Hedge fund investors could be left out of pocket as managers conjure up shortcuts to earn once again the lucrative bonuses based on performance fees that were a feature of the industry before the credit crisis.
Despite 20 percent returns last year, big losses in 2008 mean that between a half and two-thirds of hedge funds are below high-water marks — performance levels they must hit before claiming a 20 percent fee on a fund's profits.
This could persuade more managers to move to new firms where they can start earning these bumper fees straight away, forcing clients to decide whether the quality of the managers justifies the additional cost and disruption needed to follow them.
"If certain funds don't reach their high-water marks, not the founders but the number 2s or numbers 3s in a hedge fund firm could start looking at other roles," said one prime broker who declined to be named.
Managers staying put might be tempted to take greater risks to hit high-water marks, or could close a fund to new investors, only to launch a new and similar fund where clients committing new money will pay fees on performance straight away.
Like a mark on a riverbank showing how high past floods have reached, high-water marks are the top net asset value hit by a fund in its lifetime, and below these levels, a manager can't get performance fees even if the fund makes money.
The intention is to stop managers taking fees, beyond standard management charges, simply for making back money lost in previous years.
Firms such as Man Group, Brevan Howard and GLG have launched versions of their hedge funds as Ucits III funds, a more regulated structure that allows them to be sold across Europe, hence opening up the strategy to a wider pool of investors.
Such funds can often earn performance fees straight away, even if the funds they mirror are still "underwater."
"One attraction of launching a new fund is that managers can immediately begin to earn performance fees on the new vehicle," said Kate Hollis, lead analyst at S&P Fund Services.
With the average fund down 2.7 percent over the past two years, frustration is growing as managers find themselves some way off earning the fees to which they have become accustomed.
"It will create some changes — new openings or some (funds) closing," said Patrick Fenal, chief executive of Unigestion, which runs $3.1 billion in funds of hedge funds.
Moreover, managers who are above their high water marks may be unhappy sharing their bonuses with less successful managers and could leave for a rival.
"The incentive for someone who's performed very, very well to stay in a shop where de facto bonuses will be less than elsewhere (is less). They could create their own fund or go and work for someone else," said Unigestion's Fenal.
GLG star Greg Coffey's departure in 2008 was linked by some commentators to the firm's funds being below high-water marks. GLG declined to comment.
Data from Hedge Fund Research shows just 31 percent of hedge funds hit high-water marks during the fourth quarter last year, and barely half hit it during the whole of 2009.
Regulators' concerns lie elsewhere, and fears have been raised that managers some way off high-water marks may be encouraged to take riskier bets with investors' money.
"There may be incentives to take greater risk," Britain's Financial Services Authority said in a survey of 50 firms, released last week, which showed about half of hedge funds' main share classes were below their high-water mark.
Unigestion's Fenal said checks on such funds were vital.
"Most good managers are above historical high-water marks. All the ones below are more questionable. You have to question in your due diligence your motivation to keep them, to be sure they won't have (risky) behavioral patterns to reach the desired level (to earn fees)," he said.
However, some doubt whether moves such as setting up new funds will really get past investors' watchful eyes.
"Do I think some people are going to do it? Yes, of course some people are going to do it," said David Aldrich, head of securities industry banking at Bank of New York Mellon. "But ... I think investors will see through that very quickly."
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