One of the most emotive issues in recent months has been methods used by managers to defer providing liquidity when they received significant redemptions. In many less liquid asset classes, sales can only be made at significant discounts. This creates a dilemma between the rights of a redeeming investor with urgent liquidity needs and the rights of remaining investors to have the value of the portfolio optimised.
We estimate that around 25% of the industry has been forced into some form of restructuring of their liquidity terms. The offshore fund structures and LP structures typically used by the hedge fund industry afford a manager much more flexibility than the equivalent retail fund structures. There are some clauses typically in most fund documents:
• A gate limiting redemptions to a maximum percentage in a given period.
• Ability to deliver the underlying investments en species
• A right to suspend calculation of NAV in period of material price uncertainty
These clauses can be used to force agreement on a broader range of restructuring options.
Gates are allowed in most fund documents to restrict the level of outflows e.g. 20% per quarter. However, one of the problems is that everyone feels the need to “game the gate” and put in a redemption notice to at least have the option for maximum participation in any liquidity. There is also reluctance for potential new investors to commit due to the perceived overhang. Therefore, longer term a fund may wish to bring in a more comprehensive restructuring.
This is mainly used as an interim measure. It is normally at the discretion of the directors of a fund and tends to be used to buy time until a better plan can be implemented. Because of director’s liability it is not a good longer term solution. Following suspension, shareholders will be asked to vote for set options which can take the form of increased side pockets, longer lock up, etc wind down of the fund, etc. These and other options are explored further in the next few paragraphs.
Increased Side Pockets
A side pocket enables a fund to take a portion of the assets and treat them more like private equity where distribution will be based on eventual realisation. In the current stressed cycle, funds have increasingly used side pockets retrospectively when positions accounting for a significant part of the portfolio become illiquid. Even when fund documentation does not allow side pockets, the same effect can be achieved by use of an SPV. The SPV buys the less liquid assets of the fund and the SPV units are delivered to redeeming investors’ en species. The manager still remains in control of selling down SPV assets.
New Share Class with Better Terms
In general redeeming investors do not often change their minds even with slight sweetening in terms. However, many investors recognise the dislocation of pricing and there is acceptance that a longer term approach is needed to recover value; the manager for its part will also make some compromise on fees.
Short Term Lock Up
In a number of cases the price dislocation of markets created more immediate and shorter term problems with wide and uncertain bid offer spreads. Managers will get investors to agree to lock ups for a period for greater price transparency to emerge.
Continuing and Liquidating Share Classes
This is becoming one of the more popular longer term restructuring options. The fund is split into 2 slices of similarly weighted portfolios. One has an orderly liquidation and the other continues as usual. This helps placate ongoing investors who don’t want to compromise the investment strategy meeting redemptions. It can frustrate redeeming investors that they can not use all available cash of the fund to meet their redemption. However, ongoing investors can feel very strongly that they are equally entitled to that cash.
Is this Opportunistic Abuse?
We find we have to revaluate each of the manager’s actions on a case by case basis. Historically these measures would have been frowned upon by investors and funds rarely survive such actions in the longer term. However, it has now become so prevalent that much of the stigma is reduced. There is no doubt that when it became clear in late 2008 that funds were generally going to use these methods to reduce the need for forced selling, it did contribute to stability in the most affected assets’ prices.
It is still easy to be sympathetic with the redeeming investor. While a manager may argue that they are helping them extract the best long term value, they may not fully appreciate the indirect costs of delaying payments to the investor.
For the remaining investor, there is the need to ensure that the redemptions do not invalidate the ability to continue the strategy. Therefore, they can be unsympathetic to redeeming investors and reluctant to let the manager pay out large amounts of cash without protecting their position.
Most managers do try and take these decisions in a responsible manner and it seems to be a minority who abuse their position. It is certainly desirable if the proposed restructure can be put to a vote to ensure alignment of interests. Unfortunately there are a few cases where veiled threats of long term suspension or en species delivery are used to encourage passing of the vote.
Certain strategies were always much more vulnerable to liquidity risk. This is especially true for credit related strategies including convertible bonds. The least affected strategies tended to be the more directional strategies. In figure 2 we estimate the scale of restructuring for a number of key strategies. Convertible bonds proved one of the most vulnerable as only 29% of funds were able to keep to their normal liquidity terms.
Where a manager has implemented some mechanism to delay redemptions there is an expectation that some concession should be given on fees. This acts part as a statement by the manager that it is not a ploy to keep earning higher fees by retaining assets and part to recognise that these less liquid investments are by nature more passive.
Impact on Other Strategies
One of the implications of these restrictions in liquidity was that investors who were forced to find liquidity ended up taking where they could get it. Based on our estimates, the highest redeemed strategies in the 2008 H2 were:
- Statistical Arbitrage 48%
- European Long Short 25%
- Fixed Income Arbitrage 25%
- Emerging Market Long Short 24%
- Quantitative Market Neutral 24%
- Asia Pacific Long Short 20%
Some of the most heavily redeemed strategies were those that tended to offer easier liquidity terms with monthly or quarterly redemption windows and tended to be run more liquid portfolios. This has also been exacerbated by some of the fund of fund industry’s own liquidity mismatch issues for example giving their investors better liquidity terms that they obtained from their hedge fund investments.
Does the Industry need New Terms?
What this has highlighted is that many strategies are not well suited to the liquidity terms that were traditionally offered such as monthly or quarterly liquidity. Certain strategies have are generally liquid do not need to change. This would include many direction strategies such as CTA and discretionary macro. It also includes many of the equity related strategies such as more liquid long short, quantitative market neutral or statistical arbitrage.
Other strategies clearly need a longer time horizon and terms are becoming more of a hybrid between hedge fund and private equity. There is also recognition that there is a long term beta component of some strategies and the current fee structure may be over generous. Here are several broad trends we are seeing:
• Institutions are happy to accept longer lock ups but expect something in return
o Lower fees
o Hurdles on fees
o Fees more realisation based (like private equity)
• Institutions want to be more protected from perceived “hot money” investors
o Less co-mingling
o Penalties for cancelling redemptions to stop “gaming” the system.
• More transparency
o High quality risk bucketed data
o More use of managed accounts
In general, we are seeing a more engaged approach from the larger and longer term institutions to capitalise on their new found investor power.
One Size No Longer Fits All
It will no longer be so simple to have a diversified hedge fund portfolio made up of funds with monthly and quarterly liquidity. A portfolio focusing on easier liquidity will tend to be biased towards the directional and tactical trading strategies. Longer term value strategies will need a longer term structure. In the context of an institutional portfolio this does not represent too much of a challenge. Institutions are often happy to accept 2 to 3 year lock ups for more investor favourable structures.
For fund of funds the challenge is more complex. A retail fund of fund that needs a co-mingled product may now only include strategies that genuinely offer short term liquidity terms. An institutional fund of fund may need to run a segregated account for different investors to reflect the differing liquidity in underlying strategies.
The shortcomings of the current hedge fund liquidity terms were exposed in the current financial crisis. It is now clear that the different strategies are not homogenous and the terms of business the industry adopts have to change. The restructurings of many funds were only a short term fix and now much of the industry needs to focus on the term sheet of the future.