New twist to an old idea
After an investor approves an allocation to funds of hedge funds the question arises of which structure to use. For many, the most common form of investment will be through shares in an open-ended company, often set up as a limited liability partnership, or through one of many structured products wrapped around these funds. There is, though, another structure – the exchange-listed closed-end investment company.
Dating back to the 18th century, this type of company is both transparent and familiar to investors – particularly those in the UK – as investment trusts. It offers structural benefits to both private and institutional investors, and the underlying fund of hedge fund manager. Nineteen of these companies now exist and collectively they have over £2bn (e2.8bn) invested in hedge funds. Most are less than three years old. However, despite their relatively short life the sector is undergoing a period of transformation.
Closed-end investment companies are created through an issue of shares and are typically listed on a recognised stock exchange. Unlike open-ended funds, they have a fixed number of shares and their share price is a function of the demand and supply in the market for the company’s shares. At times of heavy demand, the share price may trade above the prevailing NAV per share, and at times of weak demand it may trade below the NAV per share (and so be at a ‘discount’).
The first exchange-listed closed-end fund of hedge funds, Alternative Investment Strategies, was listed on the London Stock Exchange (LSE) in 1996. However, most of the investment companies now in issue have been launched over the past three years (see table). London and Zurich are the most popular exchanges for these companies. Investment managers/ advisers range from established fund of hedge fund specialists such as Harris Associates or Man-Glenwood to subsidiaries of asset management companies, including Credit Suisse and Schroders.
Investment mandates are just as wide-ranging, from global multi-strategy to specific geographic or strategy allocations, and the underlying hedge funds range from well-known names such as Caxton or HBK to ‘emerging’ managers.
Closed-end investment companies can offer a range of structural benefits over open-ended funds.
Depending on where the investor is based, the exchange-listed closed-end structure can offer tax benefits over offshore open-ended funds. For example, the majority of the funds of hedge funds listed on the LSE are incorporated in Guernsey. These are exempt from Guernsey income tax and are not liable for Guernsey tax on the capital gains within the portfolio. Importantly, unlike open-ended offshore funds, Guernsey closed-ended entities can be structured so they are not collective investment schemes (as defined by the Financial Services and Markets Act 2000). Thus, for UK investors, gains on the disposal of shares should be subject to capital gains tax, rather than income tax, as may be suffered by UK investors in offshore open-ended funds.
These companies are governed by the rules of the exchange on which they are listed (for example the UK Listing Authority, a division of the Financial Services Authority). They may therefore be regarded as more highly regulated than offshore open-ended funds. Regulation ranges from specific corporate governance rules, such as the requirement to have an independent board of directors, to rules governing disclosure of information.
By being listed on an exchange these companies offer the potential for daily dealing, easier settlement (eg, Crest for those listed on the LSE), and a lower subscription size. By comparison, 72% of open-ended funds of hedge funds specify monthly or quarterly redemption and, on average, require a minimum initial investment of more than $500,000 (e440,000), according to our estimates.
For the fund of hedge fund manager, the listed structure offers a fixed pool of assets and so avoids the administrative distractions of inflows and outflows. It may also make it easier to take longer-term commitments (for example, to ‘emerging’ managers) or to invest in hedge funds that have punitive liquidity terms.
Managing a company listed on a recognised stock exchange may also open up a new investor base to the fund of hedge fund manager and offer marketing benefits.
Despite these benefits, the sector is undergoing a period of change. So far in 2003, one company has changed its investment mandate, another has returned some of its assets to shareholders and another has been requisitioned to consider returning assets.
In our view, the root of the problem lies in some of these companies being constructed without adequate shareholder involvement, and this has resulted in some ill-conceived structures. For example, three of the companies listed on the LSE have sterling-denominated shares and are invested in US-based hedge funds – and so have US dollar assets – but do not hedge the currency exposure. Shareholders in these funds are therefore exposed to exchange-rate fluctuations. Whilst this hedging policy was made clear by these funds in the issuing documentation, the adverse sterling–dollar movement over the past two years has had a negative impact on the share price. For companies that aim to achieve absolute returns, this is clearly unsatisfactory, and is reflected in the discount to NAV at which some of these schemes trade.
Some of these companies have also failed to put in place mechanisms that effectively control any under-performance of the share price relative to the NAV, and the emergence of a wide discount has ultimately resulted in some of these companies being required to return capital to shareholders.
There is light at the end of the tunnel, however. The three funds of hedge funds listed on the LSE during the fourth quarter of 2002 all have a sterling share price and invest in non-sterling assets, but also have a formal procedure in place to hedge the currency risk. Addressing the discount risk, they have also, in the case of Dexion Absolute, incorporated an aggressive discount control mechanism. This particular company requires its directors to propose a continuation vote if, over any 12-month period, its shares trade at an average discount of more than 5%.
Lessons have clearly been learned from the early companies and shareholders are now having a much greater say in what type of product they want. This is to be encouraged, and, coupled with greater investor awareness and demand, should ultimately lead to more funds of hedge funds managers entering the exchange-listed arena.
Mark James is the senior analyst responsible for hedge fund research at ABN Amro Equities in London
email: firstname.lastname@example.org The views and opinions expressed here are those of the author and are not necessarily those of ABN Amro or an affiliate thereof