Veteran manager Howard Marks of $67 billion Oaktree Capital Management in Los Angeles said the past two years have revealed which managers really helped clients and which ones were merely propelled by a bull market.
Looking ahead, he added, "2 & 20" as an industry standard could come under fire as investors push back.
"Getting money with incentive fees should be special. The fact that everybody could do it means something was wrong," said Marks, whose firm was among the few winners last year. "The ones who did a bad job should get out of the business."
Throughout 2009 large institutions like the California Public Employees' Retirement System (Calpers) have lobbied their fund managers to revise their terms. Some industry surveys showed the average cost of hedge funds may already be drifting lower, closer to 1.5 percent management fees and 15 or 18 percent of profit.
A few industry veterans say the old fee structure bears some blame for encouraging over-expansion of funds and for managers taking greater risks to achieve target returns.
"Incentives in the industry were very bad. They continue to be bad today," said Brian Singer. "Those incentives resulted in poor behavior on the part of investment managers."
As an example, he pointed to funds that would pursue low-probability, high-risk bets like the yen-dollar carry trade. "In late 90s and earlier this decade, we had a lot of hedge fund players that didn't have skills put on these catastrophic risk trades and leveraging them. They worked until they all blew up," Singer said.
Firms like Oaktree that distinguished themselves during the crisis have been seeing increased demand from investors.
"Successful hedge funds will be entrepreneurial; it is the essence of the craft," said Paul Singer (no relation of Brian), founder of $15 billion Elliott Management and one of the most successful hedge fund managers of the past 30 years. "Given the typical fee structures of hedge funds, they need to do something different to make money in a consistent way."
CHANGES
Ultimately, it will be the investors and their purse power that will weed out the industry.
Last year hedge funds did not make many friends if they lost money, halted withdrawals and charged their usual high fees.
Even so, Leon Cooperman, head of $4 billion-plus Omega Advisors since 1991, predicts investors will come back to hedge funds but more tentatively and with a greater focus on firms that inspire confidence.
"Hedge funds will become larger, more professional. Fewer one-man and two-man shops. There's a certain scale needed," said Cooperman, who had led Goldman Sachs Asset Management during a 25-year career at the bank. "Investors will put their money with a firm that's been around. It's all about process and controls and reputation."
Meyer, whose Glenwood seeded hundreds of firms over the years, observed that some of the changes investors are seeking today were commonplace at hedge funds in the seventies. Back then, short sellers were happy to discuss their positions, he said, because shares were easy to borrow and it helped to drive prices down.
And in a world where there were only a few hundred managers and funds were relatively small, investors were fully apprised of what was happening in their portfolios.
"You know how they talk about increasing transparency? When I started, every manager would tell you about his portfolio," he said. "I've been involved in hedge funds since the 1970s, and I can tell you the hedge fund industry has changed constantly — and it never repeats."
The business is also not one that will just roll over and perish. The promise of solid returns across every markets, come rain or come shine, by managers with proven track records will be hard to resist.
That brings us back Pallotta, who even as he closed his fund told clients he would consider launching a new offering to take advantage of the bargains created by the financial crisis. He made sure to keep his management firm open and ready for whatever his next move may be.
