Hedge Funds: Making the illiquid liquid

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The secondary market in hedge funds is on the rise as investors snap up illiquid portfolios coming onto the market, says Martin Steward

What can you do if you desperately want access to a star hedge fund manager that is closed to new investors? You go to a fund of funds that has an existing relationship with that manager. But what if that manager is ‘hard' rather than ‘soft' closed, so even existing subscribers cannot hand over new money?

That is where the secondary market in hedge fund positions comes in. There will always be investors redeeming, regardless of performance, for portfolio-management purposes. Why sell those interests back to the manager, when dozens of other investors out there would pay a premium to NAV to take them off your hands?

Bringing buyers and sellers of highly sought-after limited partnership interests has been Hedgebay Trading Corporation's business since 1999. Its proprietary Secondary Market index (see graph) shows the steady premiums being paid, year in, year out. But as the index also shows, things began to change in 2007 - and were turned head over heels in 2008.

"Now the question is not the level of premium a buyer has to pay to get access, it's the level of discount the seller has to take to get liquidity," says Elias Tueta co-founder of Hedgebay. "We can get immediate cash for investors who are gated, suspended or in illiquid redemption structures or side pockets."

Suddenly, hedge fund secondaries is a high-volume business. Supply is up - having dumped all their liquid stuff, stressed investors look to shift as much of their illiquid portfolios, too. And demand is up - a raft of distressed secondary funds of funds launched through 2008-09, anticipating that these investors would be willing to take a hit in exchange for liquidity. Hedgebay and smaller players like Citco and Credit Suisse have been joined by newcomers like CogentMarkets, SecondMarket, ICAP and Tullett Prebon.

A good deal of that increase in volumes involved pension funds - representing just 1% of Hedgebay's turnover in 2007, but 12% since. Initially found largely on the bid-side, being ‘natural buyers' of distressed positions, as Tueta puts it, Hedgebay predicts more offer-side activity as they begin to appreciate the utility of this source of liquidity for managing risk.

A troublesome hedge fund amounting to a couple of dozen basis points of a pension fund's asset allocation seems unlikely to send it scrambling for liquidity. But Hedgebay reports more and more conversations with institutions that have recently appointed their first or a new CIO, who wants to re-engineer legacy positions. Secondary market liquidity can be much more attractive than a formal redemption, if penalty charges amount to more than Hedgebay's 1% transaction fee plus the bid/offer spread and any discount to NAV.

And with strategies gone bad there are other risks besides illiquidity. "If you have this thing sitting in your portfolio bleeding performance month by month, you have headline risk," says Tueta. "Tucking an underperforming strategy under the mattress is not an appropriate response." Why sell at a discount when you could just tough it out and wait for the assets to recover? "Fine in theory, but not necessarily in reality," Tueta observes. "The manager will be struggling with his own illiquidity as investors put in for redemptions, and will sell whatever assets he can to make distributions. As soon as he does, pricing has to go south as you end up with the least liquid, most deeply-discounted tail of the portfolio. There's always a clean-up trade at the end."

In other words, you might be able to tough it out but others might not, and that could affect your fund's prospects for recovery. If those prospects are bad it is often best to get out as quickly as possible. Investors need to analyse underlying assets, managers' valuation practices and fellow investors to arrive at a likely future valuation and a discounted present valuation. "Then you have an indication of where you'd be willing to trade, on any given day, so that you can make a judgement about whether current pricing represents an opportunity to deal with this position or not," says Tueta.

Regulators agree that the development of this secondary market is good for limited partners; it is also good for general partners, who face fewer redemption requests and might find proper long-term lock-ups for illiquid strategies a little easier to sell if investors are confident in the presence of this emergency source of liquidity; and it is self-evidently good for intermediaries like Hedgebay.

But if all of its birthdays and Christmases came at once in 2008, will the secondary market now revert to quieter mission of getting investors into the best funds for a modest premium - albeit in slightly higher volumes thanks to the awareness raised during the liquidity squeeze? Tueta offers a wry smile. "The short answer is no, simply because people tend to make the same mistakes over and over again," he says. "The next screw-up? It's probably going to be UCITS."



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