By: Steve Deutsch, AllAboutAlpha.com Editorial Board

In September, the Institutional Limited Partners Association (ILPA) rolled out its “Private Equity Principles.” This document has been getting a lot of attention and is described by the organization as…

“…a set of principles and best practices for the private equity industry with the goal of strengthening the long-term viability of the asset class as an institutional investment strategy.”

Both the means and the message are worth taking a closer look.

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Like Democrat versus Republican, Communism versus Capitalism or Yankees versus Phillies, discussion and debate over fees, their justification and their pending demise is perennial and never-ending. With each market downturn and never-again wave of investor revolt, the banter over whether alternatives managers can and should be exorbitantly charging for their services inevitably heats up.

Certainly AllAboutAlpha.com is just as guilty when it comes to focusing on and feeding the fee frenzy. Only a few weeks ago we published this post about the yet-again demise of 2 and 20 in light of the new era of reduced returns – and reduced interest – in hedge funds.

So it caught our attention when Tabb Group published a report last week noting that while they too expect management and performance fees to steadily decline over the next couple of years, that according to their poll of hedge fund managers 1.75 and 21.93 are actually the new 2 and 20.

“Many wouldn’t be surprised to know that ‘2 and 20’ is still alive and well,” Matt Simon, TABB research analyst and author of the new study, “US Hedge Funds 2009: Fees, Redemptions and Managed Accounts,” noted in a statement accompanying the release of his report. “When weighted by assets under management, the reality is ‘1.75% and 21.93%’.”

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Yesterday we argued that value-added, not “absolute returns” should be the key metrics in judging the recent success of hedge funds.  Implicit in that argument is the assumption that hedge fund investors turn to the asset class for its diversification properties.  After all, losing less than the markets in 2008 was only commendable if it was not achieved by simply un-levering a market ETF.

Today, we learned of a recent survey of institutional investors that found just that.  According to Preqin (see other interesting research from this rather prolific organization) over half of institutional investors surveyed said they invested in hedge funds for diversification purposes.  The runner-up reason was “to improve the risk/return profile” of their portfolio” – another reference to the diversification properties of hedge funds.

Curiously, the survey also found that investors are now far more concerned about all issues except fund performance.  This time last year, over half said that the performance record was a “key consideration when choosing a hedge fund manager.”  This year, the number has fallen to a third.

Although “firm reputation” is slightly less of a key consideration this year, the number who said “quality of personnel” is a key consideration jumped four times over the course of 2009.  This may seem a little contradictory.  But we can think of several examples of firms with stellar reputations that were headed by “low quality” personnel…

Amazingly, the survey found that the vast majority (65%) of respondents hadn’t lost any confidence at all in their hedge fund managers over the past year.

“Backlash” (?)

These findings stand in stark contrast to a report by the FT that hedge funds are suffering an “investor backlash.”

The article contains the usual complains about lock-ups, but then quotes one market participant as saying:

“In some cases, it benefited all investors to halt redemptions and wait out the liquidity crisis. Market conditions have improved and fire-sales have clearly been averted…”

The FT cites another player who makes a similar argument.  Reports the paper:

“Most market practitioners concur that restructurings have been constructive, as they have helped managers to safeguard the interests of their funds and their investors…”

Such positive reviews for redemption gates are sure to take some of the wind out of the sails of hedge fund “backlash”.

“Haunted” (?)

Okay.  No backlash.  But according to Reuters, hedge funds are  still “haunted” by high water marks.  The news service says,

“…hundreds of managers remain deep in the hole and face some tough decisions in the coming weeks…”

But like the FT piece, this article acknowledges that the problem has all but gone away compared to a year ago.  Reuters cites Credit Suisse research that found 45% of hedge funds are actually above their high water mark, and a further 20% had a legitimate shot at a performance bonus this year.  Only about a third was going to get a lump of coal in their Christmas stocking this year.

The article concludes that,

“…strong returns have quieted dire predictions, especially among the largest and best known funds…”

Fewer “dire predictions” may be what’s behind the Preqin numbers above.  But what can we expect from the industry over the final months of 2009?

Swinging for the fences…?

But will we start to see some managers “swing for the fences” as they clamor to get over their high water marks?  With prescient timing, the Journal of Alternative Investments provides an answer to that very question in this quarter’s edition.

The article “Locking in the Profits or Putting It All on Black? An Empirical Investigation into the Risk-Taking Behavior of Hedge Fund Managers” by Andrew Clare and Nick Motson explores whether hedge fund managers actually start making big bets if they’re down as the year comes to a close.

