Hedge Funds With Short Lockups Win Investors, Survey Finds

Date: Friday, April 15, 2011
Author: Jesse Westbrook, Bloomberg

Investors are turning to hedge funds such as Caxton Associates LLC that don’t have restrictions on withdrawals when making new commitments, according to a new survey of fund clients.

Hedge-fund customers plan to allocate 90 percent of new investments in 2011 to firms that agree not to tie up money for more than one year, according to a Goldman Sachs Group Inc. (GS) survey released today. Funds that rely on longer lockup periods so they can buy illiquid assets such as distressed debt will have a harder time attracting cash, said David Solomon, co-head of capital introductions at the New York-based bank.

“Investors have more choices of liquidity terms than they did before the financial crisis,” Solomon said in an interview. “Consequently, hedge funds with less liquid terms are pursuing a diminishing pool of capital.”

The demand for short lockups is a legacy of the 2008 financial crisis, when some hedge funds restricted withdrawals to avoid having to sell assets at a loss. Investors pulled a record $154.4 billion from hedge funds in 2008, according to data from Hedge Fund Research Inc. of Chicago.

Caxton, a New York-based hedge fund with $11 billion in assets, places no limits on how long clients must keep their initial investment with the firm. It has also eliminated gates, or restrictions on subsequent withdrawals, even though the firm had never imposed such provisions.

Some hedge funds used gates during the financial crisis to prevent investors from withdrawing money.

Liquidity Preferred

While clients want fewer barriers to pulling money, the perception that hedge funds can provide better returns than other investments means the industry will continue to grow, the Goldman Sachs survey found. Pension funds, endowments and sovereign wealth funds surveyed by the firm expect the industry’s assets to increase 14 percent this year to almost $2.1 trillion.

Managers who pursue the most liquid strategies, such as those using computers to predict trends in futures prices and funds that buy and sell stocks, will be among the most popular this year, Goldman Sachs found. Investors plan to withdraw money from fund categories including credit, multistrategy and convertible arbitrage, the survey said.

Hedge funds raised a record $34.9 billion in February, according to estimates by BarclayHedge Ltd. Funds betting that stocks will rise took in the biggest share at $8.5 billion, followed by commodity trading advisers, which raised $7.5 billion, the Fairfield, Iowa-based research firm said.

Fewer Funds Selected

Investors are taking longer to scrutinize hedge funds and making fewer allocations, said Marc Gilly, who runs the capital introductions unit with Solomon.

Most investors meet with more than 100 hedge-fund managers each year. Only about three to five of those managers get money, a process that can take as long as six months and requires about four interviews, Goldman Sachs said. Investors made about 15 allocations a year before the hedge-fund industry had widespread losses in 2008, Gilly said.

“The bar is coming up very rapidly because of the institutionalization of the process,” he said. “Investors don’t have to invest and they want to wait as long as they can.”

Hedge funds on average gained 9.8 percent last year and 2.2 percent this year through March, according to data compiled by Bloomberg. The Newedge Commodity Trading Advisor Index, which tracks the category of futures funds that investors told Goldman Sachs they plan to allocate money to this year, fell 1.2 percent through March.

Lower Fees

It was the worst performing quarter for the Newedge index since the final three months of 2009, as some CTA and managed futures funds were hurt by a quick shift in currency markets after the earthquake struck Japan in March.

In contrast, strategies that investors said they planned to shun have risen in 2011. Credit-arbitrage funds rose 3.6 percent on average in the first quarter and multistrategy funds increased 2.9 percent, according to Bloomberg data. Goldman Sachs’s survey, taken in January, gathered information from 545 investors managing more than $1.1 trillion of assets.

About 40 percent of investors said they would lock money up with a hedge fund for longer than a year if the firm agreed to lower its fees, with pension funds and endowments the most eager to negotiate discounts. Hedge funds typically charge investors 2 percent of assets under management to cover costs and 20 percent of any profits.

Premium for Lockup

A lockup of three years doesn’t make economic sense unless the hedge fund is producing returns that exceed less restrictive investments by about 1.3 percentage points a year, according to a 2009 study by Emanuel Derman, head of risk management at Prisma Capital Partners. Investors should earn about 0.8 percentage point more a year for agreeing to a two-year lockup, Derman’s research found.

Prisma is a fund of funds, which charges fees to pick hedge-fund managers for investors.

“If the underlying strategy invests in illiquid investments, it makes a lot of sense to have a lockup,” Derman, who’s also a professor at Columbia University in New York, said in an interview. “What you want to avoid is instances in which the manager has a long lockup for no apparent reason.”

To contact the reporter on this story: Jesse Westbrook in London at jwestbrook1@bloomberg.net