The Hedge Fund Report: Convertible Overhang

More on Funds of Funds

Scott Johnston, a hedge fund manager at Peconic Management who also teaches finance at Yale, recently penned a missive to investors titled, "Biting the Hand that Feeds Me." In the letter, Johnston predicted that if fees go down for funds of funds, incentive fees, which are paid to the manager as a percentage of the profits and can run as high as 25%, are likely to be hit. Management fees, which are typically 1%-2% of assets, are a more logical way of paying for the service. That is because funds of funds are "franchise builders." They are valued at 10 times management fees and only two or three times incentive fees, which shows that they extract more value from managing than from performing.

Hedge fund fees, on the other hand, are unlikely to come down anytime soon, says Johnston. "No matter how you cut it, it's harder to manage money than to allocate to those that do." In fact, hedge funds are only as good as their team. Often, the departure of a well-known portfolio manager will precipitate redemptions. When a hedge fund manager walks out the door, his shop's value drops to zero, says Johnston. For hedge funds, incentive fees are not a luxury.

J.P. Morgan(JPM) has a $16 billion group in its private banking department that does nothing but invest in alternative investments for its high net-worth clients. Called Alternative Investments Group, this private banking group invests in hedge funds, private equity and real estate, and has grown steadily in 10 years. As a result, J.P. Morgan just split the leadership into two functions and created a new CEO role to be filled by Doug Wurth, a bank senior executive. Andrew Craighead, who led the group before, will be its chief investment officer.

Pequot Capital Management, the $7 billion multistrategy hedge fund, is raiding rival Citadel, poaching three of its portfolio managers. Peter Labon will handle the technology and media-telecom portfolio; Carson Levit will work on a growth equity long/short portfolio. Both Labon and Levit left Citadel earlier this year. Steve Pigott will be an analyst and portfolio manager responsible for the North American merger arbitrage investments. All three positions are new ones and all three men held similar role at Citadel. Bottom line: Pequot is expanding in these sectors.

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