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    Hard Times Come To The Hedge Funds-Loomis-Fortune-1-70 PDF

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    BERET eee Bears should have had a fine time in the 1969 market. But some followers of the hedge concept got clobbered on their shorts while being murdered on their longs. Worse than that, the SEC is moving in as HARD TIMES COME TO THE HEDGE FUNDS by Carol J. Loomis “Atalanta Partners, Takara Partners, August, Associ- ates Iearus Partners, Grasshopper Fund, Lineoln Part Here, Sage Associates, Rudman Associates, Tamarack: wecigies, Hawthorn Partners. Most investors would not Aad’a single familiar name in that collection or in 8 fist aeenore than a hundred similar firms that could follow. For all together, these firms represent an investment force capable of moving more than $1 billion in and out coho stock market, They are private “hedge funds,” those unique investment partnerships whieh operate al ‘most completely out of public view. ‘Some 3,000 investors, however, can claim a special view. for there are now that many who are limited part- ern in one or more hedge funds. Most of those investors aro wealthy, many are important businessmen, and some today are troubled about thelr hedge-fund investments hele misgivings are something new, for until lately the hedge funds looked like an investor's dream. The records they produced were consistently lustrous, and it seemed as if their stfucture was ideally geared fo success, ‘That strueture has three main features: first, the part nership arrangement fief, through which the managers sere tend can be compensated in such a way’ as 40 leave thom highly motivated to do well; second, the tse of Hor ‘rowed moriey to obtain “leverage,” a technique permitting The fund to take maximum advantage of « bull market; ree third, the use of short selling as'a “hedge,” oF pro- ation against a bear market, The trouble that has now fvisen is with the hedge, which simply did not meet last {Year's tern test. In gencral, the hedge funds were clob- Zonal hy the 1969 bear market, ending up in many cases Pith records that were worse than those put together by Regressive mutnal funda donied the luxury of short sales "The 1960 experience has been « rude awakening: for many hedge-fund investors, and has left some of them Ta strong reservations about the whole concept, For the ‘frst time in their relatively short history, the funds are Mot growing; in faet, some have suffered large with- Grawals of capital and a few have actually folded What remains, however, is still a big business, for in ‘tho last few years the hedge funds have both proliferated in'number and exploded In size. They are otll, i is true, Gwarfed by their public cousins, the mutual funds, whose atyets are jn the 50-billion range. But the more than 31 billion the hedge funds command is of quite apocial Interest, since itis money that is inclined to gravitate to- Ward the more speculative stocks and, in steady pursuit BE *performance,” to move in and out of them with ex feptional speed. Furthermore, the last couple of years fave seen the formation of some twenty-odd mutual funds That are patterned after the private funds and that are Commonty also identified as “hedge funds.” Their pres- Spee in the market substantially extends the impact of ‘the hedge concepts rhe most interested spectator of all of this growth has ‘boon the Seetrities and Exchange Commission, under ‘Wnove yoke the investment partnerships, because of their Trivate character, do not now fall, For sbost a yoar, Pre SEC has been giving the funds close new look, and While the commissioners have reached no conclusions, cer- Jain SEC staff members have made it supromely clear that they believe the funds should be brought under some form Gt regulation. ‘The managers of the hedge funds disitie Ghat thought in every respect, but what they most ff the prospect of an SEC move that would provent them from earning their compensation in the traditional way tiie By taking a share, usually 20 pereent, of the profits Tanta on thelr limited partners’ money. The glories of this arrangement, given a reasonably good stock market, Cxplain why s0 many money managers have been in- Sire to start hedge funds. But right now the threst SPISEC ection—and the threat must be judged very real ois another deterrent to growth Why the crowds gathered ‘One man who never really wanted the growth to get thi’ tar is Alfred W. Jones, who started the first hedge funds and for years had the business to himself. Jones itor a career as a sociologist and a stretch as & FonrUNE aititer in the early 1940's, established his frst limited Vurtnership, A. W. Jones & Co,, in 1952, He started + Peron one, A. W. Jones Associates, in 1961, by whteh Te he anus celebrated among his investors for having tomipounded thelr money, over his nine-year history, at & St percent annual rate, Because he was running private partnerships, Jones was able to Keep the dimensions of his eartcas very auiet, and he had no imitators of any conse ‘Guenoe until 1964, when one of his general partners-—the Peettot several to do so—pecled off to start his own fund Today three of the largest hedge