New hedge funds: smaller and thriftier

NEW YORK (Fortune) -- An industry lately synonymous with losses, liquidations, and fraud is showing signs of recovery. An uptick in new hedge funds suggests that investors are warming to them again. And trends among the newly launched funds show how that high-rolling world has changed in the aftermath of the credit collapse.

Hedge fund formation lay mostly dormant through February, says Bryan Hunter, a partner at Bermuda-based law firm Appleby Global, who structures and advises hedge funds. About 15% of funds shut down in 2008, according to Hedge Fund Research. At the end of the first quarter, the industry had $1.3 trillion in assets under management, down from about $2 trillion in 2007.

Investors began to open their wallets to new hedge funds this year, including startups by hotshots like Joshua Berkowitz, who left Soros Fund Management to start Woodbine Capital in January, and Christopher Pia, who left Moore Capital to start Pia Capital in March.

Despite the steep declines of last year, the industry is starting to regain its allure because of the evident opportunities as the economy bottoms out and starts to recover, says Tom Kreitler of C.P. Eaton Partners, a firm that helps institutional investors place money with hedge funds.

Many new funds are for distressed investments: debt, asset-backed securities, and investments taking advantage of the government's Term Asset-Backed Securities Loan Facility (TALF). However, managers are also getting back to basics with traditional long/short equities funds.

"Markets are extremely mispriced and inefficient in many areas," Kreitler says. "There has also been a large reduction in the number of funds; and proprietary trading at the old investment banks, which took out a lot of investment opportunities, has almost ended. Any strategy that uses some asset mix of equities, debt or currencies could succeed given the current dislocation."

Even so, launch activity is modest. While about 2,000 new funds were launched in 2005, according to Hedge Fund Research, the industry may not even see a tenth of that activity in 2009, many fund-of-funds managers say. This is a good thing given how overcrowded the industry was, says Randy Shain, vice president of First Advantage, which performs independent background investigations.

"The apex was near when everyone and their brother could become a hedge-fund manager. It was a time of easy money and few barriers to entry, but many of those managers probably weren't going to succeed," says Shain. And investors were more than willing to fund the boom, lured in by the promise of huge returns.

New funds are also smaller this time around because it's still hard to raise money, says Jayesh Punater, CEO of Gravitas Technology. Joshua Berkowitz, for example, launched Woodbine with about $200 million; industry experts say he would have launched with $1 billion out of the gate two years ago.

Startups are saving money whenever they can, which often means outsourcing everything that is not part of the proprietary trading strategy. For example, this could mean hiring a company like Gravitas to host back office IT needs like data warehousing.

Industry players see other changes afoot that they say should be beneficial for hedge funds and for investors. Among the themes that have cropped up among this year's smaller class of funds:

Thanks to a steady stream of hedge-funds scams, investors won't put money into new funds unless they're run by managers with verifiable track records, says Harold Yoon, head of ING Investment Management's fund of funds.

"We're seeing established managers launch additional funds on top of those they already run. We're also seeing well-known managers from established shops strike out on their own," says Yoon. But it is nearly impossible for anyone else to raise money.

People are asking more questions of managers, says Shain.

"Managers are being asked about whether they've been sued before, their trading backgrounds, and what businesses they've run. It sounds mundane, but people who defrauded investors were accused of similar shady behavior in the past," he adds.

Although the industry is not yet heavily regulated, new funds are being launched with a consideration of best practices and transparency, says Punater. In short, the industry is shedding its Wild West image and becoming institutionalized. Investors want to see real business plans.

In anticipation of a slew of rules, new funds are more transparent in terms of investment strategy and holdings.

Ten years ago, 1 and 20 was the standard for funds, says Yoon. This means that managers charged investors a 1% fee on their assets just to manage the money and took a 20% cut of the profits. He says fees grew during the bubble years, to an average 2% of assets under management and 20% performance fees. Some players, like SAC, charged up to 3% management fees and 50% performance fees. But investors are balking at such steep payments, and some new funds are offering less onerous terms.

New funds may be more flexible about locking up investor money. Managers will want to keep money for longer periods to match illiquid trading strategies, or they may allow investors to redeem their money more frequently, say observers. Either way, new funds will be clear about their terms. Investors are still upset about managers who took them by surprise when they imposed gates and suspended redemptions during the credit crisis.

While these changes are healthy overall, it is largely up to investors whether they are permanent. Says Yoon: "They won't stick if investors encourage and fund bubble behavior all over again."