It has been a tough year to be a hedge fund. Poor performance has taken its toll as regulation, high correlations, an uncertain Europe, U.S. government acrimony, and a primary election campaign that looks more like the old Jerry Springer show than what we have come to expect from the tightly organized Republican Party have hurt returns.
While 2011 was nothing to write home (or your investors) about, however, 2012 is beginning to show more promise. Though equity volumes are declining, performance actually is up. We may not know for some time whether the better performance on weak volume is the result of a prolonged dead cat bounce, a lack of bank leverage or the beginning of a new bull rally, but 2012 certainly will be different than last year.
[Despite some promising signs, half of hedge funds are skittish about 2012.]
The most significant catalyst is the recent Jumpstart Our Business Startups (JOBS) Act. Pushed through Congress with blazing speed, the JOBS Act will have two major and different impacts: First, and most publicly, the JOBS Act will open up new ways for small companies to obtain funding. The smallest companies now can leverage crowdsouring mechanisms to raise capital without SEC registration. For larger private companies, the JOBS Act increases the number of permissable private investors to 2,000 from 500 before they need to file with the SEC and become "public," and it creates larger Sarbanes-Oxley carve outs.
So what's not to like about funding new and growing companies? The SEC and a number of brokers are lining up against this part of the initiative, arguing that by drastically relaxing funding regulation, pump-and-dump and other scam artists will invade the sector and make it more difficult for legitimate business to gain credibility and funding. That said, however, there will be more companies raising capital, more ideas put into the public domain and hopefully more capital allocated to developing new business with high due-diligence standards, which should be good for professional investors.
While new funding vehicles are interesting, even more interesting for the hedge fund community, the JOBS Act allows funds to advertise. While hedge funds still will be open only to accredited investors, this nonetheless will radically change the character of the industry. If you look at industries in which advertising bans have been lifted, you see significant change: Solo physician practitioners are a thing of the past, pharmaceutical firms now focus on blockbuster drugs, and lawyers and accountants have consolidated into fewer and larger players. Regulation increases, and the game changes.
This same realignment will happen to the fund industry as well. But who will end up on top?
As funds start to advertise, they will move from manufacturers to distributors. Why does someone advertise? To attract more assets. And so it begins: The industry migrates from a focus on return to a focus on asset accumulation. And this will cause consolidation.
Traditional asset managers that currently advertise will be attracted to vehicles they can now promote. Larger hedge funds and public fund companies will be able to use their capital to attract more assets, and the smaller funds will increasingly be marginalized. How many mutual fund companies do you see with under $1 billion in assets? Now tie this into the need for managers to be relevant, consolidating flow, increasing regulatory burdens, and, from the traditional fund perspective, business model compression from increased ETF competition, and it doesn't take much of a leap till you begin to see that larger traditional funds will move in, accumulate assets and use their size to acquire smaller and more talented managers, who will have a harder time surviving on their own.
While this won't happen overnight, given the JOBS Act's implementation timeframe, we should see this begin to play out over the next few years. That is, unless the pumpers and dumpers quickly kill the goose that lays the golden egg and Congress reacts by killing the program dead in its tracks.