funds, City Associates TWO PIONEERS Bird Woden AND A HOT ‘eel mat an NEW TEAM “Geetha cosa rd ae Sone isto epee ons consort. Sara poope fee ho tea te boat by farce expe, bet he 78 Tina’ ona boa V ever wana Tobe on™ | standout rogeomar atorg hada funds fs Sanne Fina, erro, whee 20 ‘ion tn by eo fet Howard P. Bake Investors rained a pln of 138 prc mayor since they hee Wat Bokon te heogesind buna, (ret pins, hae Ate ton na eae agape en epee, Soe oe Sie cry pie ae: Shee Saar aan Pairfleld Partners, and Cerberas Associates, each up- ‘wards of §20 million In slza, are run by former Jones ten, These funds are sometimes jokingly referred to ‘"Jonea's ehlldren,” though Jones apparently feel no pater- nal affection toward the dafectors from hs oryantzaton ‘The real growth of the hedge funds did not begin until 1006, and it came then in the wake of a FoRtUNE article fon Jones (“The Jones Nobody Keeps Up With,” Per- sonal Investing, April, 1966). That article pointed out ‘hat Jones long-term record was better than that of any mutual fund, that he had chown profits In most bear mar= kets and polied through even the 1802 collapse with only small loss, and that Jones Aimaelf hed beeome rich, ‘These Items of news were enough to create almost over- night a raft of would-be hole fond managers, most of ‘whom were convinced that Jones had discovered the mil Tenniam, Sore who then went on to start funds now scknowladze thet they paved thelr way into business by ‘sing the article about Jones asa sort of prospectus, rly ing on it for help in explaining, and selling, the hedge fund concept to Investors. In the four years since, the number of hedge funds has ‘erown to an catimated 150. The estimate is FonTawe's, and it is at beat wobbly, for counting hedge funds is one of the harder jobs around, Indeed, a ook at some of the ‘complications involved reveals lot about the intriguing character of these fonds. First of all, there Se tome dliagreament these days as fo the definition of a hedge fund. Once it was not so. ‘Aifeed Jones invented the hedge fund, and therefore his ‘style of operation provided the definition, Thus, a hedge fund wad a limited partoership organized to invest in Securities with the partnership structured in such w way fs to give the general partnors—the managers ofthe fund Se abate of the profits corned on the limited partners’ money, Furthermore, Jones said—and still saye—that hedge fund is aloay leveraged and alwaye carries st Teast some short positions. ‘Fine, except that thore are all sorts of limited partner. ships around hore days that have obviously borrowed tnost of Jones ideas, but not quite all, For instanco, there ‘are some partnerships that feel no obligation to be lev- raged, or 0 be short, In fact, somo have actually re ‘nounced one or both techniques, either because they have hover felt them necessary or wise, or because they have tried them out and bombed. On the ole hand, there are ‘loo partnerships around that-are leveraged and do make ‘short aales, but that have no provision for the generat FORTUNE Je 16 101 SOME STARS AMONG THE LIMITED PARTNERS. |Win money In eight fans, Laurenes THe, than Loew's, i faye a homing thing.” - The aneuesoned ham of Ndae nd Te Dania ttto heads 2 brokerage fi orang, ha fame. i {round 85 milion fn four tnd, haf of in ‘Steherat Fine, Borcote Seraten pre fora hie ove Inveiment Judgment o that oF ‘tha nae func but ays he fares out pat ne managers ert (below) who Temiy. and is hve partners to share in the limited partners’ profits. The Question, then, is which of these partnerships, if any, should be thought of as “hedge funds”? ‘The question is plainly arguable, but it would appear that the key feature of a hedge’ fund is neither the hedge nor the loveraye, but instend the method by which the general partners are compensated. Certainly: it fe this characteristic that has spurred the Zunds’ growth and also holped arouso the interest of the SEC. Therefore it seems reasonable to count as hedge funds those limited partnerships that do not necessarily hedge and/or use leverage, but that otherwise are constructed fn the Jones mold, This definition would exclude, for example, the funds set up by brokerage houses ax vehicles for commingling the accounta of several clients into a single account; the general partner, who is typically'e representative of the firm, runs the account on a discretionary busis, getting hhis compensation from the commissions that it generates, not out of investment profits. It i$ not unusual, further ‘more, for a family to set up an investment partnership. ‘Last year around twenty membors of the Rockefeller fam- lly and certain members of the Rockefeller staff organized the Pocanties Fund, capitalized with around $4 million, Since the general partners, however, will get no part: the limited partners’ profits, this fund—and others ilar to itis not under discussion here. Nor are the called venture-capital partnerships, whose emphasis long-term investments in new nonpublic companies m them far different from the typieal hedge fund. A beacon in Manhattan Armed with some definition of a hedge fund, the c taker next comes up against the enormous problem of d covering the partnerships that might