By any measure, the first six months of 2015 has been a wild ride. The uncertainties swirling around the potential “Grexit”, the on-again, off-again specter of an FOMC rate hike, quantitative easing by the European Central Bank, China’s comparatively sluggish economy and stagnant oil prices represent a few of the numberless variables hedge funds have confronted through the first-half of 2015. So how are they faring?

Performance

In the aggregate, hedge fund returns have been less than spectacular but, they remain in positive territory. Returns averaged 3.47% through June, 2015, representing a 20% increase in the gains achieved through June of last year. While overall hedge fund performance compares favorably to the S&P 500’s 1.09% year-to-date gain as of June 30th, 2015, it is important to recognize there are outliers at either end of the hedge fund returns spectrum.

Assets under Management

Hedge funds have experienced impressive growth, achieving $2.23 trillion in assets under management through May, 2015, which translate to $92 billion in net inflows.

Management and Performance Fees

As funds compete to attract new capital, management and performance fees have continued to decline from traditional two and twenty levels. Average management fees stood at 1.69% in 2014, while performance fees averaged 19.13%. Unsurprisingly, more than 38% of the hedge funds in a KPMG survey anticipated that management fees would see additional reductions in 2015.

Exit Requests

Redemptions dropped to 3.15% in July, representing a 34% decrease from June’s 4.80% rate of redemption. The 3.15% figure is the lowest since January, 2015. It should be noted that both numbers fall within normal parameters for exit requests. In short, nothing extraordinary is occurring on this front, most notably in terms of public and private pension funds.

Hedge Fund Start-ups

2015 has seen a plethora of startup activity. Bloomberg reported at the end of the first quarter that 6 new hedge funds had launched with assets under management of at least $1 billion dollars each. Two-hundred sixty-four new funds were launched in the first quarter of 2015—second quarter numbers are unavailable at this time. However, if this rate persists through year-end, the number of new funds launched will be roughly on par with 2014.

Hedge Fund Closings

Although second quarter numbers are unavailable at this time, it can be reported that 217 funds have liquidated through the first quarter of 2015. Remarkably, if this rate holds, closures will also be on a par with 2014.

Given 6 years of an arguably artificially driven bull market in equities and bonds, it is something of a testament to the implacable nature of the industry to see net gains in hedge fund launches in 5 of the past 6 years.

Hedge Fund Sector Shifts

In the first half of 2015, we have also noted a significant shift from convertible arbitrage, distressed securities, emerging markets and event driven to the macro and multi-strategy sectors.

Equity long bias, equity long/short, fixed income, merger arbitrage, and equity market neutral sectors remain largely unchanged from 2014 levels.

Closing Observations

Despite significant headwinds, the hedge fund industry continues to advance in net numbers and in assets under management. The industry has demonstrated its resilience and its innate ability to pivot as needed to meet contemporary challenges.

 

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The passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act in July, 2010 was largely a knee-jerk reaction to the financial crisis. This sweeping piece of legislation has had, like many legislative initiatives, numerous unintended consequences. For example, many believe that Dodd-Frank is responsible for the precipitous decline of the small community bank, the life blood of small businesses across the country.

However, it is difficult to singularly lie this at the door-step of Dodd-Frank. In 1995, there were about 13,000 banks with assets under $100 million. By the time Dodd-Frank became law in 2010; this number had dropped to 2,265 and it continues to shrink. In the four years following the passage of Dodd-Frank, another 365 small banks have closed, merged or otherwise disappeared. The Minneapolis Federal Reserve projects another 317 small banks will be lost in 2015.

There are persuasive arguments on both sides of the question but, regardless of cause, the irrefutable fact remains; small community banks are dwindling and small businesses are suffering from the vacuum, unable to secure loans necessary to sustain and grow their businesses.

Blood in the Water

A vacuum, to a hedge fund, is like blood in the water to a shark. Small to medium sized businesses are finding it increasingly difficult to borrow from conventional lenders and hedge funds are rushing in to fill the void with asset-based loans to small companies.

Hedge funds can be incredibly creative in the way they structure a loan, particularly in the manner of securing their investment. Hedge funds, unlike their conventional banking counterparts, have collateralized loans to small companies in ways unimaginable to bankers.

For example, hedge funds may require that a company pledge its patents as collateral, a practice almost never seen in traditional banking. Other hedge funds have secured themselves through convertible bonds. This means the borrowing company agrees to relinquish future equity in exchange for the loan.

The Trend is Gaining Traction

Lending to small business is not uncharted territory for hedge funds but the unabated retreat of banks from small business lending is creating substantial demand. Also whetting hedge fund managers’ appetites for this type of investment are the potential returns. The research firm eVestment reports that hedge funds dedicated to lending experienced average returns of almost 12% in 2012, compared to average hedge fund returns of around 2% in the same year. This heady combination of high demand and large gains is not lost on hedge fund managers.

There is little evidence of a paradigm shift in the banking industry with regard to small business lending. As a result, hedge funds and other purveyors of alternative lending options will continue to erode the market once dominated by community banks and other traditional lenders.

We may never fully understand the reasons for the decline of the community bank but, it is heartening to see the vacuum being filled by hedge funds, private equity firms and others. More than one-half of American workers owe their jobs to small business and hedge funds are saving and creating those jobs by engaging this demand.

 

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Hedge Funds and The OECD’s Global Tax Initiative

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