's market than it was four years ago.” Lehman Brothers manages about $5 billion in hedge funds of funds.

Clontarf's Ms. Devitt observed that the current market correction has changed many hedge fund managers' perception of large institutional investors and (institutional) focused funds of funds. “I have seen hedge funds seeking to upgrade their investor base and solicit institutional capital instead of funds of funds for the past few years,” she said.

Contact Christine Williamson at [email protected]