Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance

Business Model Risk

This section of the text deals with the risks encompassed in simply running the business of being a hedge fund. It is an entrepreneurial activity that is now being held to institutional best practices as standards. It is a business that has risks that are similar to many others. Will there be adequate cash on hand, where does the working capital come from, and is it organized properly? Is there a succession plan? What happens if too many investors redeem at the same time? These and many other questions are relatively new to hedge fund managers. During the early stages of the industry's growth, hedge fund managers rarely had to face these sorts of issues. They benefited from relatively low barriers to entry, and much of the time there were even relatively low barriers to success. Capital was plentiful, leverage was available, markets were rising, rates were low, and spreads were narrowing!

Today, there are much higher barriers to entry, and the barriers to success have gotten much higher. Not everyone succeeds. In fact, over the past several years, as many as or in some cases more funds have failed than have been launched. This rarely occurred in the past, if ever. The implication to investors can be significant. A fund that fails needs to be liquidated, often in adverse conditions. Capital may be tied up; worst case, there may be litigation and embarrassment or a loss of confidence in the investor's decisions. No investor wants to give money to a manager who ...