Hedge funds are dead. Long live private assets. Remember when hedge funds were the envy of investors? The returns were magical. The managers were gods. And they bestowed their bounty on a select smart-money set.
Investors happily paid absurd fees for the privilege, typically a 2 percent management fee and 20 percent of profits. Some investors paid an additional “2 and 20” to so-called funds of funds — hedge funds that invested in other hedge funds.
It all started with a spectacular run for hedgies in the 1990s. The HFRI Fund Weighted Composite Index — an index of hedge funds — returned 17 percent annually from its inception in 1990 to 2000. It beat the S&P 500 by 1.6 percentage points annually with half the volatility. Hedge funds seemed invincible.
Seizing on investors’ credulity, every junior banker on Wall Street rushed out to start a hedge fund. According to HFR data, the number of hedge funds grew by an average of 326 funds a year from 1991 to 2000. But from 2001 to 2007, that number spiked to 889 funds a year. There were more than 10,000 hedge funds by the end of this year.
Investors also became more cavalier about fees. The percentage of hedge funds that were funds of funds averaged 15 percent from 1991 to 2000. That number jumped to an average of 20 percent from 2001 to 2007.It was all a delusion, of course. There was little chance that more than 10,000 hedge funds would on average continue to deliver market-beating returns with so little volatility. And no investment is foolproof. The HFRI Index tumbled 21.4 percent from November 2007 to February 2009. It has since returned 6.2 percent annually through July, compared with 18 percent for the S&P 500, including dividends.
Needless to say, hedge funds have lost their mystique. The number of hedge funds has shrunk by an average of 33 funds a year from 2008 to 2016. But it doesn’t seem as if investors learned anything from their hedge fund craze because they’re at it again. Only this time, the road to riches is paved with private assets. It’s been hard to make money in recent years, not only in hedge funds but everywhere. Outside of U.S. stocks, there’s been little to like.
Into that vacuum, enter private assets. The Cambridge Associates US Private Equity Index has returned 10 percent annually over the last 10 years through 2016 — the most recent year for which returns are available. That’s 3.1 percentage points annually better than the S&P 500 and 2.9 percentage points better than the Russell 2000.
It’s not just private equity. The median net internal rate of return of the private capital funds tracked by Preqin averaged 11.8% for vintage years 2007 to 2014 — the most recent year available. Those funds include private equity, private debt, real estate, infrastructure and natural resources funds. Those funds, too, enjoyed a smoother ride than publicly traded stocks.Suddenly, investors are gaga over private assets. According to Preqin, the number of private capital firms grew by an average of 220 a year from 1980 to 2015. But in 2016, that number jumped to 872. There were 7,129 private capital firms as of the end of 2016.
If all this sounds familiar, it should. Like hedge funds before them, there’s little chance that 7,000-plus private capital firms will on average continue to deliver the highflying returns that investors see in the rear-view mirror. The trillions of dollars now chasing private assets have driven up private equity valuations, slashed private debt yields and compressed capitalization rates for private real estate. None of those things bode well for future returns. Investors’ love affair with private assets may be just beginning. But if the hedge fund debacle is any guide, it won’t end happily.