Regular readers may recall our review of Claire and Motson’s original paper on the topic.  The duo found that hedge funds who were down by year end tended not to ramp up volatility after all.  However, funds that were up YTD did tend to ramp down volatility and lock in their profits.

…Or nudging oneself over the finish line

While 2009’s losers may not swing for the fences or “put all on black”, we may find that those who are tantalizingly close to break even may end up eking out a small gain on the year.  After all, there’s nothing worse for a manager than a minus sign, right?

AAA regulars may also remember this 2007 study by Nicolas Bollen of Vanderbilt University and Veronika Pool of Indiana University that found an awfully fishy anomaly in the distribution of hedge fund returns – a dearth of “slightly negative results” (click to enlarge)…

The chances of this happening naturally, according to Bollen and Pool, are pretty small indeed.

It remains to be seen if these phenomenon play out in 2009.  But it would appear that managers won’t have to make any strategic gambles or use any tactical tricks to impress institutional investors this year.  At the very least, they’ll get a nice card this Holiday season.

Apparently hedge funds aren’t the only ones having doors slammed in their faces these days.

According to a report released this week by PREQIN (Private Equity, Real Estate, Hedge Funds, Infrastructure), private equity real estate funds worldwide raised just $4.9 billion in the third quarter, the lowest quarterly fundraising total since 2003.

While at first blush one might presume it’s the lousy U.S. real estate market’s fault, in reality it’s more a reflection of investors’ still-cautious appetite for deals, and in turn their cautious appetite for investing in funds that invest in deals.

Indeed, many investors remain capital-constrained, or are being cautious about committing to firms until they are sure the funds can hit a certain minimum level.

PE Real Estate Fundraising

“Investors are very cautious, with many having seen significant declines in their real estate portfolios and are reluctant to commit to new vehicles,” says PREQIN.

With banks slow to write down the value of their real-estate portfolios, investors may not feel the need to rush back into the market, the report says.

No kidding.

The reality is that despite huge amounts of cash on the sidelines, most investors, particularly institutions, are keeping away from longer-term, somewhat-illiquid vehicles, never mind those focused on real estate.

What it boils down to is the losses private equity funds and everyone else took in 2008 — and convincing investors in the aftermath that those losses were a one-off event. Add to that still-tight credit markets and deal flow for private equity firms remains stagnant, whether real estate or anything else.

Quarterly figures recently released by Dow Jones Private Equity Analyst are a case in point: In the third quarter, 72 funds secured $25.2 billion, a 70% drop from a year ago. Year-to-date, buyout shops have seen fundraising slide 59%, from $195 billion raised by 315 funds through the third-quarter 2008 to only $79.9 billion thus far in 2009.

A separate report this week by Hedge Fund Intelligence noting hedge fund assets under management have also continued to decline shows the exact same thing.

A case of concern over a still-sour housing market, or a case of cold feet and hard lessons among investors? We’re betting both.

By:  Konstantin Danilov, CAIA, AllAboutAlpha.com Editorial Board

A recent survey of institutional investors done by London-based Preqin (Research Report: Fund Terms After the Crash) is indicating that a new trend is emerging in private equity investing. After a period of several years during which investors slowly conceded more and more negotiating power to the GP, the balance of power has began to shift back to the LPs. This is not surprising, given the developments over the past year and the current investing environment. Many investors have begun to question whether private equity is really a unique asset class with excellent diversification benefits, or just a form of extremely opaque, highly leveraged equity investing. Further, the fundraising environment remains highly competitive as many potential investors are facing an unprecedented liquidity crunch, and have neither the ability nor the willingness to invest in new funds.

Tipping the Scales

As the aura surrounding private equity managers began to fade in late 2008, investors began to reassess the lenient terms and conditions granted to GPs during rosier times. While little could be done regarding existing funds, new offerings provided prospective LPs with ample opportunity to seek more favorable terms and conditions going forward. It seems that a significant amount of institutional investors were able to take advantage of this opportunity; the survey result shows that 43% of respondents felt that the balance of power in negotiating new fund terms and conditions has shifted towards the LP during the past six months.

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As this article from Pensions & Investments points out, the long-awaited drop in hedge fund fees may finally have arrived.  Although performance fees – a significant portion of overall fees – have recently dropped to zero percent across a wide swath of funds, P&I observes this week that:

“Some hedge fund managers — including Renaissance, Citadel and Diamondback — are heeding the call from institutional investors, setting up new funds, share classes or better-priced offerings.”

