Getting caught out on Amaranth was bad enough. Getting caught out again on Sowood Capital? Not great either. And with hedge funds getting hit left, right and centtre, just how many times can funds of hedge funds keep telling us everything’s alright? Arden Asset Management, to name but one fund of hedge funds, was caught out on both counts. Tremont was another. And the response that rolls off the tongues of funds of hedge funds officials whose underlying managers go bust is always the same – we spread risk by investing in many underlying managers, so the damage is limited.
Is this really the case, however? Not according to an internal memo put out by Jerome Abernathy of Stonebrook Capital. The former Moore Capital staffer turned alternative beta shop owner is quite adamant that funds of hedge funds are losing a lot more than they claim when their underlying managers screw up. For a $5 billion fund of hedge fund with a 4% allocation to an underlying manager that blows up, a total present value of losses of more than $55 million will result, and, at the most conservative estimate, half that, Abernathy calculates.
These costs come from several directions. First is the simple management distraction that a blow-up can cause. According to people in the market, phones in August and September were ringing off the hook at certain funds of hedge funds that have recently been caught out twice. Explaining to investors once how a mistake was made will take some time for sure, as will a postmortem to see what went wrong. A second time around, and investors won’t be so easily palmed off. Revenue is also going to be lost because of the reduction in the capital base caused by the blow-up and because of redemptions by jittery investors. With the vast number of funds of hedge funds now operating, why would an investor stay with one whose due diligence appears shaky? Thirdly, revenue growth will be forgone because new investors have been deterred. Abernathy reckons that resulting redemptions and lost new allocations for a $5 billion fund of hedge fund would be a combined 10% of total assets. With average fees of 70 basis points a year on assets under management, that is no small amount.
And finally, there is likely to be a reduction in enterprise value because of the earnings uncertainty and volatility of assets caused by the underlying blow-up.
Figures like these can’t be hidden, and with the current market environment it will be easy to find out which funds of hedge funds have really been investing in their due diligence staff and risk management, and which have not.
