Hedge fund turnover threatens industry

As investment banks try to staunch the relentless hemorrhaging of top talent to hedge funds, they may draw a measure of comfort from the fact that hedge funds are battling a brain drain of their own.

'Turnover rates of personnel in hedge funds are dramatically increasing,' Robert I. Schulman, the co-chief executive officer of Tremont Capital Management, told an audience at the Securities Industry Association's annual hedge fund conference in New York last month. 'This is an institutional negative and a negative for anyone investing in hedge funds.'

Schulman's observations were drawn from Tremont Capital's tracking of thousands of funds and their employee turnover during the last twelve months, he explained in an interview. He expects defections to intensify. 'We think there will be a lot of people in motion after bonuses are paid,' said Schulman.

Show me the money

It's no secret that many hedge funds have struggled to stay above their all-time high-water marks this year. Whenever a fund dips below the mark, it must forgo profit-taking of 20% -30% and rely only on paltry management fees of 2-3%. Most funds don't generate enough this way to cover operational costs and employee bonuses. And if this year's bonus is bad, next year's will be too, unless the fund can claw its way back above the high-water mark-often by jettisoning staff along the way, unless their staff leaves first.

Deborah Rivera, founder of New York-based alternative-investment recruiter The Succession Group, says, 'I have seen that the most notable turnover is occurring at the lower levels of newer or start-up hedge funds, where young Wall Street recruits left their analyst grunt jobs for the sexiness of the hedge funds.'

The problem, she says, is that smaller hedge funds, with perhaps $100 to $300 million under management, struggle more intensely to become profitable. The serious money is made by funds with $2 -$10 billion under management.

'So these kids who thought they'd become overnight millionaires are not seeing the big bonuses they were hoping for, because the smaller hedge funds are trying to pay the partners first,' says Rivera, who is currently conducting searches for two multibillion-dollar, multi-strategy hedge funds. 'The larger firms remain very stable, from what we see, and continue to recruit and pay aggressively at all levels including the junior levels.'

Running for cover

For now, even with a nascent M&A boom underway in hedge funds, employees seeking to outrun the shadow of an unmet revenue target can usually find somewhere to go.

'There are a lot of new hedge funds starting up,' says Richard Risch, chairman and CEO of the New York-based financial search firm The Risch Group. 'Opportunities for people with hedge fund experience are much greater than ever before.'

For those seeking a fund that isn't going to go out of business tomorrow-and a firm less likely than smaller competitors to suffer from inexpert management-getting in at a top-tier fund may seem attractive. But even that carries risk.

Michael Flood, managing partner of Westwood Partners, a senior-level financial search firm in New York, says, 'The intensity and intelligence screen at the very good hedge funds is ten times that of the average investment bank. They're always looking for the best of the best of the best, and they're always sanguine about turning people over if they find a better alternative.'

Is the worst still to come?

As institutional investors, including pension funds, ramp up their alternative investments, hedge funds seeking a piece of the action need to be especially careful not to get hit by the revolving door. The consultants who advise institutional investors 'hate turnover,' says Tremont's Schulman, 'so they gravitate their clients away from these firms.'

The winners will be the hedge funds who nail recruiting and retaining along with other basic infrastructure functions. They have an uphill battle to fight. 'There's certainly less loyalty in general in the hedge fund industry than there is on Wall Street,' says Flood, 'because there isn't a new investment bank starting up everyday... If someone thinks they're going to get a better deal, they'll be foolish not to take a look at it.'