fit the pattern. hhelp as there is comes from certain state laws applyi to partnerships. Typicaly, these Jaws stipulate that eve new limited partnership must file a body of informa about itself, including the names of the partners and amotint of thelr investments, at some specified eounty state office. The great bulk of the country's hedge funds are cated in New York’s borough of Manhattan, and, tl to a provision of the New York partnership law, ean’ fushed out there with relative ease. This provision ‘quires overy now partnorship to publish tho subatay of its official filing in two newspapers; in Manhattan, nag which thus provides the beacon by which essentinlly every Manhattan hedge fund can be located ‘What the reeards show fe that, since eurly 1966, when there were only a handful of hedge funds in existence, about a hundred new ones have keen formed in Manhat- tan, Some of there have fokded, but thelr numbers are probably roughly belanced by the funds set up in certain New York suburban areas. Inquiries in around twenty other reajor cities uncovorod bout thirty more funds, fand there can be no doubt that some were missed, In total then, an estimate of around 180 ede funds sams rensonable, ‘These 150 vary substantially in size and make-up. The largest axe Jones's two partnerships, each around $40 milion in size (Zor « Vist of some other leaders, see page 139), At the opponite end of the spectrum are a few funds ‘eapitalized with leas then $100,000. Some funds have ‘more than sixty limited partners, but the average is closer to twenty, There aze even a few with only one mlted partner, The most interesting of these solo acts are funds In which the limited partner isa corporation, or an art of a corporation, Por example, the NuTone division of ‘Seovill Manufseturing Co. has invested $2,070,000 from ite pension fund, of all places, in Waterbury Associates, ‘8 onesyear-old venture run out of New York, “Like the funds themselves, the 3,000 or so investors ‘who populate them come In many varieties, Their average Investment works out to betier than $800,000, and as the magnitude of thet amount might sugaest, many have hhames thet are immodiately eeognlzable. A proce number fare corporate executives: e.g, Laurence Tiseh, of Loew's: ‘Keith Funston, of Olin Mathieson: Leonard Goldenson, of American Brosdeasting: Daniel Searle, of G, D, Seari ‘Smith Richardson Jr, of Richardson-Merrell; Lou! "ho" Poll formerly of M-G-M. Another well-Lnowa bust nessman, Nathan Cummings, of Consolidated Foods, once held limited-partnerahip interests, but has recently given them up, So has actor Jimmy Stwart, However, a pssel of other movie stars—Deborsh Kerr, Lana Turner, Rod. Steiger, Juek Palance—remain bunched in one California fund, Taurus Partners. Gregor Piatigoraky, the cellist, Pete Gogolak, the pre-football place kicker, and Thomas ‘and William Hiteheosk, solona of the Mellon family, are ‘ther examples of the diversity that isto be found among hedge-fund investors. ‘A watchdog for Mr. Phipps. Ie becomes apparent, in discussions with limited part- nets, that many never had any idea that their names, ‘much leas the size of thelr investments, were on file in ome courthouse ov atate oe building. A lot are appalied At that news, Probably out of a desire to keop what in. formation they ean confidential, the managers of some hedge fand have made their partnership flings very dif feult to find. For instance, though the managing partner of Cerberus Associates, Ronald LaBow, has bis office in owntown Manhattan and run the partnership's port folio from there, the partnership's papers are fled in aub- tirban Westchester County, where the partnership keeps fan address, in neither loelity does Cerberus have a listed phone, When one finaly lifts this veil, number of prom= Eyent ames turn up on the fans lst of investors, in. hiding Howard Phipps Jr, of the wall-enown Long. Isfand family. Liited partnerships are required to amend their fl- ings whenever important changes, such as the admission of new partners, take place. Tho latest partnership fling bby Cerberus gives mid-1966 data and shows Phipps vestment to be $2,600,000. Cerberus’ record since then ‘has boon more up than down (it has been « star performer ‘among the hedge funds) so dt is Ikely that this invest rant ia now larger, As @ footnots, it may bo recalled that jn mythology, Cerberus was the threeheaded dog who ~ guarded the gates of Hell; the name, one dictionary says, sso connotes “a watchful and formidable or surly Keepér or guard.” ‘The comfortless cushion ‘After Inst your's bear market the words “watchful” ‘and “surly” might also have been used to doseribe certain hedge-fund investors. FORTUNE has been ablo to find only 4 very few fands—most of them under $10 milion in sssets—that were in the plus colurmn for the year. Many ‘of the Targer funds had dismel records: on the frst ‘of October, when the New York Stock Exchange com- posite average was down by some 13 pereont for the year, the two Jones fands and City Assoelates were down be. tween 80:and 40 percent Figures compiled by John M. Hartwell, who rans a large investment-counseling rm and who has been man- aging two private hedge funds himself, also