The 2008 crisis was substantially defined by investors rushing out of risk-based assets and into the safety of government securities and cash as the classic flight-to-safety. This shift out of risk assets put tremendous pressure on prices: sharp declines in equities, corporate bonds, commodities and all sorts of derivatives; volatility spikes to record highs; bid-offer spreads at unheard of levels and so on. By the end of 2008, it seemed as if the world would come to a screeching halt.
And then some hedge funds halted redemptions.
Pandemonium ensued; recriminations were thrown about; investors shouted, “No way, not right!”.
Is this a fair tactic? Should hedge funds be allowed to halt or gate redemptions? Let us refer to an age-old practice for some guidance. In the US, businesses are allowed to seek protection from their creditors in order to reorganise by filing for Chapter 11 in the bankruptcy protection code. Chapter 13 provides a similar reorganisation process for individuals.
The process of buying time in order to reorganise with the intent to resume operations as a going concern is not only well-understood but a long-standing practice. But this type of formal protection does not exist in the hedge fund industry, even though (contrary to what governments would have you believe) the industry is fairly well-regulated (hedge fund and fund of hedge fund firms registered with the SEC manage about two-thirds of the hedge fund industry’s total assets). A hedge fund that halts redemptions typically does so with the intent to reorganise its business (eg investments) and to protect remaining shareholders from the adverse effects of a forced liquidation in a stressed market environment. In this context, the principal of protection and orderly restructuring is very much shared with corporates and individuals.
Ultimately, a hedge fund manager that halts redemptions knows that he is invoking a contentious right and risking alienating investors. But the other option of forced selling in a stressed and illiquid market means that remaining investors, as well as even redeeming investors, will potentially suffer larger losses. Of course, there are managers that may take advantage of their ability to halt redemptions for the sole purpose of retaining nervous investors. This practice is clearly unacceptable, especially when allowing redemptions would have little or no effect on performance. But my guess is that few reputable managers, if any, would or did engage in this practice. Donald Trump aside, companies and individuals seeking protection in Chapter 11 or 13 are not trying to game the system; they are actually looking for a second chance. The concept of a corporation with limited liability and an individual that is not put to death by his creditors is one of the primary reasons for the success of capitalism. A hedge fund’s ability to halt redemptions is a type of modified Chapter 11; it should be used sparingly and only when there is no other valid option.
It is well-understood that liquidity evaporates in a crisis. But there are good reasons why a manager would invest in illiquid investments. These typically relate to investment strategy and market. Private equity (including venture capital) would be on the illiquid side of the spectrum, whereas managed futures is considered a liquid investment strategy as investments are made in fairly liquid securities traded on commodity exchanges. Liquid markets are those of the developed world, whereas emerging markets are typically far less liquid. Each one of these investment approaches and markets provides important profit and diversification opportunities and is considered an integral part of the global investment landscape. These are valid investments which you would not eliminate for liquidity reasons – that just would not make sense. However, in a crisis like that of 2008, everything goes down together as investors seek safe harbour in the highest quality and liquid government bonds. This is pretty understandable: no one wants to be caught inside a cinema that has caught fire; we all rush for the exit and safety. But in that rush, we stomp over others. In the investment world, when markets tank, we all head for the exit. In this situation, halting redemptions is like turning on the sprinklers; it will not extinguish the fire, but it will buy time for the fire department to arrive on scene. And if hedge funds could somehow invoke Chapter 11, there might be a good chance to rebuild the cinema. Until that day, halting redemptions to reorganise is a valid option.
As a final note, many consider that hedge funds should not decline in down markets because they are able to go short or hedge. This is a common mistake since each of the hedge fund strategies taken as an isolated investment will have winning years, as well as losing years, with some strategies more prone to losing years (ie left tail risk) than others. However, a portfolio of hedge funds that is diversified across the strategies and that includes a significant allocation to protection strategies (like long volatility and short sellers) will tend towards absolute returns. I emphasise the words “tend towards” as we cannot really be completely certain about the loss probability of any investment, even triple-AAA rated US government bonds. The only things you can be really certain of are death and taxes.
Fund of funds are another matter all together. I do not believe we should condone the practice of halting redemptions at the fund of funds level that results from a mismatch in the underlying liquidity of the portfolio. A fund of funds manager that is providing monthly liquidity to its investors should have at least the majority of its assets with underlying managers that can be redeemed on a monthly basis. Lock-ups should also factor into portfolio construction such that monies are not unreasonably withheld by the fund of funds in the case of a market crisis.
This liquidity matching would seem fairly self-evident, but the reality is that most fund of funds had (and still have) serious liquidity mismatch issues. Many fund of funds manager will typically have around 10% to 30% of their portfolio matched to the liquidity they are offering their investors. The extension in liquidity (ie more and more hedge funds converting to or launching with longer redemption periods and lock-ups) became more common after the technology bubble burst and hedge funds became a popular investment choice. This process was reinforced by the credit-fuelled high-confidence/low-risk environment that led to the peak in asset prices. But when the crisis hit and a flight-to-safety ensued, risk assets declined in tandem and forced selling became de rigueur.
There is clearly then a difference between a hedge fund manager and a fund of hedge funds manager halting redemptions. The former is doing so to protect investors, whereas the latter is seeking to retain investors. Why retain? At the fund of fund level, halting redemptions is not absolutely necessary; there are other options. The best option would be to create a portfolio that does not have a liquidity mismatch. In the case where a fund of funds manager would like to invest in strategies or managers that require longer redemption periods then the fund of funds should provide a two-step process. The first step involves redeeming more liquid underlying funds and making these proceeds immediately available to investors. The second step involves creating a redeeming share class that is held in a side-pocket during the redemption process without any fees charged by the fund of funds. For instance, consider a fund of funds with half of the portfolio invested in managers providing monthly liquidity and the other half invested in managers with a one-year lock-up. In this case, the fund of funds would provide redeeming shareholders with half of their capital at the end of the first redeeming month. The other half of the investment would go into a no-fee redeeming share class that pays out at the end of one year. Bottom line: with this structure, you are not making a false promise as investors know right up front what they are getting. This approach should be clearly described in the marketing documents and not buried deep in an offering memorandum. Ultimately, is it not the underlying liquidity that exactly what an investor would receive if he invested directly in the underlying managers? An investor would be hard-pressed to suggest anything different.
This article first appeared in www.sfcsinsights.com on 14 December 2009.