Hedge Funds: The Road Back

There are examples of shirking performance responsibility in smaller hedge funds. In early 2008, before the real stock market pain hit, Dan Zwirn was forced to shut his hedge fund DB Zwirn & Co. when it came to light that he had improperly paid for a jet with investors' money (amongst other back-office issues). His performance had been steady and successful prior to those revelations. Zwirn claimed the improprieties were the fault of poor back-office oversight by his CFO and wasn't linked at all to the strategy he had overseen successfully.

Because his strategy involved stakes in many illiquid assets, it will take time to fully wind down DB Zwirn. However, only a few months after the decision to shut down, rumors began to circulate that Zwirn would be launching ZLC Global -- a new fund following exactly the same strategy as DB Zwirn & Co. Many DB Zwirn & Co. investors were going to be investing in ZLC Global, according to reports. It is puzzling that some investors can be so forgiving, but this behavior is isolated and does not undermine the value investors' gain from high water marks.

Some hedge fund managers have tried to bend the rules in their favor to collect more in fees. For example, Steve Mandel of Lone Pine Capital abides by a high-water mark but can get some portion of a performance fee the next year, if he surpasses a hurdle. In other words, you don't always have to live off psychic income if you had a bad previous year.

Another bad practice that should be changed is when hedge funds insist on long lock-up periods -- say three years -- during which they still pay themselves management and performance fees annually. They don't typically claw-back their year one performance fees if they have a major performance drop in year three.

Investors will rightly have less tolerance for these "innovations" going forward. If managers screw up, they need to pay the consequences. It's that Darwinism which makes the industry strong and should give no investor qualms about having to pay performance -- or more correctly stated, revenue-sharing -- fees.

Conclusion

The hedge fund industry will work out its excesses carried over from the last five years and become a stronger collective of funds and fund managers. Most of the lemmings will leave, until the industry once again begins to experience excessive growth. Oversight must and will improve. Lessons should be learned. But in one, five, and 10 years from now -- no matter the macro environment -- investors will still flock to hedge funds because it attracts the best managers with the most creative strategies.