Institutional Investors May Offer Hedge Fund Lifeline, Someday

"If a house be divided among itself, that house cannot stand."

Mark (circa 50 - 100 AD)

New Testament Bible

Shakeouts are never positive if you are on the losing end. The steady drop off in liquidity among Asian equity markets indicated by falling turnover, market cap and the proportion of institutional investor participants spells continued BIG trouble for the hedge fund industry. The only hope may be for the region's institutional investors to take a lead out of the CalPERs playbook and "gang-tackle" the seeding business.

BoNY recently reported that Asian institutional holdings of global hedge funds are down 40% year-on-year through 2009. Most of the selling that took place was directed at hedge fund of funds. Similarly, AsiaHedge reported that out of the universe of funds that they identify, 129 funds closed down in calendar year 2008. This was roughly 25-30%. Moreover, the prospects for further closures and asset flight should continue especially with so many managers failing to produce positive absolute returns.

This is a serious issue for the hedge fund industry itself, service providers, services in general, tax revenues (which should now fall) as well as the standard of living of participants and their associated economies. Corporate boards are also no longer under the proverbial gun to deliver shareholder value now that the scrutiny of activist managers has waned.

What we should be asking is, whether the Volatility Shock that started in September 2008 was a cyclical event or an secular one. Too many ostrich in the sand "experts" couch their state of the industry analysis in terms of cyclical factors - "good for the industry...", "survival of the fittest"..."the industry will bounce back even stronger...". This is naive.

The battle for the regeneration of hedge fund industry in Asia has two sides to it. First is supply of alpha generating talent. This means a pipeline of new managers. Under the current environment of increasing overhead costs, bureaucracy and legal requirements for start-ups the barriers to entry were raised for 2009. It will take over $100 million for an ongoing concern to survive a couple of market cycles, as well as to attract any long-term desire for institutional assets.

If you thought that there was a shortage of quality talent prior to 2007-08 what about now? The global industry shrank from a reported $1.89 trillion in Jan 2008 to $1.25 trillion by Dec 2008.

The next issue is demand. Institutional investors such as pension funds, and life insurance companies continue to have rising liabilities for the foreseeable future. They all face the same dilemma of needing non-correlated alpha that can generate some multiple over LIBOR (400-600 basis points) in order to meet anticipated liability exposure. And many cannot and will not raise the exposure to stocks (too volatile) and bonds (low yields). This leaves liquid alternative investments including hedge funds.

But we have already seen that the supply of those mangers is shrinking anyway, which means that a previously tight SS-DD situation will get tighter as demand remains the same or even increases in the years ahead.

This is why the CalPERs seeding model called the Sprout Program makes so much sense. CalPERs already has the in-house skills to pick managers so why not take away that task from HFoFs, do it internally and eventually create hedge fund capacity with an enterprise value that might benefit employees at some later date.

In return for this, the emerging managers still initially under the CalPERs umbrella with CalPERs money to help them build a meaningful track record). As I see it, the goal is not to find the next George Soros, but rather to have a strategy and process that is transparent, disciplined and scalable producing steady, decent returns. And if it fails, presumably the business will be simply closed down with monies pulled.

Asia's institutional investors would be wise to consider such a model. They could collectively reduce search and transaction costs as well as to negotiate the strategy, fee and capacity agenda of many of the future hedge funds. It makes so much sense, that it is amazing why it has not been done before.

Unfortunately, it may yet be a few years before the regions investors realize what opportunity they might have to really embrace hedge fund strategies and talent. For the potential return will require some risk. Mahalo.