The search for yield is leading investors to hunt down illiquidity premia. Florian de Sigy and Benjamin Keefe make the case for secondary hedge fund interests

With traditional sources of yield near all-time lows, it comes as no surprise that long-term investors are exploring a diverse universe of assets that could help in the search for real yield.

One alternative that has been receiving increasing attention is the secondary hedge fund market. Over the past two years we have witnessed the emergence of dedicated ‘fund of illiquid hedge fund’ portfolios sponsored by long-term investors such as sovereign funds, family offices, and pension funds. The number of launches of this type of fund has increased again this year, sponsored by some large and well-known names.

Pre-crisis, this sector was fairly insignificant, where a few investors traded privately into and out of much sought after and closed hedge funds. The immediate aftermath of the Lehman Brothers collapse caused the market to multiply in size, dominated by high-net-worth individuals raising liquidity to meet cash calls elsewhere in their wealth portfolios. Despite the market contracting from its $200bn (€159bn) peak to $70bn, it has matured and is dominated by specialist, long-term, institution-backed investors.

Undoubtedly, venturing into what many view as the uncharted waters of illiquid hedge funds has its overheads. For insurers and banks, holding illiquid stock comes with a regulatory capital charge that is increasing under Solvency II and Basel III. Risk has always been a key consideration for investors - the risk that is prevalent in this sector is ‘risk of the unknown’, as information is closely guarded. As always, however, risk creates significant opportunities.

The market is dominated by the Pareto Principle - the law of the vital few: 80% of trades in are in 20% of the available illiquid hedge funds. Although investors have been willing to invest nearly $3bn in dedicated illiquid portfolios in the past year, there is still an emphasis on a few better-known funds.

The demand for these sought-after funds results in a reduced upside. By definition, the sought-after illiquid funds trade at smaller discounts and therefore provide, potentially, a lower return on investment than their more neglected peers. Nevertheless, this issue can be easily overcome with the right knowledge and skills.

Another concern is the implementation of Solvency II-type principles for pension funds, which could distort supply and demand. The sector, however, continues to evolve, as the demand for detailed analyses of illiquid hedge fund portfolios has increased. The ability to demonstrate the underlying qualities of the portfolio, and to give a better sense of its intrinsic value, means that investors are better able to gauge the right level of discount around which to make, and accept, bids.

When a fund is less well known, having a forensic knowledge of the implicit merits of its portfolio can provide additional security. A crucial but often overlooked aspect is to understand what the fund is invested in now, as opposed to its pre-crisis portfolio. In many funds that were originally invested in asset-backed loans, but which now hold the collateral against which the debt was secured, the borrowers have long since defaulted.
Alternatively, many creditors accepted equity in lieu of debt repayments and now hold shares in unlisted companies. In both these examples, the current portfolio make up is markedly different to that which was originally intended. Potential buyers often disregard a fund because of its pre-crisis portfolio, unaware that the positions have changed significantly.

This level of analysis enables opportunities to be identified on two levels. First, buyers can familiarise themselves with the current risk and return profile of an available illiquid hedge fund. This increases their comfort levels - and the corresponding amount they may be willing to bid. Second, hedge fund managers can be advised on raising liquidity through the sale of real assets that may exhibit longer liquidity characteristics than is optimal for the fund.

While the trading of illiquid hedge fund shares has increased, interest in the real assets held by the funds has risen to an unparalleled level. It opens up the liquidity-impaired hedge fund to a new and previously untapped source of capital, which in turn can be used to return liquidity to investors. And for private equity managers and other highly specialist investors, it represents a untapped source of often high-quality assets with good upside potential. These real assets offer a variety of investments, and often do not represent the original strategy of the hedge fund.

Prior to the credit crunch, many hedge funds - particularly those with an emphasis on credit strategies - started to offer private loan arrangements as a way of putting cash to work. These loans were often backed by some form of physical collateral - from plant and machinery through to a controlling interest in a privately-owned business. With the onset of the crisis, the debtor companies defaulted and the hedge funds took charge of the assets backing the loan.

Subsequently, the companies have turned their fortunes around but find themselves and their new owners inadvertently in a strategic mismatch. The credit hedge fund manager originally created the loan facility as a way of creating a steady income stream, but now has a portfolio of private shares at a time when the underlying company may be in need of an experienced private equity investor. Potentially, intermediaries can create a winning situation - the hedge fund manager gets access to precious capital to return to shareholders, the private equity managers gets access to previously closed-off quality investments, and the underlying business gets a much more suitable and intentional partner, with the possibility of further cash injections.

With the need for yield uppermost in the minds of institutional investors, it is hardly surprising that there is growing willingness to search among lesser known and less well understood segments of the securities markets.

Illiquid hedge funds as a high-yielding asset class with lower sensitivity to the wider markets themselves, as well as being a source of illiquid real assets, are still in the early stages of emerging. But indications are that this sector has yet to develop to its full potential.

Florian de Sigy is managing partner and Benjamin Keefe a director at Gamma Finance in London