It’s an Investor’s Market as Hedge Funds Shift

Date: Thursday, March 26, 2009
Author: Rob Cox, New York Times

NOT long ago, investors lined up to write checks to hedge funds, with visions of huge returns. But after last year’s lousy investment performance and record levels of hedge fund closures, many are now realizing that hedge funds aren’t an asset class, but a legal construct — and the legal agreements can be absurdly one-sided.

With the balance of supply and demand tilted in investors’ favor for the first time in years, even some star managers are now on the back foot. It’s time for investors to push for their rights.

Of course, fees are central to this conflict. The level of fees charged by hedge funds and, crucially, their structure — for instance, the idea of spreading them over several years — are hot topics with investors. But the issue goes beyond that to more qualitative areas. A fund’s outside investors, often known as limited partners or L.P.’s, are in fact usually more limited than partners.

Depending on the small print supporting his particular legal edifice, a hedge fund manager can have dictatorial powers: to change his investing style at will; to appoint the directors who nominally oversee his funds; to give some investors “side letters” conferring better deals than others have; to sequester unruly investments in “side pockets” where they can be left indefinitely to mature or die; to decline investors’ redemption requests in full or in part; and so on.

Blocking withdrawals has most annoyed investors lately. Many wanted to pull money out as the hellish 2008 ground to a close, because they either needed it elsewhere or wanted to stash it somewhere less risky.

But plenty of managers blocked withdrawals, claiming this was best for their fund investors overall. Many investors instead saw at least some instances of this as the managers acting in their own interest.

Consider New York-based Steel Partners, whose Steel Partners II fund faced significant redemption requests. Beyond simply blocking withdrawals temporarily as many funds did, the firm merged the fund into a holding vehicle the fund had previously owned, locking investors into its not-very-liquid stock — all apparently without any absolute requirement for investor approval.

Hedge funds in the United States have some of the most manager-friendly legal documentation. Mix in a more letter-of-the-law mindset than their European counterparts have, and United States-based funds have raised the most investor ire.

It’s not that experienced investors are pretending they didn’t understand the small print. It’s that they feel some managers have acted unfairly and ignored the spirit of their relationship with investors who entrusted them with money.

L.P.’s have at least two options in response. One is to pull their cash, as soon as they are able, from the funds they no longer trust. Morgan Stanley researchers view it as a sine qua non for future success that funds didn’t “gate,” or block redemptions, during the recent market turmoil.

The other is to insist that new funds — and maybe even old ones — take a fresh approach to the relationship between fund managers and investors. Because market forces were in their favor, managers were able to negotiate such one-sided deals along with their generous fees. Now that the dynamics have shifted, investors shouldn’t be shy to take what legal ground they can.

That’s not to say full-on democracy is the order of the day. Hedge funds aren’t publicly traded stocks or mutual funds. They are mostly still private partnerships involving wealthy and sophisticated investors, who hand over money because they trust specific fund managers’ judgment. But investors could, for example, insist on a vote on critical actions like gating. Or they might propose requirements for more obviously independent governing boards for funds.

The typical hedgie might see such moves as too much of a change from standard operating procedure. But it would be harder to argue against one potential investor safeguard — the ability, perhaps with a supermajority of L.P.’s votes, to force the orderly liquidation of a fund if they lose confidence in the manager. For that to be possible, managers would have to be more open about telling investors who their counterparts are, something most of them are loath to do.

If it started happening, though, it would be a sign that investors had taken the initiative and started to redesign the hedge fund legal construct to better suit their interests.