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Hedge Fund Managers Set Up for Next Acts

Julie Creswell|The New York Times
Friday, 17 Sep 2010 | 8:19 AM ET

James J. Pallotta, a legend of the hedge fund industry, is calling a do-over.

CNBC.com

James J. Pallotta closed Raptor Global last year and is opening a new fund.

After shutting his giant fund following a humbling loss, Mr. Pallotta, the money manager who is an owner of the Boston Celtics, is doing what hedge fund types do in tough times: he is opening a new fund.

There have been plenty of mulligans in the rarefied realm of hedge funds these days. Mr. Pallotta, 52, is one of a number of prominent money managers who are trying to start afresh after the tumult of the financial crisis.

By closing one fund and opening another, managers can, in a stroke, wipe clean their investment records and start collecting fees from new investors.

Who would entrust their money to a hedge fund washout? Plenty of people, it turns out. Before the financial collapse, Mr. Pallotta had a record of handsome returns. His new fund, called Raptor Evolution (his old one was Raptor Global), will in all likelihood have no trouble drumming up investors, analysts said.

“Will it be easy for him to raise money? Yes,” said Tim Berry, a head of hedge fund investments at Private Advisors, a Richmond, Va., firm that advises large institutions on their investments. “He has a long track record of success.”

Others hoping for a comeback include Gabe Nechamkin, a former trader for George Soros, and John W. Meriwether, whose Long-Term Capital Management failed spectacularly in 1998. Mr. Nechamkin is on his second fund, Mr. Meriwether his third.

Not everyone will get a second or third chance. Hedge funds, whose outsize returns — and paydays — defined an era of Wall Street riches, are in the midst of a painful shakeout.

Over the last two and a half years, investors have withdrawn nearly $320 billion from these private investment pools, leaving the industry’s combined assets at $1.5 trillion, according to data from BarclayHedge.

Small funds have been hit hardest. Since their number worldwide peaked at 12,000 in 2007, it has fallen to about 8,400, according to research from the executive search firm Heidrick & Struggles.

The industry as a whole struggled in 2008 and 2009, and this year is not looking much better. For the year through the end of August, the average hedge fund was down 1.4 percent, according to Lipper, a unit of Thomson Reuters. Investors are increasingly asking themselves whether they would be better off putting their money in a low-cost index fund. The Standard & Poor’s 500-stock index is up 0.5 percent.

Given that showing, nearly half of the hedge funds included in the Hedge Fund Research Index have been running below the levels they need to attain to earn their rich performance fees for the last three years. (Hedge funds typically charge a management fee of 1 to 2 percent and take a 20 percent cut of profits provided they pass performance milestones known as high water marks.)

“It’s a pretty crowded field with very high fees,” said Todd Buchholz, a former managing director at Tiger Management, the hedge fund firm run by Julian H. Robertson Jr.

“I don’t see that this is the death or the last gasp of hedge funds, but there is certainly a shaking out going on here,” said Mr. Buchholz, who now oversees a real estate hedge fund called Two Oceans. Some managers are closing underperforming or money-losing funds and trying to persuade their old investors, plus some new ones, to provide new capital.

These funds face two challenges, however. Many have to agree to make up past losses before earning a performance fee from their previous investors — if those investors return at all.

Most also have to indicate to investors that they have learned their lessons and that the investment strategies of their new funds — at least on the surface — will address past problems.

Will Investors Forgive and Forget?

Jeffrey Gendell’s firm, Tontine Capital Partners, averaged returns of 38 percent from 1997 to 2007. Tontine Capital oversaw $7 billion before it closed two funds that had lost more than two-thirds of their value in 2008; a few months later, in 2009, Mr. Gendell opened a new hedge fund.

The new fund, Mr. Gendell said in a letter to investors, would invest only in easy-to-trade securities and would not use leverage, or borrowed money, to improve its returns. Mr. Gendell vowed he would not collect performance fees until investors had recouped their previous losses. A spokesman said Mr. Gendell declined to comment.

It is unclear whether Mr. Nechamkin and Mr. Meriwether, neither of whom returned a call, are using new and improved strategies or offering to make legacy investors whole before collecting new performance fees.

The looming question for these and other managers is whether investors are willing to forgive and forget.

Hedge fund managers and their employees are reluctant to discuss their attempted comebacks. One individual who worked at a fund that closed and is now trying to raise money for a new fund said many in the industry were trying to play up their past success, rather than their recent losses.

“It creates a weird dynamic,” this person said, who asked not to be named so as not to jeopardize the new fund. “You want to be part of the good, but not part of the bad.”

For Mr. Pallotta, whose Raptor funds had more than $12 billion in assets at their height, there were a lot of good years.

Mr. Pallotta — who recently built a 27,000-square-foot home in one of Boston’s wealthiest enclaves — posted average annual returns of 19.2 percent in the 15 years he worked for the billionaire Paul Tudor Jones and five years before that at Essex Investment Management.

Raptor was spun out of Tudor Investments in late 2008, after the fund lost 20 percent. Turning in a flat performance in the first few months of 2009, Mr. Pallotta shut the fund in that June, telling investors in a letter that he had doubts about “the sustainability of certain aspects of the industry’s structure and short-term focus.”

A spokesman said Mr. Pallotta declined to comment.

With his new fund, Mr. Pallotta is going back to Square 1, recreating the conditions that he had at the start of his career, said a person with knowledge of the fund, who declined to be named because of continuing efforts to raise capital.

Using a small team and focusing on a small number of securities, Mr. Pallotta is not looking to become a megafund for now, this person said. So far, Mr. Pallotta has won back some old investors, as well as new ones. But he will not earn a performance fee on the new fund until previous investors recoup their losses.

As Mr. Berry put it: “If he’s passionate about investing and doesn’t mind working with a smaller capital base for a while and wants to prove to investors he’s still got it, then he’ll do fine.”