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Home > Asset Management Best Practice > Hedge Fund Challenges Extend Beyond Regulation

Asset Management Best Practice

Hedge Fund Challenges Extend Beyond Regulation

by Kevin Burrows

Executive Summary

  • The loss of liquidity and its impact on hedge fund performance.

  • Redemption issues and their impact on future practice.

  • Management challenges and sector performance.

  • The threat from alternatives to hedge funds.

  • How the crash changed the rules of the game.

  • The dilemma of a global regulator.

Introduction

Victim Rather than Villain

The hedge fund sector has been vilified by some politicians, both in Europe and in the US, as if it were a significant contributor to the banking collapse and subsequent global recession. In reality, the hedge fund industry was very much a victim of the banks during the latter half of 2008, and there are some significant litigation actions pending, in which hedge funds are suing investment banks for alleged misdealings in their collateralized debt obligation (CDO) products and credit default swap (CDS) transactions.

However, potential misdealings aside, it is clear that the dreadful performance turned in by many hedge funds in 2008 was precipitated not just by stock market and property price collapses, but also by the total loss of liquidity in all risky markets, a direct consequence of the massive deleveraging by banks. At the same time as they were reducing the size of their balance sheets, numerous banks closed or drastically slimmed down their proprietary trading desks, leaving hedge funds with no bidders for any instrument that had any degree of complexity about it.

Adding insult to injury, many banks forcibly withdrew previously agreed lines of credit to hedge funds, forcing any hedge fund manager running a leveraged strategy to liquidate their positions as fast as possible. Finally, their clients, disappointed by the lack of “absolute returns” that they were implicitly promised by the hedge funds, became extremely nervous, and many decided to turn their investments back into cash, even though they often had nowhere to put the cash (as banks themselves posed a risk for any significant cash holding), and had no clear alternative investment strategy in sight.

The Impact of Redemptions

Faced with the perfect storm of poor performance and severe redemption pressure, hedge fund managers were forced to close funds or suspend redemptions, in order to protect values for those investors remaining with the fund. What the sector experienced during 2008, in other words, was less a performance issue, with strategies failing to work, than a bank run caused by their liquidity mismatch. Money that fund managers thought was “sticky money” (i.e., money that would stay with the fund for the medium term, and so give the fund’s investment strategy a chance to work) turned out to be “on demand” money that investors urgently wanted returned to them.

It did not appear to matter, in these circumstances, whether the hedge fund was invested in assets that the investors could expect to be highly liquid, such as equities or government bonds, or whether the fund had a very illiquid strategy, such as asset-based lending, where there was effectively no liquidity or secondary market for those loans. In the latter situation, if a significant proportion of the investors run for the exit at the same time, the fund management has very few options. They can either halt redemptions or run the risk of paying out all of the remaining liquidity at the expense of those opting to stay. Or they can simply liquidate the fund.

Management Challenges and Sector Performance

In reality, the way the hedge fund sector as a whole managed the difficult circumstances that characterized the second half of 2008 and the opening months of 2009 was highly commendable. As a generalization, portfolios were managed in a way that protected the interests of as many investors as possible. As a fund-of-funds manager, we were often on the phone to our hedge fund managers saying that, on behalf of our investors, we did not want the fund attempting to pay out all redemptions by liquidating the portfolio at fire-sale prices, as that hurts everyone. We wanted to see redemptions frozen and value preserved.

What the hedge fund sector has learned from this whole experience is that there is a definite price to pay for liquidity, or the lack of it. Investors clearly value the ability to convert their investment back into “cash at hand” in a reasonably short time frame. That ability has a significant value, so in future we will see that option priced into the contract between investor and fund. Moreover, for investment strategies that are largely liquid, the dealing terms will be forced to become more liquid to match the underlying instruments. As a consequence, we will see more monthly dealing hedge funds, with perhaps only a month’s notice or even less for withdrawals. We will also witness the continued development of many more daily dealing UCITS III type funds, trading in long-only and long-short strategies, in response to this new-found desire on the part of the investor community for highly liquid products. (The caveat to this, as we shall see in a moment, is that in the current investing environment, it is not clear that hedge fund managers have that much more added value to offer, even in this new format, versus passive investments such as an exchange-traded fund or ETF, where the units can be traded at any time, and where the unit charges are vastly lower than hedge fund fees.)

While the near-liquid funds move to highly liquid redemption terms, strategies that legitimately need a longer investment period to realize their returns, such as distressed debt and structured credit, will move their terms to something more akin to a private equity structure, with anywhere from a two-to-five-year lock-up, and no option for investors to get their money out early. The “middle ground,” which used to be comprised of hedge funds with 90-day exit clauses, but where the strategy was, in reality, rather more liquid that this conveys, will come under huge pressure to improve its liquidity terms. It will not be possible for managers to seek to hold assets just to control them; rather, they will have to match the liquidity terms of the clients to the liquidity terms of the assets. That will be a very significant change for the industry.

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Further reading

Article:

  • Andrew Baker. “Shorting—An essential endangered hedge.” Financial Times (June 8, 2008). Online at: tinyurl.com/62xgb7w

Websites:

  • Alternative Investment Management Association (AIMA): www.aima.org
  • “Majority of hedge fund assets under management now from institutional investors” (AIMA press release): tinyurl.com/6gn89yb

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