MyTake March 5, 2009, 12:01AM EST

The Good, Bad, and Ugly in Hedge Funds: A Manager's View

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Naples (Fla.)-based BusinessWeek reader Eric Jackson is founder and managing member of Ironfire Capital LLC and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund Ltd.

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Man Group in Britain will be the model for the biggest U.S. hedge funds, running multiple strategies and catering to the institutional investor and pension fund community. It's likely the funds with more than $5 billion in assets today will assume the mega-fund mantle in the future. Funds under that level will shrink or sell out. However, niche hedge funds will continue to thrive, as long as they have unique strategies that are successful.

Most will prosper with a couple hundred million dollars in assets, although some niche strategies can handle up to $2 billion. This is where a lot of innovation and outperformance in the industry will emerge. For example, the most feted hedge fund manager of the past two years is John Paulson, who made billions betting on credit default swaps, which predicted the severe souring of the housing market.

Prior to 2007, Paulson's firm was best known for its unremarkable, yet steady positive returns and merger arbitrage expertise. It's likely that he couldn't have made his bearish housing bet at a bigger shop. The perceived risk he was taking on with the CDS, especially going against the conventional wisdom at the time that housing would rise steadily because it always had in the post-World War II era, would have been rejected. Investors will be always on the lookout for the next great manager whose wave they can ride—and it will come from the smaller, more entrepreneurial managers.

Nothing Personal

Here's a scary thought for hedge fund investors: Hedge funds domiciled offshore (e.g., in the Caymans or British Virgin Islands) have boards of directors that tend, in my experience, to be far more lax and chummy than most corporate boards. (U.S.-based funds typically do not have boards as they operate as general partnerships.) These offshore boards tend to be small, typically two or three people, one of whom is often the hedge fund principal. Since the board oversees the investment manager's mandate, this is a huge conflict of interest that most hedge fund investors don't talk about.

Although it would be wrong to have a large bureaucratic board for a relatively small and entrepreneurial organization like a hedge fund, small boards often encourage managers to ask "friends" to fulfill this role. As a result, board meetings tend to be informal, tough questions don't get asked, and a real debate of legitimate risks facing the fund is avoided.

Many funds end up appointing a "rent-a-director" who lives locally and usually is recommended by, and affiliated with, the offshore lawyer working for the fund. These professional board members often have no job except serving on dozens of similar fund boards. They are simply there to be paid, so they clock in and clock out of meetings with a 9-to-5 mentality that would make a Dilbert character blush.

There are excellent hedge fund directors. However, perhaps not as many funds would be imploding this year had their boards done a better job at holding managers' feet to the fire when times were good.

Slimming Down

The hedge fund industry will be working off its "too big, too fast" growth in the coming years. We're going from 10,000 hedge funds to perhaps 6,000 in the next few months. Performance, operational, and increased regulatory issues will weed out one-third of all hedge funds within two years. Remaining fund managers will have fewer staff, less leverage, and less compensation.

Those hedge fund managers with creative and differentiated strategies (and a track record and a background check that pass due diligence muster) will always find investors. Anyone worth their salt will stick it out; the dead weight and hangers-on will leave. That will make for a better overall industry.

Amid this upheaval and in the wake of the recent Bernard L. Madoff scandal, two hedge fund-related service providers will flourish: (1) third-party administrators who independently calculate a fund's month-end net asset values (NAV) for investors, and (2) third-party due diligence consultants who will scour the backgrounds and documents of fund managers looking for red flags to warn potential investors. I am amazed that these are still not considered absolutely required by investors before making an investment.

Who will wilt: the big fund-of-hedge-funds. Investors want managers who create value. Middlemen who take margin out of the value chain will be forced to defend their existence. Manzke, Tremont, and Fairfield Greenwich showed us through Madoff that too few funds-of-hedge-funds do meaningful due diligence on their investments that they promised their partners. Funds-of-funds won't die but will drop away in large numbers. Only those that are truly differentiated will survive.

Investors will (and should) place more conditions on fund managers and demand more transparency. Although it will be much easier to do this in a post-Madoff world, an investor's size relative to other investors in a fund will still determine his power to demand this transparency.

Registration Debate

Politicians on both sides of the aisle have called for more oversight on hedge funds, including a suggestion for mandatory "registration." What would registration really accomplish? Many hedge funds will continue to reside outside the U.S. and not need to register. But the largest hedge funds—with a majority of assets—in the U.S. already have registered and file their 13-F list of holdings on a quarterly basis. Registration for registration's sake, giving the government an abundant amount of data to do nothing with, seems a waste of time. Madoff, by the way, was registered with the Securities & Exchange Commission.

If the government wants to help improve capital markets, they should be prosecuting scammers and Ponzi schemes like Madoff, preventing "naked" short-selling abuses, and making it easier for shareholders to oust lazy and nonperforming members of corporate boards.

The hedge fund industry will work out its excesses carried over from the past five years and become a stronger collective of funds and fund managers. Most of the lemmings will leave, until the industry once again begins to experience excessive growth. Oversight must and will improve. Lessons will be learned. And investors will continue to flock to hedge funds because the industry will continue to attract the best managers with the smartest strategies.