Amidst increasing scrutiny by regulators for insider trading, the hedge fund group SAC Capital Advisors runs the risk that its investors will begin to ask for their money back in such massive amounts that the firm will be forced to close. Last week, Wall Street Journal reporters Dana Cimilluca, Juliet Chung, and Jenny Strasburg reported that SAC expects investors to withdraw (redeem) at least $1 billion in 2013.
But the fund's ability to escape collapse thus far reveals a lot about the unique issues that face hedge funds, and also how the funds are governed.
The roots of SAC's problems plagues all hedge funds. Unlike other investment funds, hedge funds are always at the risk of a collapse from investor withdrawals, much like a bank run. Private equity and venture capital funds, by contrast, lock in their investors' capital for several years. And while mutual funds are required by federal law to meet investor redemption requests immediately, their investors are less fickle.
So why is SAC still in business despite all the regulatory attention?
First is the fact that hedge funds are often indistinguishable from their top manager. In the case of SAC, that's Steven A. Cohen. Since it is unlikely that Cohen will be implicated in any regulatory wrongdoings, investors can remain fundamentally confident in the fund.
And then there's SAC's returns, which have been 30 percent a year on an annualized basis since the fund group was launched in 1992. With returns like those, investors are unlikely to abandon ship in large numbers. As academic research makes clear, hedge fund investors certainly care a lot about returns. And the best hedge fund performers, like SAC, tend to keep performing well over time.
In addition to personality and performance, though, SAC has governance tools that help prevent an investor exodus.
Like most hedge funds, SAC uses contract-based redemption restrictions. According to the WSJ story, investors are limited to quarterly withdrawals of no greater than 25 percent of their own investment. More commonly, hedge funds use so-called "gates" that limit total investor withdrawals to around 15 to 25 percent of the fund's value.
Investors are also probably very comforted by the fact that SAC principals personally invest in the funds they manage, an arrangement common in the hedge fund industry. SAC, however, has an unusually large amount of capital that comes directly from Cohen and SAC employees. Of the $14 billion SAC manages, $8 billion (57 percent) comes from Cohen and SAC employees. By contrast, a 2010 study found that of the 32 percent of hedge fund managers in its sample that personally invested in their funds, the top co-invested amount was $300 million.
And although SAC charges some of the highest fees in the industry (3 percent management and 30 percent performance fees), it is unlikely that SAC will lower its fees to placate investors anytime soon. This is not only because SAC investors are likely more than satisfied with their returns even after the fees, but also because they believe, as some academic studies suggest, that higher fees create incentives for the best hedge funds to keep on outperforming.
The counter-intuitive conclusion is that, when it comes to funds like SAC, higher fees may actually be a governance device that protects investors against the losses and mediocre returns found in other funds.
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