In case you have forgotten how many hedge funds lost large sums of money when the global markets melted down in 2008 and early 2009, consider this new data from Greenwich Associates. Despite the huge recovery in the global markets since they hit bottom in March 2009, roughly 45 percent of U.S. hedge fund managers and half of hedge funds in Europe and Asia say one or more of their funds is still below their high-water mark.
This is after nearly 55 percent of U.S. hedge funds participating in the Greenwich Associates/Global Custodian Study and 35 to 40 percent of hedge funds in Europe and Asia reported returns of at least 20 percent from the first quarter of 2009 to the first quarter of 2010. In fact, 90 percent of the funds said they made money during the 12-month period.
This is sobering data that will have a wide ranging impact on the hedge fund industry for the next few years.
For one thing, it seems like it will be later rather than sooner before many of these under-water funds break even. Why?
While you may think some of the underwater funds may take on more risks to get even quickly so they can begin to hand out bonuses, the opposite seems true. Greenwich points out that hedge fund leverage levels remain significantly below those commonly employed by managers before the financial crisis.
Sure, industry-wide average gross leverage ratios increased from 1.8:1 in the first quarter of 2009 to 2.0:1 in the first quarter 2010. For fixed-income funds, the increase was higher than the industry average, to 2.3 in 2010 from 2.2. However, Greenwich stresses that these leverage levels remain well below the 2.3 average reported by all hedge funds and the 3.4 average among fixed-income funds in 2007.
However, the research firm does point out that many funds plan to kick up this leverage in the next 12 months, including 37 percent of Asian hedge funds, 30 percent of European funds and 23 percent of U.S. funds.
In the meantime, the unexpectedly large number of hedge funds still below their high-water marks could rattle the industry. This means for the third straight year, many key employees either are not getting bonuses, or the firms principal is paying it out of his own pocket. Some of these bonuses might then be less than would have been paid if the fund were flush.
And, lets face it. Most people who work for hedge funds share Willie Suttons motivation: Its where the money is. If key analysts and portfolio managers are doing well for the past 1½ years and they feel they are not being adequately compensated, they will leave for a firm that can afford to pay them.
And even though a number of principals are using their own dough to keep their staff happy, they are not going to do this forever. Three years is a long time.
The under-water firms could also have trouble recruiting top people who are itching to leave their current firms.
Investors also may be leery of stayingor investingwith these firms, figuring they could suffer a brain drain. Other firms in the industry may shy away from doing business with them, fearing counter-party risk.
So, ultimately the firms with a number of funds below their high-water mark may welcome an investment or takeover by another financial institution or financially sound hedge fund or investment management firm, which could be in a better position to fund bonuses and lure top recruits. Some of these firms may be public and have stock to dangle.
Another alternative: A hedge fund firm with several funds may decide to close down or merge the under-water fund into a money-maker.
If a firm with under-water funds experiences a decline in assets, this could, in turn, result in layoffs, which we earlier chronicled [LINK: http://www.institutionalinvestor.com/alternatives/Articles/2701146/Growing-Pains-for-Hedge-Funds-and-Their-Staff.html] is a growing industry trend.
Whatever the case, it is another indication that the hedge fund industry has a much longer way to go before it fully recovers, even though total industry-wide assets under management are not far off from their all-time high.