suggest the ‘extent of the destruction. During the month of June, when the market, at measured by the Big Board's composite average, dropped by 8.9 percent, elght hedge funds on ‘which Hartwell collected data (his own two were In- ‘luded) dropped on the average by 16.3 pereent, In July, ‘when the market fell 64 percent, the funds were down by an average of 10 percent, And in August, when the ‘market bounced back briefly, the seven funds for which Hartwell had data averaged only a 4.2 percent gain, come pared to a 45 poreont gain for the composite average. ‘Despite the ‘weight of this and other evidenee, som hedge-fund managers have attempted to persuade their investors Uhat 1969 wasn't really aa deplorable a it might have seemed. Charles #. Hurwitz, who runs three private Ihedge funds in Texse and aloo one of the largest public hedge funds, Hedge Fund of America, reminded the shareholders of that fund a few months ego that “the hedging feature is desiymed to reduce losses in a down- thar, not eliminate them.” He also referred to the “eash- Toning” effet of the hedge concept during 1969. Some stockholders must have shuddered to think where they ‘would have bein without the cushion. Fer at the end of November, ina tabulation of 879 mutual funds prepared ‘by Arthur Lipper Corp, Hedge Pund of America's 24 per~ cent decline for the year left ft siting In the 840th spot. [Even then, it was some distance ahead of the oldest public hedge fund, the Hubshmen Fund, whose cushion had not prevented {from losing 47 percent for the your and tak: fing firm possession of the 879th spot Euphoric at sixty-nine Alfred Jones, a candid and likeble man, is one hedges fund operator who has not taken 1963 lightly. He has brooded about the year’s catastrophes, and believes he ‘ean trace thor esuses, The trouble began, he says, in the 1986-68 period when the craze for performance swept the fvestment world and when all sorta of money man- fagers,inelading those in his own shop, got overconfident ‘about their ability to make money. Jones's record for this period was excellent: during his three fiscal years ending. ‘May 31, 1968, ehrough 1968, the limited partners In A. W. Contin page 136 FoRTUNE mnsey me 103 Change Begins in the Doctor's Office mind Consideration is seldam given to innovations in the system or forms of practice. Thus iti difficult for most practicing phy- sicians to appreciate the arguments of their critical colleagues “or even to understand what they are talking about. ‘During their training period, doctors go through what Dr. Lewis of Harvard calls “a greater socializing, process than ‘even the priesthood.” For at least seven years they spend al» ‘most all of their waking hours with other doctors or would-be doctors, not only absorbing medical information but, in Dr. Lewis! words, “learning how to act and think as well” Con sciouely or otherwise, most pattern themeelves after the role models set by their inatructors. Humane, but also human “When they are accused of “making too much money," doc- tors ean with some justiee point to the fact that medical edu- cation is tremendously expensive—even allowing for the fact {that so much of i is government-subsidized. The Association ‘of American Medical Colleges estimates the average bill for four years of medical school at $20,000. After they get their degree, moreover, most doctors spend three ar more years 25, {ntoms and residents. More than 90 pereent of interns and residents atill receive salaries under $6,000, although some ‘hospitals pay far more. According to 2 1968 study sponsored by the Department of Health, Raineation, and Welfare, doc- tora below the age of thirty-five typically earn less than other professionals except clergymen. And this ix at a time HARD TIMES COME TO THE HEDGE FUNDS contissedjrom pers 108 Jones & Co. realized gains—after deduction of the general partners’ 20 pereant of profits—-of 29 percent, 22 percent, and {5 percent. In all three years, these gains (as Well as those te- ‘conded by Jones's other partnership) were far superior to those made by the broad market averages. As the new fiscal year began in mid-1968, the profits eontinued to build up. Even ‘Jones himself, despite his sixty-nine years, was caught up in “hat he describes as the “auphoria” of the times. Ho says he began to worder—for him, the very thought was heretical — ‘whether his hedging strategies, which had always been aimed “at softening the effoet of a potential market declineand whieh tind therefore held back iis gains In bull markets, might not hhave been misguided; perhaps it would have been smarter, hho told himself, to have run at full risk all the time, thus taking maximum advantage of the genoral upward trend of the market. It svas in this frame of mind that Jones and his organi. zation came into late 1968 and into a market top, which, of ‘course, contd not at the time be easily recognized as such. As the market slid, Jones and his portfolio managers gradually cut back: their risk by building up short positions—but as he says, it was “too little, to Inte.” By May 81, all ofthe early {gains of the fiscal year iad been wiped out, ‘The breakeven Jorformance that Jones was obliged to report to is investors