What a difference two years make. In late September 2008, Lehman Brothers Holdings Inc. had just filed a bankruptcy petition, and hedge fund redemptions were growing in size and speed. Some even thought, at the time, that the viability of the hedge fund industry itself was in doubt. But two years later, the industry is not only viable, but vibrant, and facing a very different set of challenges. Whereas the problem in late 2008 was, generally, too little money, the problem today, at least for some managers, is too much money. That is, a growing number of hedge funds are reaching a level of assets under management (AUM) above which it will be difficult for their managers to deliver performance consistent with target returns or expectations. As a result, managers are closing such funds to new investors or new investments. See “Primary Legal and Business Considerations in Structuring Hedge Fund Capacity Rights
,” Hedge Fund Law Report, Vol. 3, No. 22 (Jun. 3, 2010). There are at least four reasons for this trend. First, gross assets under management by hedge funds are growing. See “How Can Hedge Fund Managers Accept ERISA Money Above the 25 Percent Threshold While Avoiding ERISA’s More Onerous Prohibited Transaction Provisions? (Part One of Three)
,” Hedge Fund Law Report, Vol. 3, No. 19 (May 14, 2010). Second, institutional investors are, with some notable exceptions, shifting away from funds of funds in favor of direct investments in hedge funds, for two primary reasons: increasing familiarity and comfort on the part of institutional investors with direct hedge fund investing, and skepticism regarding whether the due diligence and monitoring services performed by funds of funds justify the extra layer of fees. This shift to direct hedge fund investing can strain capacity in various ways. For example, in times past, a pension fund might have invested $10 million in a fund of funds that in turn invested $8 million in an underlying hedge fund and kept $2 million in cash. Today, that same pension fund might invest the same $10 million directly in the underlying hedge fund, resulting in $2 million less capacity in the hedge fund. See “Three Significant Legal Pitfalls for Hedge Fund Marketers, and How to Avoid Them
,” Hedge Fund Law Report, Vol. 3, No. 36 (Sep. 17, 2010). Third, a disproportionate share of the capital recently invested in hedge funds and expected to be invested in the coming quarters has flowed into larger funds. See “Dodd-Frank May Impose New Obligations on Managers of Large Hedge Funds and Plan Asset Hedge Funds that Enter into Swaps
,” Hedge Fund Law Report, Vol. 3, No. 32 (Aug. 13, 2010). And fourth, some institutional investors are changing their approach to allocations in ways that, on balance, may result in larger percentages of their portfolios being allocated to hedge funds. See “Implications for Hedge Funds of a Potential Paradigm Shift in Pension Fund Allocation Strategies
,” Hedge Fund Law Report, Vol. 3, No. 16 (Apr. 23, 2010); “Lessons for Hedge Fund Managers on Liquidity, Allocations, Marketing and More from Yale’s 2009 Endowment Report
,” Hedge Fund Law Report, Vol. 3, No. 14 (Apr. 9, 2010); “As Pension Funds Exceed Hedge Fund Allocation Guidelines as Other Asset Classes Decline More Precipitously, Hedge Fund Managers Ask: Will Pension Funds Redeem or Revise their Allocation Guidelines?
,” Hedge Fund Law Report, Vol. 2, No. 17 (Apr. 30, 2009). The net effect of these four factors is that, in certain strategies, the demand for hedge fund capacity is starting to outstrip the perceived supply, or as Simon Ruddick, CEO of alternative investment consultant Albourne Partners, Ltd., put it in recent comments
to Pensions & Investments, “Contingent institutional interest massively exceeds credible alpha supply. This means capacity is bound to be an issue sooner or later.” In order to help hedge fund managers think through whether, when and how to close their funds to new investors or investments, this article discusses: recent example of closings; the benefits of hedge fund size; the drawbacks of size, or in other words, the rationales for closing; hard versus soft closes; the overlay of capacity rights granted in side letters; using hedge fund closings to manage the composition of an investor base; disclosure with respect to closings and reopening in hedge fund governing documents; communicating with investors; side letters; managed accounts; and fiduciary duty. Before proceeding, a caveat is in order. We recognize that for every hedge fund manager running up against capacity constraints, there are one or probably many managers knocking themselves out to raise funds. At the industry level, there may well be sufficient capacity to meet the investment demand. However, implicit in our phrase “perceived supply” and Ruddick’s phrase “credible alpha supply” – and in the “race to the top” phenomenon discussed above – is a note of risk aversion: for many institutional investors, the issue is not hedge fund capacity overall, but capacity with the largest, most established managers. Such risk aversion may be rational for the managers of many institutional investors in light of restrictive investment policies, considerable personal downside for investment losses and limited personal upside for returns in excess of modest targets. However, the opportunity cost of that risk aversion includes the strong returns that, according to studies
, can be generated over long periods from a portfolio of smaller hedge funds. See “The Space between Alpha and Beta (and Why Hedge Fund Investors Should Care)
,” Hedge Fund Law Report, Vol. 3, No. 24 (Jun. 18, 2010). Also, industry participants expect Dodd-Frank in the U.S. and the AIFM Directive in Europe to increase the costs of launching and operating a hedge fund management company, and thus to diminish entry into the hedge fund business by potential new managers, increase exits by closure or sale and decrease the total capacity in smaller hedge funds.