Overcoming the Capital Challenge

The lower levels of leverage both of the hedge funds themselves and their investors, coupled with the willingness of Asia hedge funds to meet redemption requests, recognising that suffering a reduction in assets under management would go towards preserving the future relationship with cash-hungry investors, has meant that the level of hedge fund restructurings in Asia may have been less than in other parts of the world.

However, the desire among investors for cash liquidity continues to affect the capital raising capabilities of Asian hedge funds. Borne out of the forced redemptions from funds of all types in 2008 to 2009 and reflective of the credit issues faced by investors in the financial crisis, this desire remains a pressure on hedge funds. In addition, some recent investment flows would be characterised as “hot money” investment decisions, not necessarily an approach, which sits well with the investment timeline horizons required by many Asian hedge funds or their investors.

A New Breed of Tools

A corollary of the financial crisis has been the damage suffered to the credibility of some of the traditional tools previously employed by hedge funds to keep investors invested.

However, the investors’ reaction to the employment of such tools may offer some useful pointers to new hedge funds seeking to raise capital in Asia. Indeed, the changing tastes and tolerances of investors have had an effect on the structuring of hedge funds.

For example, redemption gates were originally intended to prevent forced sales of investments in order to meet redemption requests and also to prevent the subsequent overweighting of the remaining unsold portfolio towards less liquid investments. The imposition of redemption gates, however, has caused objections by investors where seemingly used as a defensive weapon by investment managers seeking to prolong the life of the funds rather than to enable the orderly sale at what the relevant manager regarded as appropriate prices.

In addition, where an investment manager continued to charge fees to investors kept in the fund not through their own wishes but merely by the decision to erect the redemption gate, this has added to the dissatisfaction.

The investors’ appetite for lock-in periods, even for a lock-in period of a year or less, has declined. Lower fees during the lock-in period may soften the blow, but this does not necessarily atone for the lack of liquidity so sought for by investors.

Side-pockets continue to have a place in the pantheon of hedge fund structuring but appear to encounter significant resistance unless the investment strategy justifies their inclusion. Even where the fund’s investment strategy does contain an element of private equity/illiquid investments suitable for the side-pocket mechanism, the investors’ appetite for such hybrid vehicles seems to be on the wane.

A Decline in Alternative Strategies

With the advantage of many excellent private equity houses in Asia for investors to choose from, there is less demand for a hedge fund which invests in other alternatives such as private equity and real estate or longer-term, more event driven strategies. Even the carrot of deferred performance fees for the side-pocket investments (until the relevant exit events, for example) is not proving strong enough to persuade investors that this is a sufficient recompense for (potential) years of illiquidity in the side-pocket.

Long notice periods for redemptions and infrequent redemption days which are not reflective of the underlying investment strategy of the hedge fund are unlikely to be tolerated by investors motivated by cash liquidity and fleetness of investment timelines.

The death knell for hedge funds seeking new money will be – if they or their managers are in a guise of a previous vehicle – suspended redemptions unless such suspensions were justifiable in order to effect an informal wind-down of the fund or with their full agreement, the investors were persuaded to take a long-term view as to the valuations of the underlying assets and that the valuations available at the time of the suspension did not reflect their true values.

While redemption and illiquidity will be at the forefront of the minds of hedge fund investors who have endured the financial crisis, fees will always be a significant consideration.

One of the biggest challenges to managers and investors alike for those hedge funds which have weathered 2008 to 2009 is likely to be the performance fees’ high-water marks. Typically, a manager would have charged a management fee of 1% to 2% and performance fee of 20% of the appreciation in the net asset value over a particular performance period. Such net appreciation would set the high-water mark for the next performance period (prior high). Thus, a hedge fund which makes a loss in a performance period must achieve the prior high before earning performance fees in a subsequent performance period.

Uphill Climb to Regain Prior High

The problem for hedge funds which suffered significant losses is that it may take years to reach the prior high. But of course, the manager still needs to pay the salaries of employees and investment professionals, the office rent and other day-to-day expenses during that “loss” period. The management fee of 1% to 2% is unlikely to cover such costs and if the hedge fund cannot reach above the prior high, it has no gains on which to charge a 20% performance fee. A manager is thus faced with the possibility of working for free until such time as the net appreciation exceeds the prior high or winding-up the hedge fund in the hope that he has built up sufficient goodwill in the profitable years to raise enough capital for a new fund.

An alternative adopted by some managers has been to change the high-water mark. Under the modified high-water mark structure, the manager will earn a reduced performance fee on gains under the hedge fund’s prior high but may not earn a 20% performance fee until the hedge fund recovers all the loss (and any subsequent depreciation in net asset value) plus usually 150% of the loss (the modified prior high). For example, if the net asset value at the commencement of a performance period is $1 million, this will be the prior high.

However, if during the next performance period, the net asset value drops by $100,000 to $900,000 and that loss has not recovered by the end of such period, the prior high would be increased by $150,000 to equal a modified prior high of $1,150,000 (being 150% of the $100,000 loss is $150,000 plus the prior high). Until such time as the net asset value of the hedge fund has appreciated from $900,000 to equal the modified prior high ($1.15 million for example), the performance fee will be chargeable at a rate of 10% only. Any net appreciation in excess of the modified prior high will be chargeable at a rate of 20%.

Depending on how long it takes the hedge fund to reach the modified prior high, the actual performance fee paid to the manager may be lower than if the manager had retained the original terms of earning 20% performance fee over the prior high. However, the trade-off for the manager is that it can stay in business and manage the investors’ money even though the performance of the hedge fund is below the prior high.

This article first appeared in the HFMWeek Hong Kong 2009 special report (Pg 25, Hong Kong 2009 issue). For more information, please visit