Barbarians at the hedge fund gates

Date: Tuesday, December 16, 2008
Author: SJ Berwin,

With investor confidence in the doldrums, many hedge fund managers are under siege from investors clamouring to recover their capital. Max Ziff, co-head of UK financial advisory services at Houlihan Lokey, and Victoria Younghusband (pictured), co-head of the hedge funds team at SJ Berwin, examine the variety of options available to managers desperate to avoid disposing of their most liquid assets or selling holdings at fire-sale prices.

With hedge funds having generally outperformed both the equity and debt markets so far this year, it is a little surprising that confidence in the asset class is at such a low ebb. Perhaps some of this can be laid at the door of political commentators who seek to portray hedge fund managers as responsible for much of the ills of the financial world, but certainly the damage of being caught on the wrong side of the Porsche-Volkswagen bear squeeze has done nothing to enhance the confidence of investors in troubled markets.

As a result of this lack of confidence, following an initial trickle of redemptions the dam seems to have been well and truly breached. The third quarter saw net outflows of USD31.7bn compared with USD1,722bn in total industry assets under management, according to HFR, but outflows are expected to be substantially higher in the fourth quarter.

An increasing number of hedge funds are struggling to meet liquidity needs by selling assets at distressed prices, which risks becoming a downward spiral of falling net asset values triggering more redemptions, which in turn force sales at even more depressed levels.

Against the background of falling prices it is critical that hedge funds value illiquid assets commensurately with their liquidity requirements. While the International Accounting Standards Board and the Financial Accounting Standards Board continue to struggle with what constitutes fair value in fast-moving and volatile markets, this provides little consolation to hedge funds facing redemption demands where NAV needs to equate to realisable value so as not to risk transferring value from remaining investors to those exiting the fund.

This issue of transferring value from remaining to exiting investors has even been seen in supposedly liquid money-market funds, where Putnam was forced to close and liquidate its USD12.3bn prime money-market fund on September 17 following receipt of redemption notices from 10 percent of its investors. Putnam's decision was based on the possible need to sell the most liquid investments in the fund to meet redemptions, thus resulting in a deteriorating portfolio for the remaining investors.

In essence, the major issue faced by the majority of funds is one of timing. If funds had the luxury of holding investments for an extended period, in the way private equity funds do, they would have much greater flexibility to value their investments other than on a potentially forced realisation basis. It is for this reason that, in an attempt to pull out of the tailspin in which they find themselves, a number of funds have resorted to various mechanisms that address accelerated redemptions and illiquid assets in their portfolios.