While fee pressure may appear to be a relatively new phenomenon, research in the past has shown that in aggregate, investors have been forcing down the fees charged by higher risk hedge funds.  A study written in October 2008 by Gavin Cassar at Wharton and Joseph Gerakos of the University of Chicago found…

“…a positive association between the quality of internal controls and the performance fees rewarded to managers, consistent with investors protecting against potential financial misstatements by placing less emphasis on the reported performance when internal controls are less likely to detect or prevent managers from manipulating reported performance.”

In other words, investors have always put pressure on riskier funds by forcing them to charge lower performance fees.  However, unlike the current flavor of hedge fund investor activism, this pressure seems to have resulted from investors simply voting with their wallets and avoiding riskier, unproven funds – thus forcing them to lower their  fees to attract capital.

These charts from the paper confirms data we presented in this post a few months ago, showing that less than half of all funds actually charge a 2% management fee…

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(By: Konstantin Danilov, CAIA, AllAboutAlpha.com Editorial Board)

Private Equity valuations have received a great deal of attention recently because of FAS 157, a new accounting standard that requires firms to use exit prices when calculating the fair market value of portfolio companies. The new calculation methodology is markedly different from the previously accepted practice of valuing portfolio companies at the purchase price, and has revived the timeless Private Equity “Valuation Debate”.

On Another Level…

In a recently released paper, Espen Robak discusses the intent and implications of FAS 157 for reporting firms. The most fundamental change resulting from the adoption of the standard is that the definition of fair value is no longer the entry or purchase price, but rather the exit price of an investment. The standard creates a valuation hierarchy rating system, which places a greater emphasis on observable market inputs versus assumption based methods:

• Level I – the inputs used are actual active market prices
• Level II -  the inputs used are quoted prices for similar assets in active/inactive markets, or other observable/derived market inputs
• Level III – no observable inputs are available

Firms should, in theory, feel pressured to avoid Level III classifications, because these will require increased disclosure as well as the least credibility with investors. The standard also states that firms can’t ignore available market data, even if the market is not perfectly liquid. (For an additional discussion of FAS 157, see Kalin Kolev’s paper.)

The Valuation Debate

Many GPs simply don’t see the point; they argue that private equity is a long-term investment and that interim valuations mean little in the context of actual long-term results. Why should investors be concerned with a current exit price for an investment that is 5 or 10 years away from being exited?

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When we first examined the secondary market for hedge fund stakes, there was only one company in the business, Hedgebay (see related post).   Several others jumped into the business early this year and were welcomed with sudden industry growth as hedge fund investors began to scramble for liquidity.

While all hedge fund investors could have used a little more liquidity over the past 12 months, funds of funds were apparently doing most of the scrambling – trying to respond to redemption requests on one side and redemption gates on the other.

Earlier this month the Wall Street Journal reported that the customer base served by HF secondary markets has changed as a result.  Reported the Journal:

“‘Last year, it was very much a local story dominated by individual investors in Swiss private banks spooked by actual and alleged links to Madoff funds on top of dismal performance,’ said Elias Tueta, co-founder of Hedgebay, which provides a platform to match up buyers and sellers of hedge fund stakes.

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A few days ago, we noted that despite hedge funds having succumbed to the double-whammy of poor performance and scandal, institutional investors seems remarkably sanguine about their alternative investment portfolios.  A survey by SEI and Greenwich found that two-thirds of institutions expected their hedge fund allocation to “stay the same” even by the time the survey was conducted in January – well into the great hedge fund draw down of last fall.

Sounds nuts, right?  Well, now another survey seems to corroborate this finding.  In fact, a survey of 50 institutional investors released last week by Preqin, a London-based consulting and research firm, found that half of respondents said the turbulence of the last 12 months has not affected their confidence in hedge funds and they are continuing to invest.  If that isn’t surprising enough, the survey found that more than a quarter of respondents said their confidence had increased and they planned on increasing their allocations to hedge funds.

As you might guess if you read this website on a semi-regular basis, we’re not surprised by those whose confidence was unaffected.  But we’re very curious about what occurred in the past 12 months that could have actually increased one’s confidence in any investment, let alone hedge funds.  The snap survey was conducted only a few weeks ago, so unless the respondents had been at a Monastic retreat in Nepal or stuck on a South Pacific island with the cast from Lost, they would have had plenty of time to second guess their investment decisions over the past year.  A measly 7% (1 in 14) said they were reducing their allocation to hedge funds (chart from report below).

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