The Hedge Fund Mirage

The Hedge Fund Mirage

The Illusion of Big Money and Why It’s Too Good

to Be True

Simon Lack

John Wiley & Sons, Inc.

Copyright © 2012 by Simon Lack. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:Lack, Simon, 1962- The hedge fund mirage : the illusion of big money and why it’s too good to be true / Simon Lack. – 1 p. cm. Includes bibliographical references and index. ISBN 978-1-118-16431-0 (hardback); ISBN 978-1-118-20618-8 (ebk); ISBN 978-1-118-20619-5 (ebk); ISBN 978-1-118-20620-1 (ebk) 1. Hedge funds. 2. Investments. I. Title. HG4530.L23 2012 332.64′524–dc23 2011035473

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

This book is dedicated to my wife Karen and our three wonderful children Jaclyn, Daniel, and Alexandra.

Contents

Introduction xiAcknowledgments xv

Chapter 1 The Truth about Hedge Fund Returns 1How to Look at Returns 2Digging into the Numbers 3The Investor’s View of Returns 6How the Hedge Fund Industry Grew 10The Only Thing That Counts Is Total Profits 13Hedge Funds Are not Mutual Funds 14Summary 16

Chapter 2 The Golden Age of Hedge Funds 19Hedge Funds as Clients 20Building a Hedge Fund Portfolio 22The Interview Is the Investment Research 24Long Term Capital Management 27Too Many Bank Mergers 30Summary 33

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Chapter 3 The Seeding Business 35How a Venture Capitalist Looks at Hedge Funds 36From Concept to the Real Deal 38Searching for That Rare Gem 41Everybody Has a Story 46Some Things Shouldn’t Be Hedged 50The Hedge Fund as a Business 52Summary 56

Chapter 4 Where Are the Customers’ Yachts? 59How Much Profit Is There Really? 60Investors Jump In 63Fees on Top of More Fees 65Drilling Down by Strategy 69How to Become Richer Than Your Clients 74Summary 77

Chapter 5 2008—The Year Hedge Funds Broke Their Promise to Investors 79Financial Crisis, 1987 Version 80How 2008 Redefined Risk 82The Hedge Fund as Hotel California 85Timing and Tragedy 93In 2008, Down Was a Long Way 97Summary 98

Chapter 6 The Unseen Costs of Admission 99How Some Investors Pay for Others 101My Mid-Market or Yours? 104The Benefits of Keen Eyesight 107Show Me My Money 111Summary 115

Chapter 7 The Hidden Costs of Being Partners 117Limited Partners, Limited Rights 118Friends with no Benefits 120Watching the Legal Costs 125Summary 128

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Chapter 8 Hedge Fund Fraud 129More Crooks Than You Think 130Madoff 133Know Your Audience 134Accounting Arbitrage 101 136Checking the Background Check 138Politically Connected and Crooked? 140Paying Your Bills with Their Money 141Why It’s Hard to Invest in Russia 143After Hours Due Diligence 145Summary 146

Chapter 9 Why Less Can Be More with Hedge Funds 149There Are Still Winners 151Avoid the Crowds 154Why Size Matters 158Where Will They Invest All This Money? 166Summary 168

Afterword 171Bibliography 177About the Author 181Index 183

IntroductionWhy I Wrote This Book

It was early 2008, and I was sitting in a presentation by Blue Moun-tain, a large and successful hedge fund focused on credit derivatives. Its founder, Andrew Feldstein, had previously worked at JPMor-

gan, and was widely respected in the industry. JPMorgan had been a pioneer in the development of the market for credit derivatives, instru-ments which allowed credit risk to be managed independently of the loans or bonds from which they were derived. This was prior to the 2008 credit crisis later that year in which derivatives played a key role, and Blue Mountain had generated reasonable returns based on their deep understanding of this new market. The meeting took place around a large boardroom table with a dozen or more interested investors, and the head of investor relations went through his well-honed explanation of their unique strategy and its superior record.

