Hedge Funds: Hedge funds and the crisis
Citi Prime Services canvassed the opinions of hedge funds and hedge fund investors on the impact from and response to the liquidity crisis of 2007-08, and to gauge its longer-term implications for the sector. Sandy Kaul discusses the findings
Over the past 10 years, the hedge fund industry has expanded rapidly. That speed of industry growth and extended period of capital inflows helped mask many procedural and structural issues that only came to light in late 2008 as the credit crisis triggered a liquidity crisis in the hedge fund industry. Over 50 hours of interviews, we attempted to identify the major themes and explore what the industry has learned and how it will respond.
Hedge funds' severely limited ability to use their collateral to finance positions forced many to de-lever or remain on the sidelines during a period of market opportunity.
The Lehman Brothers bankruptcy, Bank of America/Merrill Lynch merger, and the drop of the Reserve money market fund under $1 touched off a panic that resulted in the LIBOR/OIS spread skyrocketing to 364 basis points by mid-October 2008. This set the stage for a liquidity crisis in the hedge fund sector as prime brokers had diminished ability to fund positions and/or tap into their bank's balance sheet.
Smaller funds were primarily in single prime relationships with one of two major industry participants. Anecdotal evidence suggests that at least one major firm began to manage funds off their platform and another called for increased collateral to sustain positions. Many small funds were left with no financing options and were forced to liquidate positions.
Larger hedge funds tended to have multiple prime relationships which allowed them some insulation from any one prime broker's demise or demands. Even still, many with illiquid portfolios were forced to de-lever. Those with more liquid portfolios were better able to meet prime broker margin calls, but had little capacity to take advantage of market opportunities.
Institutional investors found their portfolio value and liquidity affected by other investors' actions and, in many cases, found unexpected assets were held in the portfolio, which should have been outside a manager's mandate.
In the majority of cases investors' money was co-mingled. During the crisis, managers had to choose actions that benefited the totality of their investor pool. For many with illiquid assets, this caused them to throw up gates, create side pockets or suspend redemptions. The nature of some holdings came as a surprise to many investors as, up until the crisis, most hedge funds reported little to no information on their portfolio investments - only their portfolio returns.
Many fund of funds experienced a serious mismatch between the terms they offered on their portfolios and the liquidity they were able to realise on their hedge fund investments. In constructing their portfolios, they had mixed hedge fund managers with varying liquidity terms in order to achieve strategy diversification. A significant number of fund of funds failed to anticipate how illiquid many funds would become in a period of concentrated outflows. Rather than being able to withdraw capital in a blended manner across their pool of managers, funds of funds found that their illiquid managers often could not or would not meet redemptions: hedge funds with more liquid assets had to cover a disproportionate share of redemptions, leaving the remaining assets in the fund less liquid.
Response 1: Many institutional investors initially tried to replace co-mingled exposures with separately managed accounts or ‘funds of one', but encountered significant trading, operational and cost concerns.
Investors found that it was much more difficult to mimic hedge fund portfolios and returns via managed accounts. Furthermore, many hedge fund investments require investors to hold their own ISDAs and separate prime broker terms. Many investors could not meet the operational demands of administering the managed account without a robust back office or costly platform manager.
Some investors, particularly fund of funds, began to explore ‘funds of one' - in which the investor is the sole LP owner, or the dual LP owner along with the manager, of a separate share class - as a compromise structure between a co-mingled fund and a managed account. These structures are easier to administer, but costly to set up. By 2010, improvements in investors' perception of hedge fund engagement and infrastructure were helping to swing interest back toward co-mingled structures.
Response 2: Hedge funds emerged with the goal of diversifying their mix of investors and ensuring a more stable capital base - reducing funds of funds and obtaining more direct pension fund, endowment and high-net-worth capital. Many embarked on a series of operational and structural investments to create more ‘institutional' organisationss.
Across the industry, hedge funds diversified their set of service relationships, with nearly all funds now multi-prime. Many added custodians to ensure better asset protections and more stability for their portfolios.
Many hedge funds improved their liquidity terms, increasing the frequency of redemptions and notice periods and shortening lock-ups, either in their flagship funds or as new share classes.
Larger hedge funds invested money into their IT infrastructure, building robust risk tools to help senior managers independently monitor activity across funds; integrating risk reports into real-time trade decision-making tools to support the investment process; and building shadow accounting and reporting systems to monitor their service provider data and activities. Many also expanded their operational staff and invested time and planning into cataloguing and identifying risks across their entire set of processes. Many hedge funds matched their improved infrastructure with a new willingness to provide investors transparency into their portfolios and the inner workings of their operations as part of expanded due diligence.
