Tuesday, January 27, 2009

Deephaven to Close

Deephaven Capital Management was a hedge fund that reached about $4B assets at one time. They announced today they are closing shop, selling themselves for $7MM plus potentially $30MM more (depending on fund performance and how much money leaves), to Stark. They still had over $1B in assets, so as one analyst said, the $7MM is 'paltry'. I used to work there, and as they were kind enough never to sue me I have nothing but nice things to say about them. But they highlight an interesting hedge fund dilemma.

Say a fund is down 35% or so, as many funds were in 2008. If you expect a volatility of 12%, and hope for a Sharpe of 1, it will be 3 years before you make any incentive fees again (the 20% of profits). That's because a high water mark means you only make the 20% after your investors are back to their high water mark. Now, if you own the fund, you are probably wealthy enough to stand 3 years of no cash flow from the basic fund. You probably also get a lot of non-cash utility from owning your fund. Thus, I can see why you still keep it going if you are an owner-manager. In Deephaven's case, they were 51% owned by Knight Capital, meaning, the main owners were not much involved in day to day management, and have other core businesses to manage, ones they actually control day-to-day. So, if you are down about 3 years of expected returns, for an outside owner, it's a good time to exit.

I suspect many funds are facing similar cost/benefit calculations. If a fund is down 30+%, most of those who don't feel a real stake in the action will have a big incentive to shut down, because of these high water marks.


Anonymous said...

does the high-water mark carry over?

is Stark sound? IIRC, they were in the news for financing movies etc not too long ago.. also trading CAT bonds?

Anonymous said...

High water marks must encourage exactly the type of strategies that usually give small positive returns and occasionally blow up (e.g. selling out-of-the-money puts, or doubling your bet every time you lose and going back to betting 1 unit every time you win). I feel like a good fraction of hedge fund "alpha" was/is exactly this effect.