Hedge Fund Closure Rate May Rise to 20%, Merrill Lynch Says

As much as 20 percent of hedge funds globally may be liquidated by the first quarter because smaller managers are starved for fees and new capital, according to Bank of America Corp.’s Merrill Lynch & Co. unit.

Hedge fund managers overseeing less than $100 million may be the worst hit, said Justin Fredericks, New York-based head of U.S. capital introductions, a prime brokerage team that brings together hedge funds and potential investors.

Hedge funds globally returned on average 1.65 percent this year, according to Hedge Fund Research Inc., headed for the third-worst annual return since the Chicago-based company started to track data in 1990 on concern that the recovery in economic growth may falter. About 93 percent of the $9.5 billion net inflows into the industry in the second quarter went to managers overseeing $5 billion or more, said HFR.

“Going into the year-end, there will be significant closures and we estimate it could be as high as 20 percent,” Fredericks said in an interview Sept. 17 in Hong Kong. “A large portion of managers are still below high-water marks. Performance is flat and money hasn’t been flowing to smaller managers.” High-water mark refers to the historical peak net asset value of a hedge fund.

Hedge fund liquidations as a percentage of the total number of funds will rise from about 15 percent in each of the last two years because most of the new money coming into the industry is going to the largest managers, said Fredericks.

Industry Assets

The closures are not expected to have a significant impact on overall industry assets under management because managers overseeing $100 million or less control a small percentage of the total, said Fredericks, who was attending a hedge fund capital introduction conference organized by Merrill Lynch. Closures will be offset by new fund starts, with the total number of managers to remain stable, he said.

About 53 percent of all hedge fund firms manage less than $100 million, controlling between them 1.7 percent of industry assets as of June, according to HFR data.

There were almost 7,000 hedge funds, excluding funds of hedge funds, in the $1.65 trillion global industry at the end of June, according HFR. The industry attracted $23.3 billion of new money from investors in the first half, HFR said.

Twelve of the 15 largest U.S.-based hedge fund managers grew their assets significantly over the past year, said Fredericks.

About 40 percent of hedge funds are still under their high-water marks, making them unable to charge incentive fees for possibly the third consecutive year, he said.

Pension Funds

Small funds run by managers who oversee multiple funds also are more likely to be liquidated, Mairead Kenny, Merrill Lynch’s London-based head of Europe, Middle-East and Africa capital introduction, said in the same interview.

The largest managers have been favored by a new crop of investors, most notably public and corporate retirement funds, because they’re perceived to be safer investments, Fredericks said.

Ohio Public Employees Retirement System and National Pension Reserve Fund, the Irish national pension fund, are inviting investment consultants to bid for mandates to advise them on hedge fund allocations, according to Fredericks and Kenny. Swedish pension funds including AP1 and AP4, and ATP, the largest Danish pension, recently started to allocate money to hedge funds, said Kenny.

Mid-Sized Funds

Merrill Lynch recently observed more inflows into mid-sized managers overseeing $1 billion to $3 billion as some of the largest funds stopped taking money from new investors, Fredericks said.

Some of the most established institutional investors in Europe, such as those in Scandinavia and the Netherlands, are starting to move away from the biggest managers in favor of their smaller rivals, Kenny said.

“They’re feeling a little less comfortable at this point with the book of the business these guys are able to run,” said Kenny. “They feel the guys a little smaller are more nimble, possibly they could have a better partnership with them as well.”

Still, it will take a few more quarters for the inflows to trickle down to even smaller managers, said Fredericks.

Providing Capital

Some of the largest institutional funds of funds have indicated they intend to restart allocating money to early-stage hedge funds through dedicated units, which may drive inflows to smaller managers, Joanne Bryant-Rubio, Merrill Lynch’s Hong Kong-based head of capital introductions in Asia-Pacific, said in the interview.

Merrill Lynch is seeing more investor interest in macro funds which seek to benefit from broad economic trends by trading equities, bonds, commodities and currencies. Investor interest in equity long-short funds that involve macro-economic analyses or focus on energy has also increased, Fredericks said.

Investors also favor event-driven funds, particularly those seeking to profit from companies going through mergers and acquisitions, he added.

Hedge funds are mostly private pools of capital whose managers participate substantially in the profits from their speculation on whether the price of assets will rise or fall.

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