As if the old adage about Main Street coughing and Wall Street catching pneumonia wasn’t tired enough already, new kindling was added to the fire in recent days in the form of abysmal performance numbers put up by some of the industry’s best known hedge funds as well as word that certain marquee portfolio managers were packing it in. Dan Benton, who made his name at Pequot and Andor Capital Management, announced he would be shutting down his fund in October. Former CNBC financial news commentator Ron Insana‘s advisory fund-of-fund vehicle told it’s investors that it would cease operations shortly as well.
Predictably, the schadenfreude has already begun. There are some within the venture ranks that have maintained that hedge funds and private equity groups had effectively sucked all the oxygen out of the room for venture firms these past six years in terms of attracting limited partner capital. While there is anecdotal evidence that one could argue supports that claim, I remain unconvinced. The principal rationale for venture firms imploding, at least as far as I have witnessed, has had very little to do with competition for investor dollars by hedge and private equity funds and has been largely the result of mediocre returns from mediocre venture outfits, persistent legacy issues, partner infighting, a dreadful dot-com/tech meltdown that took longer than anyone expected to work its way through the system, and a host of other ills. In almost all the cases that I have heard of, blaming hedge funds and private equity groups for draining the capital flows from venture groups has really been about sour grapes and about finding a convenient straw man to punch. Add to that the caricature that the popular media has provided of hedge fund and private equity players throwing themselves lavish birthday parties, buying robber baron-esque country estates, and indulging in over-the-top spending sprees, and you have a convenient whipping boy that is begging for a pile-on and a great story line for glossy magazines about the imminent bursting of the hedge fund bubble.
Sure, it makes for great copy, but not so fast. In its own Oscar Wilde-ian way, the demise of the hedge fund is being greatly exaggerated.
I don’t pretend that my crystal ball is any clearer than most in these matters, but I have been wondering aloud for years how the mathematically unsustainable lofty hedge fund returns could be, well, sustained. The hedge fund industry did not grow inasmuch as it exploded. From 800 active firms to 6,000 firms a few years later, to some 20,000 funds some time after that. If one accepts the premise that markets are efficient, it becomes pretty clear very quickly that returns must normalize over time as the market becomes ever more crowded with hedge funds all trying to beat the market. The inelegant image it conjures up is that of Miami Beach retirees all walking a small sandy beach with their metal detector wands in hand looking for that lost Rolex or wedding band. One guy will probably make a bundle. If there are 10 retirees out there, perhaps two will enjoy “outsize returns” for their time investment while the remaining 8 will cover costs and eke out a living. What we have come to — to push this metaphor to its logical conclusion — is 500 people on the beach…and it’s bedlam.
Ok, perhaps not a great analogy, but you get my point. Everyone in venture (and, I suspect, in the hedge fund business) loves to talk about finding the “white spaces” — those elusive regions no one has discovered yet. [i.e. That patch of sand no one has yet tilled with their metal finder.] Raw, exciting areas of opportunity where other investors aren’t breathing down your neck (yet) and there is time to roll up one’s sleeves and make a go of things. As more and more people pile into these sectors, incentives get perverted, valuations go haywire, and it’s almost impossible to get to a positive outcome. Typically, only a handful of smart investors find a way to eke out a couple good deal exits and everyone else licks their wounds and moans about the sector getting “overfunded.”
As tough as this is in venture, it’s just dreadful in the hedge fund world because of the mechanics of that business. Like in a sailing regatta, everyone is tacking off everyone else. Show a little success and you will find entire platoons of me-too copycat hedge funds mimicking your every trade. Pretty soon, you need to go further out on the risk profile to chase that elusive outsize return and then, like Icarus and his wings of wax, things don’t turn out so well. Now I know why there are almost always empty bottles of Tums strewn on every desk I walk by on the times I find myself at a hedge fund’s offices – especially lately.
While I do not cheer at the knowledge that some of my friends on the hedge fund/buyout fund side of things are in crisis right now, such a development could be good news for venture. Pendulums swing in only one way — too much this way, and then too much the other. Forever.
As for the hedge fund business, it will survive and prosper. Of that, let there be no doubt. But it will be leaner and more differentiated that it has become in recent years. This is in large part because in order to provide “outsize returns” hedge funds really need to get back to their entrepreneurial roots and eschew the temptation to raise excess capital and become like the bloated, glorified asset managers that they seek to best in terms of market returns. As the saying goes, one starts out in both life and business trying to break the mold; pretty soon, you are the mold.