One Day of Hedge Fund Discussion, Two Takeaways
Last month I presented at an Ivy Plus hedge fund event. The discussion throughout the day was spirited, and two issues in particular stood out to me. Without further ado:
1. First-Loss Capital is Controversial
We all know it’s a tough market for smaller hedge funds looking to raise capital. With a lot of smart, ambitious investment minds out there trying to jumpstart funds, it makes sense that first-loss capital continues to grow as a tool for increasing AUM.
But is all of this a good idea for the hedge fund and its limited partners? I’d characterize the Ivy Plus attendees as somewhere between “dubious” and “morally outraged”.
I’m tempted to argue this is all one big gray area. After all these are legitimate, if risky, funding deals willingly entered into by the hedge fund. But there is one issue that raises red flags – as Santangel’s Review points out, first-loss deals introduce a potentially severe short-term bias to the hedge fund.
It is this variable that I think (a) invites managers to stray from their strategies, (b) presents a potential blindside risk to limited partners, and (c) ultimately undermines the fund’s stability. I understand why funds consider first-loss capital, but I’m not optimistic that the impact of its current incarnation will be positive for the hedge fund industry.
2. The Pitfalls of High Fixed Costs
One of my favorite investing axioms is “when a company builds a shiny new headquarters, it’s time to short their stock.”
This idea came to mind as Merlin Securities presented takeaways from their latest whitepaper on operating a successful hedge fund. The biggest mistake hedge funds make? Inflating fixed costs by overinvesting in people, office space, and technology.
In other words, hedge funds are no different than many other businesses. You can check out the full Merlin paper for a basic reminder that no business can thrive when its expenses outpace its revenue.