High water marks still haunt hedge funds

NEW YORK (Reuters) - Hedge funds have rallied from last year's stunning losses, yet hundreds of managers remain deep in the hole and face some tough decisions in the coming weeks.

The fund industry suffered one of its worst years ever in 2008, when the average hedge fund fell by 19 percent amid tumbling markets exacerbated by record withdrawals.

Yet even as managers quickly mounted a comeback -- the average fund rose 17 percent over nine months -- roughly 10 percent of the industry's 8,000 hedge funds may remain deep in the hole by year-end.

"The high water mark outlook will be a lead story going into the last six weeks of the year," Credit Suisse (CSGN.VX) global head of prime services Philip Vasan said in an interview.

Before markets began rallying in March, a number of Wall Street executives warned a large chunk of the industry may face pressure to shut down or suffer staff departures. The reason: funds cannot charge full fees, usually 20 percent of profits, until they exceed their "high water mark" or peak value.

Without these performance fees, fund managers may be hard pressed to pay annual bonuses or even meet overhead costs. In some cases, firms will close funds. Star traders may defect to rivals or, increasingly, strike out on their own.

"A number of high quality people who would never have left their firms are deciding that if they have to work for free, they might as well build a business for themselves," said Deutsche Bank (DBKGn.DE) global prime finance co-head Barry Bausano.

Credit Suisse research determined that about 45 percent of the funds we looked at were at or above their high water marks going into September. Another 20 percent were down by 10 percent, or within striking distance in a reasonable period.

But a quarter of all funds were 20 to 30 percent down. At the low end of that range managers needed to rally 43 percent just to break even.

With so much at stake, Wall Street is poring over hedge fund performance data. And so far this year, strong returns have quieted dire predictions, especially among the largest and best known funds.

"More and more funds have rebounded and are close enough to where they can see the high water mark, to a point where they feel they can get over it," said John Laub, Americas head of prime brokerage at UBS (UBSN.VX). "It seemed a lot more daunting when we started the year."

It is difficult to generalize in an industry with dozens of different strategies and where individual fund performance varies so widely.

Even within the ranks of the hardest hit funds, there are many circumstances that could convince managers and their clients to stay the course. For one, funds will consider if they are close and can surpass peak levels early in 2010.

Some firms are attracting new capital, which pay performance fees at lower fund values. Others have renegotiated terms with investors, agreeing to lower fees for an extended period rather than receive no fees this year.

"Firms that are still well below their high water mark are adopting different strategies," said Alex Ehrlich, Morgan Stanley's (MS.N) new global head of prime brokerage.

"Those that did not close are trying to manage their way forward through performance, or, in some cases, offering revised terms," he said.

The big shakeout also will not be felt equally across the board. Among funds with less than $500 million: 12 percent were down 30 percent or more, compared with 6 percent of big funds.

"Most of the consolidation will be outside the top 5 percent of funds," Bausano said. "So will a couple of thousand funds close? Absolutely; but the majority will be three guys in a garage ... rather than more established managers."

(Reporting by Joseph A. Giannone; Editing by Richard Chang)