Investors are looking to go to the ‘molecular level detail' on hedge fund portfolios and many hedge fund managers are facilitating this review by providing snapshots of their portfolios on a lag. Some hedge funds are also beginning to permit investors to see their prime broker or fund administrator reports directly or have agreed to report to an investor's chosen risk aggregator.
Operational due diligence has also become a norm, with separate teams with deep operational backgrounds delving into the processes, controls and IT platforms at a fund.
Response 3: Fund of funds and consultants are creating more nuance by adjusting their portfolio construction approach to align investment strategies along a ‘liquidity spectrum'.
Liquidity has emerged as a new third dimension in the evaluation of hedge fund investment strategies — supplementing the traditional considerations of style and leverage. Strategies invested in highly liquid underlying assets are being pressured to offer up more aggressive liquidity terms that offer investors better cash management options. Strategies in less-liquid assets are seen as being able to demand more intermediate terms, and strategies in illiquid assets are needing to incentivise investors to lock up capital through ‘complexity premiums'.
Implication 1: Grouping strategies by liquidity, style and leverage is moving the industry toward a set of ‘segments', providing investors more choice for allocating within alternatives and helping to blur distinctions with the long-only and private equity silos.
The least-liquid hedge fund segment - strategies that invest in distressed and thinly traded securities, as well as in ‘hard' assets, often linked to commodity production (eg, copper mines) - is taking on the profile of a private equity investment. Investors are being offered incentives to lock up capital for extended periods and, as a result, are determining their level of interest vis-à-vis their private equity investment capital.
The most-liquid hedge funds are now taking on profiles that narrow the gap between these strategies and traditional long-only investment fund offerings. Many hedge funds, particularly in liquid, equity-focused strategies, are now offering monthly liquidity options. UCITS funds, a regulated hedge fund structure offered in European markets, offer liquidity as frequently as weekly.
Implication 2: Improved liquidity and transparency in simple hedged strategies position these funds as viable substitutes for investors looking at more aggressive, ‘active' long-only funds or new ‘alternative mutual funds', for enhanced returns.
Many institutional investors have begun to divert ‘relative' return allocations to ‘passive' ETFs and index funds, and to preserve allocations, many active long-only managers are beginning to launch new ‘alternative mutual funds' that rely on investment techniques typically used by hedge funds. SEI shows assets under management in alternative mutual funds and regulated UCITS funds up $110bn in 2009, to $367bn - in a year when inflows to hedge funds and ‘active' long-only managers both fell.
Implication 3: Increasingly, investors looking to take on exposure and achieve diversification within an asset class can choose from a broad array of investment structures — some regulated, some ‘institutionalised' and some private equity-like.
This proliferation of choice could work to evolve institutional investors' approach to asset allocation. In the 1980s-1990s, investors used an asset class approach to allocation, balancing equities, bonds, cash and commodities in the portfolio. By the 2000s, investors had adapted to more complex markets by moving towards ‘portable alpha', where a portion of the portfolio was invested in strategies that were seen as uncorrelated to broad markets. Now there is evidence that investors may move towards an ‘asset-based structures' decision where they select an array of investment structures with differing risks, returns, liquidity profiles and fee structures within an asset class in order to achieve diversification.
Hedge funds are likely to be the primary beneficiaries of this approach and attract large capital flows as investors shift allocations from ‘active' managers to alternatives to achieve more aggressive returns and cover liability shortfalls. Large hedge funds with ‘institutional' profiles are likely to be the main recipients of increased allocations. This will increase scrutiny on these managers about their ability to generate returns that do not correlate to beta. Indications are that the 200-plus hedge funds managing at least $1bn in assets each already control 69.5% of the industry's total assets. That figure is likely to become more concentrated, as these firms are best positioned to sustain their operations and investments, based solely on their management fee in periods when fund returns are below previous high-water marks.
Role specialisation is also more evident at larger funds and most have built extensive investor relations teams. This enhances the organisation's ability to pursue and maintain direct relationships with institutional investors and their intermediaries in a period when investors are recognising the benefit of such relationships, and are looking to spend more time getting to know a manager. Large managers also have the trading expertise and reputation either directly or via affiliations with traditional managers, to offer regulated alternative funds. Such was the rationale for the BGI/BlackRock merger and other recent high-profile mergers or ventures.
The biggest concern interviewees expressed about these large hedge funds drawing the majority of institutional flows is about whether the size of the fund itself becomes a hurdle in creating alpha. This uncertainty has existed for some time and was underscored during the liquidity crisis when many of the larger, more-liquid managers demonstrated a higher-than-expected correlation to beta in their portfolios.
This is an edited version of a ‘Citi Perspectives' report published internally earlier this year. Sandu Kaul is US head of business advisory at Citi Prime Services