A 'Second' Wind For Hedgies

Date: Tuesday, May 19, 2009
Author: GereLyn Terzo, IDD Magazine.com

Satellite Asset Management, a once high-flying hedge fund that managed billions of dollars in assets, was recently forced to shut down at the hands of massive investor redemptions. The failure sent shock waves through the industry, which watched as the George Soros prodigies who ran Satellite began liquidating their funds.

Another nail in the coffin of a left-for-dead asset class? Hardly. Investor confidence in hedge funds is actually on the rise, and companies are finding a budding opportunity in the secondary market for otherwise illiquid assets.

According to a recent Goldman, Sachs & Co. survey, which covered 460 investors representing $1 trillion of assets directly invested in single-manager hedge funds, cash levels across portfolios will decline 6% from 2008 year-end levels. This means 6% of cash, or $85 billion, could potentially be redeployed. Of that, $70 billion would come from the fund of hedge funds group, according to a Goldman Sachs spokesperson.

One place investors, including hedge fund of funds, are increasingly turning to for that capital is in the secondary market, a nascent opportunity for hedge fund participants. Growth in the secondary markets for hedge fund assets is being driven by the wave of restructurings funds went through over the past nine months.

There is currently about $100 billion sidelined in hedge fund assets, capital that is either locked up or subject to other liquidity restrictions, such as gates, according to sources. These restrictions have frustrated hedge fund investors with little or no access to liquidity. Enter the secondary market, where the restricted investor can trade places with a more adventurous one. The advantages for the seller are getting out of a position in a hedge fund they might otherwise have been stuck in for months or longer, while a seller obtains a position at a discount -- anywhere from a 10% to 60% discount from the seller's book value.

While the buyer and seller negotiate on price, other terms, such as fees, are discussed among the new investor and the general partner.

Hedge fund secondary market activity is primarily happening one of two ways, including a direct transfer of a limited partner's position from one LP to another. The other trend surrounds side pockets, which are created when a hedge fund manager places illiquid assets in an investment vehicle separate from the hedge fund. Investors typically hold onto these shares until a fund manager figures out a way to tap into liquidity. "There's lots of work to do on both sides," says one hedge fund consultant.

This opportunity is inspiring new businesses and creating a pipeline of new jobs on Wall Street and in London. SecondMarket, a marketplace for illiquid assets, is a hybrid market comprised of an online trading and research platform manned by about 100 employees. SecondMarket expanded into the LP interest market earlier this year to match sellers of holdings in private equity and hedge funds with prospective buyers.

Jeffrey Bollerman recently joined SecondMarket from Citigroup, where he developed investment products, to spearhead the LP initiative. "We're seeing a lot of investors entering and this market is growing dramatically. Investors are entering the capital markets again, and they are considering something that didn't exist in the past and that's the secondary market," Bollerman says.

Cogent Partners, an investment bank historically focused primarily in private equity transactions, similarly recognized an untapped opportunity for hedge fund assets in the secondary market. On May 11, the firm launched a hedge fund advisory business, leveraging the relationships and experience it had already established on the private equity side of their business with hedge funds.

"We pioneered the role of the intermediary in the secondary market in private equity," says Brenlen Jinkens, managing director with Cogent. "What we're doing is in response to client inquiries and demand. We helped bring liquidity to private equity portfolios, and there are those same concerns on the hedge fund side. We organized ourselves to address them," he says.

As part of that positioning, Cogent hired Pascale Alvanitakis-Guely, who formerly advised hedge funds on corporate transactions for Lehman Brothers, to spearhead the effort out of London. "It's an interesting new market," says Alvanitakis-Guely. "There are a number of players, which are mostly catering to the needs of high net-worth individuals. We felt what was missing was a true advisory business where you could structure a transaction on behalf of institutional investors, which typically have much larger investments in hedge funds."

Alvanitakis-Guely compares structuring a hedge fund transaction in the secondary market with doing an M&A and private placement deal, combined. Jinkens agrees. "Effectively, there is a lot of work to do once the buyers and sellers meet. They must establish the best price, they have to agree on the transaction, and establish the legal groundwork required to execute the transaction. That requires competence on the advisory side," Jinkens says.

Of course, hedge funds are notoriously mysterious, and the private investment vehicles are not always transparent. "Admitting you're active in the secondary market is a little like admitting to Internet dating," Bollerman says.

Hedge funds are also used to attracting a high-quality investor base, which makes the vetting process in the secondary market more intense. For example, Alvanitakis-Guely says fund managers want to know who Cogent is approaching as a potential replacement investor. "They want to avoid new investors who are only interested in making a very short-term investment and taking advantage of buying at a discount from an investor who is desperate for liquidity," Alvanitakis-Guely says.

SecondMarket addresses this by establishing what the firm refers to as a MicroMarket, which allows a hedge fund general partner to create their own terms and universe of investors. "GPs have veto rights. No matter how much a buyer and seller want to do a transaction, if the GP says 'no,' it's not happening," says Jeremy Smith, the chief strategy officer with SecondMarket.

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