Compared ta 4.8 percent gain for the Exchange's composite ‘Qverage, and so, for the first time in his history, Jones had fin- {shed ascond to the market, “Jones's reaction, other than dismay, was to involve him self more closely with the business, which in recent years had ‘occupied leas and eas of his time, Included in his immediate ‘witen many are still saddled with debt from thetr modical- school days. ° ‘Later, not surprisingly, doctors make up for the lean years witha vengeance, According to Medical Economies, themedian ‘net income of self-employed doctors below the age of sixty- five in 1967 was $94,700. ‘The figure undorstates the ineome ‘of the well-established man. For, while it excludes interns and residents, it includes young doctors just entering private practice—and many of them report not losses for a year or ‘two, Between 1955 and 1967 physiclant’ median ineome rose fa startling 117 pereent—20 percent in the last two years, as ‘medicare and medicaid poured new money into the medical marketplace, Certainly one important consideration that makes doctors oppose a reorganization of the health-care ays- ftom is the fear that it may threaten their financial position. ‘As Dr. Rashi Fein, the medical economist, recently told & congressional subeormittes, “Doctors may be humane, but ‘they are also human, ‘With fow exceptions, physicians are conscientious and dedicated to providing the best possible care for thir own par tien, But preoccupied with this demanding onosto-one rev sponsibility, and limited by background and training, most fare unwilling to recognize the flaws in the general system, and tthe unmet needs of many of their fellow citizens. The flaws, however, are now showing up everywhere—in the waiting rooms, in the hospital corridors, and in the figures on the coat of care. Change has to come. If they want to guido its ‘rection, paysiciane must quickly begin to supply some leadership. As Dr. Knowles warns, “If we want to keep our profession free, We have to control ourselves, and act in the public intorest.” END, problema was some unrest among his limited partners. One ‘of them, tn fact, had written to complain that the standard bf fiving to which he had become accustomed was incompat- {ble with break-even yeara, Jones, while he ean hardly view hhis Imited partners as on the verge of destitution—thelr ay- ‘erage investment is even now around $500,000—is neverthe- {ens sympathetic to such problems; for his funds, more than most in existence, include a large number of investors who hhad very little to start with and whose partnership interests, now represent virtually their entire wealth. Acknowledging {this, Jonesnovr says that his unds will not in the future be xy ing for the big swings, but vill instead aim for moderate, steady growth. (“Moderate,” to Jones, it not to most people, ‘Seems tp mean gains of 20 0 80 percent. a year.) In his annual letter to his partners ast July, Jones spelled out his thoughts a little farther: “Bach monoy manager is now fully aware of the necessity of running his segment as though the typical Limited Partner were retired and had all of his capital, say $500,000, invested in our business.” Crowding up on the short side ‘Jones's midyear decision to keep his short positions high, though it eame at a time when the market was still heading ‘down, did not got him out of the woods. For, as almost any ‘hedge-fund operator ean testify, itisone thing toassumeshort positions and another to make money on them, even in a ‘bear market. The alleged difficulties are numerous and have ‘een recited so often by battered short sellers that they are by now fairly well known. One is a procedural difficulty: by ‘an SEC rule, short eas in listed stocks ean only be made on an “uptick” (Le. the last change in the price of the stock must have been upward); this restriction makes large posi- tons hard to establish, Another difficulty arises from the ten deney of Wall Stree’s analyste to concentrate mainly on continued page 136 HARD TIMES COME TO THE HEDGE FUNDS cotined Aeveloping buy recommendations, meanwhile ignoring the short side, Such few gaad sharts as are then discovered tend to beeome overerowded, and crowds tend to bring én short squeezes. Stil other diffielties have to do with the odds: the beat short eale in the world ean produce only a 100 per fit, wheress a long position offers the possibility of unlimited gains. Flipping the situation, a short position, should the stock begin to rise; can Tead to runaway losses. Finally, and not by any means least, psychologically it is much easier to panie about a short position than a long one. Tn most years this litany would also include the complaint that there is almost no way to produce short profits in a gen~ ‘rally rising market, Last year that exeuse was not available. ‘The market favored the shorts, and yet many hedge funds still lost money-—er, at the best, made only 2 little~on their short positions. Some heeige funds say that 1969 had its spe- cial problems, among them the existenes of too many hedge funds looking for aborts. In addition, the mechanies ofa short sale require that the seller borrow the stock to consummate his sale; last year the Street's