It was boring, and as my attention drifted away from the speaker, I began flipping through the presentation. Interestingly, Blue Mountain included not just their returns but their annual assets under management (AUM) as well. You could see how their business had grown steadily off the back of solid but unspectacular results. Clearly, everyone involved was enjoying quiet, steady success. I was curious how much profit the

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investors had actually made, since their returns had been moderating somewhat while AUM continued to grow. I started to scribble down a few numbers and do some quick math. Since Blue Mountain also disclosed their fees, which included both a management fee (a percent-age of AUM) and an incentive fee (a share of the investors’ profits) there was enough information to estimate how much money the found-ing partners of Blue Mountain, including its owner Andrew Feldstein, had earned. With what turned out to be good timing in late 2007 they had recently sold a minority stake in their management company to Affiliated Managers Group (AMG), an acquirer of asset management companies. I made a few more calculations. Feldstein was not only very smart, but highly commercial. My back-of-the-envelope calculations showed that the fees earned by Blue Mountain’s principals, including the proceeds from its sale to AMG, were roughly equal to all of the profits their investors had made (that is, profits in excess of treasury bills, the riskless alternative). Blue Mountain had made successful bets with other people’s money and split the profits 50/50. Was this really why some of the largest institutional investors had been plowing enor-mous sums of money into the hedge fund industry? Was this a fair split of the profits? Was it even typical of the industry, or were Blue Moun-tain’s principals unusually gifted not only at trading credit derivatives but at retaining an inordinately large share of the gains for themselves? The hedge fund industry had enjoyed many years of phenomenal success, and the collective decisions of thousands of investors, consul-tants, analysts, and advisors strongly suggested that there must be more value creation going on than my quick calculations implied. So I started to look more closely, and I found that while the hedge fund industry has created some fabulous wealth, most investors have shared in this to a surprisingly modest extent. I tried to think of anyone who had become rich by being a hedge fund investor (other than the managers of hedge fund themselves) and I couldn’t.

Many of the professionals advising investors on their hedge fund investments will be familiar with the conceptual disadvantages their clients face as presented in this book. They will likely be surprised at the numbers and may disagree with some of them (though there can be little doubt about the overall result). But the people best situated to tell this story, the people with the necessary knowledge and insight, are

Introduction xiii

busy still making a living from the hedge fund industry and have neither the time nor inclination to stop doing that. I am a product of the hedge fund industry myself, and it has provided me financial security if not membership on the Forbes 500 List. To counter the obvious charge of hypocrisy that readers may level at this industry insider now disdainfully commenting on his profession, please note: My journey through hedge funds was guided by the same principles I espouse but that too few investors follow. Invest off the beaten track, with small undiscovered managers; negotiate preferential terms, including a share of the business or at least preferential fees and reasonable liquidity; demand (and do not accept less) complete transparency about where your money is. If more investors had done so, their investment results would have turned out to be far more acceptable.

But hedge funds will not disappear, at least certainly not by virtue of this book! There are a great many highly talented managers and that will undoubtedly continue for the foreseeable future. The question for hedge fund investors is how they can more reliably identify the good ones and also keep more of the winnings that are generated using their capital. This book attempts to answer those questions.

Acknowledgments

Many people provided input, support, and ideas as this project made its way to print. I’d especially like to thank Professor Tony Loviscek of Seton Hall University. Tony’s encourage-

ment as well as valuable feedback helped take an essay and turn it into something bigger. David Lieberman read the entire manuscript and provided helpful suggestions. Several people also reviewed individual chapters including Andreas Deutschmann, Miles Doherty, Larry Hirshik, Henry Hoffman, and Andrew Weisman. I am indebted to all of them for their time and interest. I’d like to thank Josh Friedlander of AR magazine, both for ensuring my original essay on hedge fund returns was published and also for his introduction to John Wiley and Sons, the publisher. Laura Walsh, Judy Howarth, Tula Batanchiev, Melissa Lopez, and Stacey Smith at John Wiley tolerated my impatience with the ponderous publishing calendar and guided this project to comple-tion. Finally I’d like to thank my mother Jeannie Lucas, whose many years in financial journalism were invaluable as the initial editor and enthusiastic supporter of her son’s first book.

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The Hedge Fund Mirage

Chapter 1

The Truth about Hedge Fund Returns

If all the money that’s ever been invested in hedge funds had been put in treasury bills instead, the results would have been twice as good. When you stop for a moment to consider this fact, it’s a

truly amazing statistic. The hedge fund industry has grown from less than $100 billion in assets under management (AUM) back in the 1990s to more than $1.6 trillion today. Some of the biggest fortunes in history have been made by hedge fund managers. In 2009 David Tepper (for-merly of Goldman Sachs) topped the Absolute Return list of top earners with $4 billion, followed by George Soros with $3.3 billion (according to the New York Times). The top 25 hedge fund managers collectively earned $25.3 billion in 2009, and just to make it into this elite group required an estimated payout of $350 million. Every year, it seems the top earners in finance are hedge fund managers, racking up sums that

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