The "Sting" of Hedge Funds.

Two events got me to thinking about the hedge fund Industry over the weekend. The 1st was a party thrown in Narragansett, Rhode Island by hedge fund manager Joseph Healey who had the British musician Sting play for his guests for his 40th birthday party. Mr. Healey invited over 200 guests to the party but he also fixed the stage so that Sting played to a sizeable free crowd out on the Narragansett beach. One of the folks soaking in the free music on the beach was me. You can read about the concert here: http://www.projo.com/news/content/projo_20060806_sting6.1eede32.html. Sting was great by the way. He played many of his well known songs as well as some old Police tunes.

The 2nd event was the closing of a well known and well respected energy hedge fund at the end of last week. Motherrock Energy Fund was run by an ex-Nymex president who by all accounts was well regarded in his business. Bloomberg broke the news on this here http://www.bloomberg.com/apps/news?pid=20601109&sid=a2RV_7_smzJ4&refer=home at the end of last week.

Now first for disclosure Lumen Capital Management, LLC runs a small private fund which is not open to new investors. Also this is not an article set to bash Mr. Healey or the Hedge Fund business. I don't know Mr. Healey, cannot say what kind of investor he is or what kind of returns he has generated for his clients. I will also note that most of the money Mr. Healey shelled out for this concert is reported to have gone to charity and he certainly made an effort to enable the beach goers to hear the concert. The only comment I want to make is that most 40 year olds in this country do not have the money to have Sting come sing at their birthday parties.

But that is the nature of the Hedge Fund business where the potential to take what is a standard 20-40% of the profits of the fund has the potential to force its principals to take exponential risk. Often the way these funds are set up so that it is head the principals of the fund win, tails the investor lose.

Take Motherrock for example. Bloomberg reports that the fund had more than 400 million dollars in customer assets earlier in the year and made 23% on it's customers money last year. If say for example the fund had average assets of 300 million dollars all of last year it's principles earned almost 14 million dollars . Here's the math ($300 million X 23%= $69,000,000. Assuming the principal's of the funds take is 20% of the profits that means they split $13,800,000.) In case you are wondering the expenses of the fund would have been charged against the 1% management fee that the fund would have charged its investors in this case another $3,000,000.

Now to further the Motherrock example, Bloomberg also states that this year the company is shutting down its doors because it has lost 23% this year. The investors who made 20% last year on their money have given all of that back plus more. Also in case you are wondering, unless there is something atypical in Motherrock's documents, the principals of the firm aren't required to give back any of what they earned from the fund last year unless they do so voluntarily or can be forced to do so by a court which is a very hard proposition to attain.

Now in theory what is supposed to keep a hedge fund working for its investors is something called a "Highwater Mark". The highwater mark usually states that once the fund suffers a drawdown-that is once a fund declines below last year's close- the principals do not get paid again until the fund gets back above last years reported amount. So if on the $300 million above stated example Motherrock had lost 23% or roughly 69 million dollars then the principals could not be paid again until they had again moved above their "highwater mark. This in theory should keep the manager's interests aligned with the limited partners. It often doesn't. The math works against the fund. A fund down 23% like Motherrock has to earn back 30% just to get back to break even. Often when faced with these sort of odds the principals of the fund just close up shop.

Now here is one of the dirty secrets of the investment business. If as a principal of a fund I have an investment structure that absolves me of most liability from loss via an offering memorandum, if I'm pretty smart in the risk assessment area, if I am willing to use leverage (sometimes a lot of it via margin), if I get lucky and if my markets treat me right I might be able to generate those 20+% returns. I might be able to do it for a couple of years. But I might not be able to do it forever. If I can't and particularly if I'm using leverage the losses can be overwhelming. Often many years of gains evaporate in a matter of months.

Sting quit playing the other night to a thunderous applause from us on the beach. Investors in hedge funds when things go brutally wrong often don't feel like clapping.