Hedge funds and Private Equity - PES

The rising number of hedge funds appears to go hand in hand with increasing competition
between hedge funds. The market for those hedge funds pursuing arbitrage strategies is but
one example of this. Here, a massive inflow of money managed by a growing number of hedge
funds appears to have competed away many arbitrage opportunities.
Due to increasing competition hedge fund managers have engaged in a search for alternative
ways to maintain or increase yields in a market where average yields seem to be sloping downwards.
In this context, many hedge fund managers are likely to consider investment opportunities
involving more risk than was the case in the past. At least this is what has happened in the past,
for instance in the early 1970s. In his recent book Hedge Hogging, the hedge fund and Wall
Street veteran Barton Biggs describes the years from 1970 to 1973 as a period in which
increasing competition led many hedge fund managers to take ever greater risks, with facile
hedges. As a consequence “(…) many hedge funds crashed and burned because they were
really just leveraged long funds and as a result suffered huge declines”, Biggs writes, adding
“Other funds had bought private equity-venture deals that turned out to be totally illiquid when
things got tough.” 64
This process of rise and fall does not seem to be historically unique. For instance, the period
between 1995 and 2002, a period characterised by first an upward and later a downward
sloping market had a failure rate of 32% among funds with assets under management lower than
$ 50 million. The same happened to around two thirds of funds of a size between $ 50 million
and $ 150 million. This percentage decreases significantly to less than 4% in the case of funds
with more than $ 150 million assets under management. The highest failure rates are found in the
field of managed futures (derivatives) that we turn to further below. By contrast, convertible arbitrage
and event driven strategies appear to have considerably lower failure rates. 65
Since 2002 the market has been sloping gradually upward for developed markets and rapidly
upward for emerging markets, e.g. South-East Asia. Yet, this process might stop once more and
lead to large-scale failures. It is difficult to assess when this could happen. And in the absence
of regulation it is most likely that the failures will repeat themselves. Moreover, the failures may
have a much more profound impact on financial stability than we have seen in the past. This is
not least due to some of the factors that will be addressed in the rest of this chapter, among
them the growing amount of assets under management.
5.2 Growing assets under management
The crisis of LTCM and other hedge funds proved only to be a temporary setback for the longterm
growth of the hedge fund industry According to conservative estimates, assets under
management by single strategy hedge funds, and the so called funds of funds, have climbed
from less than $100 billion in 1990 to more than $1,100 billion in 2005 (see Part I)]. Less
conservative estimates suggest that the assets under management amount to more than $1,800
billion in 2005. 66 Currently, the staggering growth rates – a 16-year average of 15% p.a. –
continue. Thus, some even predict that the assets under management could double again within
the next three years. This growth increases the potential impact of a financial crisis.
Despite its rapid growth, the hedge fund market remains small compared to the size of the
markets for non-alternative investments, such as the market for traditional mutual funds (UCITS).
For instance, mutual funds globally managed $ 17,771 billion in 2005. In other words, hedge
funds managed assets of between 6 and 10% of what mutual funds managed. This ratio has
grown by around 0.7-1.0% since 2002 EoY (+12%).
64 Biggs, B. (2006): Hedge Hogging, Hoboken (NJ): Wiley & Sons.
65 The President’s Working Group on Financial Markets (1999): Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,
http://www.ustreas.gov/press/releases/reports/hedgfund.pdf, p. viii (17.11.2006).
Part II – Six concerns about our European social market economy
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