Hedge Fund Profits Declined 30% Last Year, Citigroup Says

The outlook for hedge funds, already closing at the fastest pace since the financial crisis, is about to worsen, according to Citigroup Inc.

Industrywide profits in 2014 declined 30 percent from a year earlier to $21.9 billion because of poor performance, the bank estimated in a report. Hedge funds returned an average of 1.4 percent in 2014, their sixth straight year of underperforming U.S. stocks, according to data compiled by Bloomberg, and the worst since 2011.

“Poor performance will be most acutely felt by small hedge fund firms,” Sandy Kaul, global head of business advisory services at the New York-based company, said in the report, referring to those with an average of $100 million in assets. “These funds simply did not generate enough performance-fee revenues in 2014 to cover their gap.”

Hedge funds typically collect a management fee of about 1.5 percent of assets and a performance fee of 18 percent of profits. That can mean billion-dollar fortunes for some managers who exceed benchmarks, and for larger firms, they can still cover costs. Smaller funds that don’t perform are less able to cover any operating shortfalls such as paying staff. After last year, some firms will have difficulty making up an aggregate $615 million operating shortfall, Citigroup wrote.

Returns Shrink

Average hedge fund returns have shrunk as the industry has exploded in size to $2.8 trillion from $973 billion in 2004. The industry has shifted as investors gravitate to larger, more established managers. Some banks, including Bank of America Corp., are also cutting prime brokerage ties or increasing fees for hedge funds that don’t meet profitability targets.

Weak returns combined with record-high industry assets mean that management fees now account for a bigger share of total profit than revenue from performance fees in years when returns slump, according to the report. Last year it was almost 2.5 times greater, Citigroup said.

Some of the best-known hedge fund managers earned the biggest profits in 2014.

Bill Ackman, the billionaire investor who wages campaigns against corporate management and boards, made more money for his clients than any of his rivals, according to a Jan. 26 report by LCH Investments. Hedge fund managers netted $71 billion for investors last year, with the top 20 accounting for $25.2 billion, London-based LCH said.

Equity Value

Last year’s performance resulted in only a 7 percent drop in the theoretical equity value of the industry, which fell to $239 billion, according to Citigroup. The calculation estimates the amount of capital that would be raised from selling off equity shares in the hedge fund firms.

The value fell at a lesser rate than profits because proceeds from management fees are weighted more highly than those from incentive fees, which tend to be less stable, when valuing of firms.

Hedge funds’ $31.2 billion in 2013 profits accounted for 34 percent of the $93 billion in total asset management industry revenue, according to the report.

The bank’s survey was based on responses from 149 firms with $581 billion, or about 20 percent of industry assets.

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