Managers place limits on hedge funds, but few clients are complaining

The institutionalization of the hedge fund industry and the mountains of cash that came with it are leading more managers to limit inflows, close funds or return money to investors.

Far from being upset with these moves, chief investment officers of pension funds, endowments, foundations and sovereign wealth funds are reassured that their hedge fund managers are capping assets to preserve their ability to generate returns.

Some big, institutionally oriented hedge fund managers, such as The Baupost Group LLC, Third Point LLC and Highfields Capital Management LP, have announced they will be returning money to investors at the end of the year.

But observers said those firms are outliers. More large or strategy-constrained hedge fund managers are either closing their funds to new capital, allowing inflows only from existing clients, or accepting assets from new clients solely to replace redemptions.

Among the institutional hedge fund firms sources said have done soft or hard closes for some of their hedge fund strategies, or intend to do so soon, are:

• Cevian Capital, Corvex Management LP, JANA Partners LLC and Senator Investment Group LP for event-driven strategies;


• Steadfast Capital Management LP, Visium Asset Management LP, Scopia Capital Management LLC and Emerging Sovereign Group LLC for equity long/short;


• BlueCrest Capital Management LP, Graham Capital Management LP and Discovery Capital Management LLC, global macro;


• Bracebridge Capital LLC and Capula Investment Management LLP, market neutral; and


• D.E. Shaw Group and CQS (U.K.) LLP for multistrategy.

“A lot of these hedge fund guys are being forced to deal with these issues for the first time because of institutional investors. The new client base requires a very different way of managing the firm and its investment capacity,” said Damien Loveday, global head of hedge fund research in the London office of Towers Watson & Co.

“No one should be surprised that this is happening. It's symptomatic of what's becoming an increasingly institutional market,” Mr. Loveday said.

“We've seen a lot of soft closes,” he said, because “a lot of managers have reached capacity and are in the enviable position of only needing to accept replacement capital.”

A senior executive at a large multistrategy hedge fund company who spoke on condition of anonymity said the firm hasn't closed its funds but now is only accepting investments — in fairly big chunks — from institutional investors who “think like we do.”

Smaller institutional prospects that had been in the firm's pipeline are clamoring to get into the funds, but the source said they are politely told that they just can't.

Hedge fund firms are driven to control asset size by solid returns, both for investors and for portfolio managers who have invested their own money in the funds, sources said.

But current market conditions are making it hard to generate good returns for hedge fund strategies, especially if the manager has large chunks of money to invest.

“Markets are cyclical and in the cycle we're in now, multiples are high, liquidity is good and nothing bad is happening or is on the imminent horizon,” said Stephen L. Nesbitt, CEO of alternative investment consultant Cliffwater LLC, Marina del Rey, Calif.

“There was a strong expectation about opportunities in a distressed Europe, which really haven't come to pass yet. Hedge fund managers just aren't finding good deals at cheap prices and they are complaining a lot about the lack of volatility,” added Mr. Nesbitt.

The current environment is not as “bad as previous market cycles when a lot of hedge fund managers hard-closed their funds and a number of those that remained open toughened their terms by raising fees or extended out the liquidity of the fund,” said Raymond T. Nolte, co-managing partner, chief investment officer and portfolio manager in the hedge funds-of-funds unit of SkyBridge Capital II LLC, New York.

But global market conditions definitely favor smaller hedge fund managers over larger ones, Mr. Nolte said.

“Portfolio managers can make trades, just not many great trades. The magnitude that trades can be amped up to is much lower than it was,” Mr. Nolte said.

He noted that the days of individual investments returning between 20% and 30% are gone — at least for the moment — replaced by returns in the 8% to 12% range.

“Those little niche trades won't move the needle for big funds,” said Mr. Nolte.

SkyBridge manages $5.6 billion in hedge funds of funds, mostly for institutional investors and is nearing capacity because of its preference for smaller hedge fund managers, Mr. Nolte said. The funds likely will hit their capacity limit within the next 12 to 18 months.

Hedge fund firm capacity is of growing concern to both investment consultants and funds-of-funds managers.

“We pay a lot of attention to a hedge fund manager's asset base. To be effective, a portfolio manager often has to be able to manage assets nimbly, and it's easier to do this with $2 billion than it is with $10 billion,” said Michelle McCloskey, senior managing director at FRM, the New York-based hedge funds-of-funds unit of Man Group PLC, London.

FRM managed $12.9 billion in hedge funds of funds as of Sept. 30.

“You need to be very cognizant of a hedge fund manager's capacity, assessing the firm's real capacity, not the capacity the company says it has,” cautioned Towers Watson's Mr. Loveday.

Regarding true capacity, consultants and funds-of-funds managers alike approve of hedge fund managers with the self-discipline — and instinct to protect their own investment — to control asset size firmwide or in particular strategies.

“We like to see a hedge fund manager close funds or return assets when capacity is reached. It shows a lot of investment discipline,” FRM's Ms. McCloskey said, adding that when a manager closes a fund, it's not uncommon that the fund will be reopened when the investment climate improves.

Boston-based Baupost Group, which includes a wide swath of institutional investors within its client base, is returning assets at the end of the year, said Seth A. Klarman, president and CEO.

Mr. Klarman advocates holding cash when markets are pricey and bargains are scarce: Between 30% and 35% of total assets were held in cash in mid-September. But he previously pledged to keep Baupost's total assets at between $20 billion to $25 billion.

Diana DeSocio, a Baupost spokeswoman, confirmed in an e-mail that Mr. Klarman has told investors to expect to have some money returned.

Institutional investors aren't getting too giddy with their returned cash, said Alex Da Costa, director of hedge fund research and consulting for investment consultant Pavilion Advisory Group Ltd., Montreal.

“Investors who do receive cash back are typically reallocating to other managers in the same space,” Mr. Da Costa said in an e-mailed response to a request for comment.

Added Mr. Nesbitt: “None of Cliffwater's clients have ever said anything negative about a hedge fund returning capital. That action reinforces the perception that the hedge fund manager is looking out for client interests.”

Bloomberg contributed to this story.