back-office difficulties greatly complicated the borrowing process and frequently fmpeded the short seller. ‘Nevertheless, the hedge funds’ main problem last year was of @ more elementary Kind: they simply pieked the wrong stoeks to short, In particular, there were many funds whieh, figuring that the market would go down, also figured that the drop would be led by some of the high-multiple growth stocks, e.g., LB.ME, Xerox, Burroughs. Actually, these stocks. ‘came through the decline in first-class shape, and in early De- ‘ember were not far from thelr highs for the year. Bruises for puppeteers ‘The debris of 1969 has naturally prompted some hedge- fund investors to atk just what i ie that the hedge-fund eon- copt is doing for them. If short selling does not afford pro- tection in a down market, then why short at all? Why not Instead retreat (o eash when the rearket looks bad? In taking this tack, these investors are, of course, leaning toward the views of those fund managers who have never gone in for hort selling or who have at some point given it up. Lately, this group has been gaining some new supporters, among them John Hartwell, whose short-selling experience comes not only rom his private funds, but also from a publie hedge fund he Dogan in 1988, Hartwell, though he has not yet abandoned shor selling, has eome to doubt that itis worth the effort put into it. "Hedging is vastly overrated as a concept. People argue that there is paychological comfort in having 2 short por sition. [used to believe it, but I don’t any more. Istopped be- Tieving it after we got bloody and beaten from short selling.” "They haven't capitulated in the Jones camp, however. Al- fred Jones and most of the fund managers who came out of his stable remain convinced that hedging is not only a de- sirable strategy, but i eaventia if the portfolio manager is to ‘keep the nerve he needs to operate aggressively, snd suesess- fully, on she long side, Talk to the general partners of such fans as City Associates and Fairfield Partners, and they will speak rucfully of 1969 and tell you they should lave been able to pull out of it with peeits, They regard their fare to do co 22 a reflection not on the hedge concept itself, but on theie own ability to handlo it properly. After all, i is clear that the great majority of stocks went down last year, an, that there were innumerable opportunities to clean up on the short skle—itonly those opportunities had been saized. “Th riaviorietté always works,” one fund manager said recently. “It’s the puppeteer who changes.” ° ‘The debate about this particular marionette is likely to he prolonged, for a single bear market ean hardly settle matters, fone way or the other. In the meantime, the hedge-fund busi- ness seems certain to undergo extensive changes, some of hich have already begun to materialize. In a way, the busi- ness sat this juncture typical of those industries in which sup- ply has at least temporarily exceeded demand, and in which some casualties are the inevitable result. No one knows ax- actly how many hedge funds have folded. But a fair number Ihave, Two that have just closed down are New York's Hay- mar Associates, and Los Angeles’ Associates West, both of which got their Investment advice from HayWood Manage- ment Corp., a subsidiary of Hayden, Stone Ine. Both also hhad poor reeords in 1969. So did Woodpark Associates, a New York partnership that is now leaving the scene, albeft slow- ly, Although ithas been trying to liquidate for several months, itis stueke with more than $1. million in securities that are “re- sirietod,” ic., that eantot be sold until they are registered with the SEC. Various problems have delayed the resistra- on, and as of last month Woodpark’s investors still had not ‘ot this money out. "The arvival of the new year will mark not only the demise of certain other unsuccessful partnerships and the constrie- tion of still others, but will also bring the liquidation of one ‘of the country’s oldest, largest, and most successful invest- ment partnerships, Buffett Partnership, Ltd., of Omaha. To tall the Buffett operation a hedge fund is accurate only in the sense that Warren B. Buffett, thirty-nine, the general part~ net, shares in the profita of the limited pariners. (Under his (quive unusual arrangement, the limited partners annually Koop all of the gaine up to 6pereent; above that level, Buffets takes a one-quarter eut.) Otherwise, he is set apart from the regular hedge fumdsby the fact that he has invested almost ex- ‘Cusively in long-term “value” situations. Buffett's record has ‘heen extraordinarily good. In his thirteen years of operation {allof them, ineluding 1969, profitable) he compounded his in- ‘yostors’ money at 824 pereent annual rate, Recently, the part- rership's assets stood just above $100 million, a figure put- ting Buffett ahead of Jones in size, "But now, to the immense regret of hialimited partners, Buf- fet is quitting the getme. His reasons for doing 30 are several, ‘and inelude a strong feeling that his time and wealth (he isa tmillianaive many tines over) should now be directed toward ther goals than simply the making of more money. But he ‘also suspeets that some of the juice