About the impact of High Watermark on hedge fund closings

Lakes suffer when the rivers and streams flowing into them run low for a prolonged period. Sometimes it can be seasonal factors; it can be climate change, or increased use of the water upstream, like the River Jordan feeding the Sea of Galilee in Israel. In extreme cases the water course can become a string of ponds separated by dry land if the typical rains do not fall in the right place beyond the minimum amount.

Something analogous can happen on the hedge fund landscape when capital flows dry up. Good returns begat capital flows which begat increasing AUM, and hence an enhanced ability to attract and retain staff (in the virtuous circle). In the vicious circle, once a bad absolute return is seen as a poor relative return in the peer group for the strategy, the investors in the fund put it on “negative watch” like the ratings agencies. After review, if there is not a sound basis for staying on board, the flow of capital out can be frighteningly quick: a very profitable business at 10x of capital can be breaking even at 3x of capital and into losses at 2x, regardless of brand name, heritage or even sometimes even of long term track record. “What have you done for me lately?” is the rhetorical question in the minds of investors, even if does not cross their lips.

In the September 2009 edition of The Hedge Fund Journal I wrote that:

“One of the reasons for fund closures is the impact of the high-water mark feature, common to modern-era hedge funds. On an industry index basis, the industry’s price (NAV) peak was as long ago as October of 2007. Based on the NAVs at the end of August 2009, a typical hedge fund still has to show a NAV appreciation of 11% to get to the old high-water mark…For some managers it could be years until they earn a performance fee. The impact has already been seen in staff movements – even partners of established funds have a disincentive to stay at funds well below their high-water mark. And there remains the classic incentive of performance fees to entice quality staff to funds at or near their peak NAVs. In this regard it is interesting to see that two founding partners and the head of Asia for The Children’s Investment Fund Management (TCI) have left the firm recently, and that on the other side of the coin Brevan Howard has just taken on three senior staff at partnership level. Brevan Howard’s flagship Global Macro Fund was up last year and is up nearly 15% this year.”

http://www.thehedgefundjournal.com/research/simon/blog/big-fish-in-shrinking-ponds.php

 

1) You're a published writer? Wow! :eek:
2) Instead of a "2 & 20" fee, go with a "20 & 2" arrangement instead.

 

Inability to pass their high water mark has a massive impact on hedge funds closing.

Why are Citadel losing all their top guys?
Their main funds were down 50% in 2008 and even though they rose about 60% last year, they are a long way from breakeven. And they are about flat this year.

But perhaps Citadel is not the best example here, it can handle poor performnace better than most as it charges a 8.75% management fee.

No new high water mark basically means no bonuses. And top staff want to be well rewarded. Basically the cycle is:

poor performance --> below high water mark --> no bonuses --> top staff leave --> performance suffers further --> redemptions.

Or sometimes as soon as staff leave the money bolts out the door eg. Greg Coffey at GLG.

 

I think that would be a problem with J.P. Morgan's compliance department.

 

1) Citadel is "usual". They may defer a lot of compensation for managers instead of paying out everything at year's end.
2) That management fee is "excessive".
3) There has to be an acknowledgement that there is too much mediocre talent that doesn't belong in the business in the first place.