More evidence that the amount of juice used by hedge funds was never as great as many assumed

Vitamin "L"

Hedge funds and leverage seem to have become synonymous in recent years.  Yet when we surveyed the recent history of hedge fund leverage last spring, we found that in aggregate, hedge funds were using only modest amounts of leverage after all.  In fact, data from the last few years seemed to indicate that aggregate hedge fund leverage reached a high of around 3x – a far cry from the “30x-40x” number quoted by some financial commentators.

One caveat to our scan of recent data was that many hedge funds use derivatives that are implicitly leveraged even if the hedge fund itself uses little or no leverage.  So aggregate hedge fund leverage could still have been many times higher than reported leverage.

The recent edition of a series of excellent McKinsey reports addresses this very question.  The report, titled “The New Power Brokers:  How Oil, Asia, Hedge Funds, and Private Equity are faring in the financial crisis” (free registration req’d.) contains the following chart showing the combined effect of fund-level leverage and securities-level leverage.

leverageratios

Curiously, the McKinsey analysis adds up to about the same leverage levels that were reported in various other studies (and that did not discriminate between leverage borne out of debt vs. derivative positions).

Underwater hedge funds: Marianas Trench Style

Another notable chart in this must-read report is the following one showing the number of funds that are so deep under their highwater marks right now that it would take over 2 years for them to come up for air.

Marianas

According to the firm, over a third of hedge funds will take 2+ years to recover (assuming they produce the same returns as they had during the ’03 to ’07 period).   This makes them candidates for liquidation by their managers – who, says McKinsey, “may choose to shut these funds rather than operate solely for the 2% management fee.”

“Dot-com Bust”

The report makes an interesting observation about the recent boom and bust in Hedgistan:

“One fund manager we interviewed called this [the HF shakeout], the “dot-com bust” for hedge funds.   But just as the dot-com bust hardly spelled the end of the Internet business, the challenges of the past 18 months will not cause the collapse of the hedge fund industry.”

Regular readers know that we often compare the growth trajectory of the hedge fund business to that of the e-business sector.  Both were based on a new and disruptive “technology” that disintermediated traditional value propositions.

However, in this 2007 post, we questioned the likelihood of a hedge fund “bust” in the dot-com sense of the word.  Hedge fund valuations are based on objective data on current asset values and do not embed any information (hype) about the future of the hedge fund management industry itself.

But after viewing the past 18 months from our front row seat, we have come to realize that  the “dot-com bust ” analogy with a twist may be appropriate after all.  During the dot-com boom, supply of new issues was limited, so stock prices rose.  Demand was expressed in the marketplace by higher prices since supply was relatively inelastic.

Hedge funds, on the other hand, are infinitely scalable and prices totally inelastic (in that they do not respond to demand – only to the value of underlying assets).  So with higher prices (NAVs) unable to remove the froth from the hedge fund market, and with supply being totally elastic, the hedge fund boom was expressed as a boom in supply not price.

Ergo, the hedge fund “bust” was expressed as a crash in quantity, not price.  So in a sense, the “dot-com” analogy actually holds up pretty well.

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3 Comments

  1. Anonymous
    July 17, 2009 at 6:35 pm

    How does one factor in the billions of dollars lost to fraudulent hedge funds, and how is that reflected in the charts?


  2. PD CAIA
    July 29, 2009 at 1:46 am

    two comments:
    1. The McKinsey numbers pale by comparison with the other alpha-seekers of our world, the banks’ prop desks. Total unlevered assets, if you can estimate them, for i-banks, would have been 2-3 times that of the h-fund industry. And leverage was stratospheric – I remember GS in November 2008 underling their prudence in reducing their leverage to only 16x. Sixteen Times. I’d take a wild guess that, if you factor this into McK’s numbers, you’d get a range from more like US$20tn to US$3tn (note – “guess” – don’t quote me!). The reduction in the firepower of the h-fund industry is tiny compared with that of the i-banks…
    2. …so the amount of alpha-seeking capital has imploded, maybe down by 90% in some markets/sectors, and hence returns on capital currently invested should be much higher than the period 2003-2007 – so those managers below high water mark may recover it more quickly than McK estimate. I suspect relatively few managers will close because they’re too far below HWM (as they still retain the long-term optionality of their revenue stream) tho’ we are seeing and will continue to see managers close because the size of their assets is not longer viable.


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