has gone out of the stock. ‘market and that sizable gains are in the future going to be very hard to come by. Consequently, he has suggested to his, jnvestors that they may want to take the “passive” way out, investing their partnership money ot in the stock market Dut instead in municipal bonds. Happiness at tax time If Buffett fs right in his appraisal of future market con- Jitions, alot of hedge-fund managersare going to be out look- ‘ng for jobs that pay better than those they now have, Many could not at this moment survive another losing year, for as ‘one general pariner puts it, “20 pereent of nothing is noth- ing.” Lately, a few new funds have been set up with pro- ‘Yikions that’ in effect, endow the general partners with sal- fries in those years ia which profits are nonexistent or very ‘mall; ordinarily, these salaries are Uuen. considered to be ad- ‘tances against profits to which the general parmers may be- como entitled im future years. This kind of arrangement, continued paige 188 HARD TIMES COME TO. THE HEDGE FUNDS cnn however, nnotapt to swoop the hedge-fund business. Most in ‘vestors seem likely to feel that, in handing over 20 pereent of their profits in such years as these exist, they are already doing plenty for their general partners’ welfare. In addition, many of these investors are sophisticated enough to know that whon the general partners get around to paying thefr income taxes, there is something very won- lerful about that 20 pereent. Tt is not, in tax terminology, ‘eompensation,” and it isnot, therefore, automatically treat~ cd as straight income. Instead, the 20 pereent is the general partners" share of the fund's profits, and these, ifthe market hhas been kind and the management wiee, may be totally or Targely in the form of long-term gains. ‘The reaults can be spectacular. Consiier a fund of modest si2e—~say, $5 millon, Assume that it makes 2 gain of 20 per- cent in a year (most funds did that well, or better, in 1967 ‘and 1968) and that this §1 million is all in long-term gains. ‘That leaves the general partners—there will probably be only ‘wo or three of thom—with $200,000 in long-term profits to call their ovn, It is a heady scenario. There simply are not ‘many other businesses in which the entrepreneur ean hope to aequite, in fairly quick fashion, substantial long-term gains ‘without necessarily putting up & eont of his own eapital. Te should he noted, howover, thst many hedge-fund get eral partners do have large amounts of their own eapital in their partnerships, The company of the general partners ob- viously works to aoathe their investors, sineo it reduecs the possibility that the general partners will engage in wild spec- ‘lation, figoring that they have Tittle to lose and Tots to sain, Irthe talk on Wall Street isto be believed, come of last your's heclge-furel failures invalved funds whose managers put into thetn litle or no eapital, and who were therefore able to shrug. off the rlisasters that developed. Repercussions from the Douglas affair ‘The next dieastrous happenings may emanate from the ‘SEC, whieh for years has been fretLing about the hedge funds ‘and which lately has been trying strenuously toarriveat some Uecisions about them. A year ago the SEC sent out an ex hhaustive questionnaire to some 200 investment partnerships that it had spotted by one micans or another. (FORTUNE's in- ‘uities, however, tuned up a number of partnerships that hhad been overlookes! by the SEC.) The Commission is now compiling the answers to this questionnaire, and is virtually ‘awash in facts about hedge funds. ‘In the meantime, eetain members of the SEC staff have al- ready concluded that the Commission must take steps to res ulate these funds. The staff rests its ease on legal arguments, maintaining that bwo laws the SEC has long administered, ‘but has never interpreted as applicable to the hedge funds, do apply to the funds and do require their registration with the Commission. Be that as it may, it also seems clear that the staff thinks the hedge funds ahould be regulated and that ‘the Comission must find a way to do it. One staff member spoke recently of the “crisis numbers” to which the funds hhave grown, and therehasheen much SEC talk about the “im= pact” of the funds on the market. Some hedge-fund oper ators ask bitterly whether itis not premature to be forming ‘opinions about impact, sineo the questionnaires have not yet been analyzed, The question is apt, but it is also true that the staff has seen a great deat of the Hedge funds in various in- vestigations. In addition, the staff has access to the records ‘of.the publie hedg@ funds, and these indieate “impact™in the form of vigorous:trading aativity. Some of the publié hedge funds have been turning over their portfolios at a rate more than seven times the average for all mutual funds. (One investigation that brought the staff into contact with the hedge funds is that whieh led in 1968 to an SEC pro ceeding against Merrill Lynch, Pieree, Fenner & Smith and ten of its important customers for their alleged misuse 1966, of certain bearish information relating to Douglas craft. Merrill Lynch settled its part of the ease, and so did fone of the customers, City