Why Hedge Funds Close Down

Hedge funds are closing this year at a rate not seen since 2009, according to Bloomberg. But this Bloomberg article is missing one critical point……why shut down at all if the investors are still keeping their money in the fund?

This question of mine went unanswered for my first few years in the financial industry. Just having bad performance generally isn’t reason enough for anyone in the financial industry to “give up.” Is the closing of a hedge fund some sort of “honorable” resignation?

Funds “Close Down?” Really?

Hedge funds reserve the right to shut down. Keep in mind this doesn’t mean they are bankrupt, or even that they have lost money. It just means that they sell their holdings, send the proceeds back to the investors, and stop operating. A hedge fund could conceivably “shut down” after having enormous gains.

On its surface, it is a perfectly normal and logical idea. It is just like any other investment venture. A restaurant starts out, does business for a period of time, and then sells, sending the proceeds of the final sale value back to the original investors.

But mutual funds don’t shut down very often

Do you hear about regular mutual funds shutting down? Yes, it happens sometimes, but very rarely. Mutual funds generally hang on for a long time, and sometimes get absorbed into another funds, but they almost never shut down and send the cash back to investors.

This is what perplexed me for a while. Why shut down the hedge fund just because of some lagging performance, especially if the investors haven’t pulled out their money? It is hard to built up client investors. Why end the whole venture through self destruction? Was it like a political resignation? Kind of like a Secretary of Defense that has made some horrible errors and resigns honorably?

Not at all. Hedge funds shut down because of the way they fee. And once you understand how this works, it all makes sense. Like most aspects of the hedge fund industry, it is not pretty and done solely for the benefit of the fund managers.

How they fee

Hedge funds generally charge a 2% base fee and then 20% of the profits above the investors’ original start value. This can be pretty complicated. The hedge fund has to keep track of every single investor’s starting value so they can calculate the proper fee on the gain above this starting water mark.

If a hedge fund has a little negative performance, they can end up in a situation where there isn’t a lot of gain above the investors’ starting value for them to harvest their big 20% of gain fee. All they get to take is the base 2% fee (which is still way to high, but apparently not enough for the insatiable appetite of the fund manager). If the hedge fund’s performance is sharply negative, it can be some time before they can recover enough to get back to most investors’ original “watermark” before they can start harvesting the big 20% of profits fee.

So what does the manager do in this situatioin? They don’t like the current “watermarks” for their investors, so they just shut it down. They send out the cash and then start a new fund….and all the new investors in the new fund have fresh starting value “watermarks,” so there is now a new chance for the hedge fund to get profits and charge that big 20% fee.

Sound pretty sad? It is just one more reason to stay away from hedge funds.