Associates; but the rest of the eus- tomers are stil fighting. Among these are the two Jones funds, Fairfield Partners, John Hartwell’s organization, and Fles- cehner Becker Associates, a hedge fund formed in 1860, Ail are charged with having received “inside information” about Douglas from Merril Lyneh, and with having then made sales ‘and /or short sales ot Douglas stock. The outcome of this ease continued page 140 HOW THE HEDGE FUNDS LINE UP Name Location Auacto A.W.donee Co. ‘ALWolones Associates Now York ‘$80,000,000 leachnar Recker Assoviaten PEE Partners, New York 45,000,000 Cerberus Assoriates Now York 40,000,000 Polefold Partners Greenwieh, Conn. 35,000,000 City Associates Now York 32,000,000 Steinhardt, Fine, Berkowitz New Yorke 30,000,000 Lincoln Partners Chicago 25,000,000, Strand &Co. S87 Partners New York 22,000,000, Berger-Kent Associates Berger-Kent Inet, Partners NewYork and Waterbury Associates Denver 22,000,000 Atalanta Partners NewYork 20,000,000 Harborside Astootates Broadstree! Partners New York 16,000,000, Hawthorn Partners New York 15,000,000 First Security Co. New York 15,000,000 Gusrante-Farrington Assoc. Boston Equity Associates ‘Boston 14,000,000 Herman, Kalmbach & Co. Merridohn Partners New York 18,000,000 Foxwood Associatas Greenwich, Conn, 12,000,000 Now Court Partners New York 18,000,000 Goodnow, Gray & Co. Greenwich, Conn, 18,000,000 Hartwell & Associa Park Weatlake Associates New York 18,000,000 Century Partnars Now York 12,000,000, ‘Nor pivate neage funds by any means, ae eager to divulge ther see ‘but lot con be learned on thet subject rom parrashi lings, ane tom Iimwad parmete and cern fund managers. Tae ht therefore teprasante ones beat etinaes ant the igontty ane equity epi (3 yestens) hie tenty lrget hedge fond “grou” comping a otal of twenty: rin funds Other szabie fendi. Columbus Partners (620 milion) ona init Asoclaee (612, milion)—re omit bacaure the genes! Danner re not compensated on » performance Bass “These are some ineresing name bah the funds: Harborside end yonceret are run out of Allen & Co, tho Investrent banking tm: New Cooat wes eo up by te Bothechid aching none; Sand and 8.8.7. ‘be menoged by Samuel M. Stayer, the Bridge expr. “FORTUNE lancery 1800 130° LATERM EE TT TE TE I HARD TIMES COME TO THE’ HEDGE FUNDS commas is still in doubt, but meantime it represents the first official thrust of the commission against the hedge funds. Last year the American Stock Exchange also roade its own, ‘move against the hedge funds, and in so doing delivered some ‘more ammunition to-the SEC. Back in 1963, the Amex began to worry about the heavy impact tha: hedge-fund trading seemed to be having on certain stocks. After investigation, the exchange concluied thst its rules applying to members ‘and alfod members could also be construed to apply to hedge funds in which these members ere partners, Consequently, ‘tdeereed last spring that inthe futureauch hedge funds would ‘be obligad to abide by certain existing exchange rules, inelude ingone prohibiting “excessivedealing” onthe part of members trading for their own accounts. (The key seetion of this rule ‘bars members—and now their hedge funds, too—trom sak ing any trade that would accentuate the rise, or fall, of any sack already engulfed by trading activity.) Fhe Amex's new Policy helped some of its member firms (Goldman, Sachs for one) to decide that it just might be better if they stayed clear of hedge funds in the first place. Subsequently, a number of brokers gave up hedge-fund partnerships. “Paris is worth a mass” Like the Amer, the SEC may have to resort to some i direction if tis to take out after the hedge funds. The com- risson's basic legal bother about the funds is that they are unquestionably investment companies, but of & varity that is able to wiagie out from under the Investinent Company ‘Act. The wigale arises from a clause in the act that exempts ‘an investment company from registration ifs first i has w= er than 100 sceurity holders (and all of the hedge funds are within that limit); seeond, it does not engage in a public of- fering of tts securities. There is no hard and fast definition of 4 publieofforing, but itis efear that to avoid trouble a hedge fund must be circumspect in ts soietation of investors, must supply thet with much the same information that would nor- mally be included in a prospeetus, and must restrit its tim- ited partners to investors who are sophisticated enough to understand what i is they are getting into. Some hedge-fund ‘managersare meticulously careful about that last point. Those advised by Kenneth J. Bialkin of the New York law fir of Willkie Parr & Gallagher, frequently take prospective inves- tors to him to be interviewed for suitability. Bialkin says he thas turned down a fairnumber—‘mostly women.” Since it cannot get at the hedge funds through the Invest- ment Company Act, the SEC is thinking of trying couple of other routes. Its staff has advancod the opinion that the hedge funds are “dealers” in securities, a term that, up to now at least, has maioly embraced chose frms that “make ‘markets in various stocks, The law, however, definesa “eal=

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