Hedge funds warned over shift to illiquid instruments

Hedge funds moving into illiquid asset classes could put themselves in a dangerous position.

Hedge funds which are increasingly investing in private equity instruments and assets have been warned they could face liquidity mismatches.

A growing number of hedge funds are embracing illiquid asset classes as a means by which to generate returns in what has been a low and zero interest rate environment. Many traditional hedge fund strategies have struggled to make money in this turbulent macroeconomic environment with the average manager posting losses of 3.85% over the last 12 months, according to data from Hedge Fund Research.

These downcast returns have prompted investor withdrawals and fee pressure on the traditional 2% management fee and 20% performance fee model. It has also led to hedge funds pursuing investment opportunities in illiquid assets more commonly associated with private equity. A study of clients by international law firm Seward & Kissel found 88% of hedge fund clients permitted quarterly or less frequent redemptions compared to 81% in 2014. Just 12% of fund managers permitted monthly redemptions, according to the latest Seward & Kissel study, compared to 19% in 2014.

The push into private equity has caused consternation in some quarters. While hedge funds are increasingly adopting less liquid redemption terms, some in the private equity space feel this is not enough. A number of hedge funds have redemption terms of one year for highly illiquid positions while a typical private equity manager will have a seven to 10 year investment time horizon. If investors into these illiquid hedge funds demand their cash, those managers could struggle to offload those assets, particularly if markets are highly volatile.

“The move by hedge funds into private equity is not a new phenomenon. In fact, it occurred in 2006 and 2007 and a number of hedge funds with illiquid exposures got their fingers burnt in the crisis as a result. It all comes down to liquidity. Hedge fund investors can subscribe and redeem assets at certain times – be it monthly, bi-monthly or bi-annually. Hedge funds must have sufficient liquidity – say investments in cash or bonds – to meet those redemptions should they arise. Those hedge funds with illiquid exposures may struggle, particularly if their redemption terms are not correlated with the underlying liquidity of their assets. There is a huge risk of a liquidity mismatch in some hedge funds. It is simply not possible to press a button and sell a private company or property asset, and hedge funds with such exposures must be aware of this,” said David Bailey, a founder at Augentius, a global private equity and real estate fund administrator.

The push into illiquid assets is also partly a result of Basel III capital requirements at banks. Many banks have been forced to unwind illiquid positions, such as collateralised loan obligations and residential mortgage backed securities, which hedge funds have acquired at discounts. Other hedge funds have gone further and made significant investments into infrastructure and hard, real assets.

Some point out this is replicating errors made prior to the financial crisis when a number of hedge funds found themselves exposed to illiquid assets which were beyond their investment remit. However, the enhanced transparency at hedge funds nowadays does mean investors are usually fully aware of what is in their portfolios. There are concerns that hedge fund managers, which have a trading background, may struggle with the long-term nature of private equity, as well as managing companies. “Hedge funds are dealers at the end of the day. There are questions as to whether some will have the capability to roll up their sleeves and get involved in the running of a private company in their portfolio,” commented Bailey.

There are also concerns that some service providers – particularly hedge fund administrators – may struggle to value complex illiquid private equity assets. A number of fund administrators do provide multi-asset class coverage, and valuation of level three assets and this should not be an issue for them. Bailey said those administrators simply focused on hedge funds may struggle with coming to a subjective and highly complex valuation around hard assets.

Equally, a number of private equity managers have launched hedge funds including Carlyle Group, Blackstone and KKR. The latter holds a 24.9% equity stake in Marshall Wace, the London-based hedge fund manager. The shift by these large private equity managers into hedge funds comes as they seek to become full-scope alternative asset managers. This can help increase their investor base and enables them to obtain diversified sources of returns. “The largest hedge funds and private equity managers have the resources, capital and skill-sets to diversify their businesses across different asset class. These large managers can simply hire the relevant personnel to make it happen,” said Bailey.

Interest in private equity has increased at a time when investor confidence in hedge funds is waning. Hedge Fund Research data found $15.1 billion exited hedge funds in the first quarter of 2016, making it the worst quarterly outflow since the nadir of 2009. It was also the first consecutive quarter of outflows in seven years. Meanwhile, BNY Mellon analysis found 44% of real estate managers and 39% of private equity houses expected Assets under Management (AuM) to grow by at least 50% in the next five years.

The BNY Mellon study found that while institutional investors such as pension funds and family offices had the biggest appetite for real investments, nearly half of private equity and real estate fund managers predicted retail allocations would account for a higher level of capital inflows by 2020 than they do today. The BNY Mellon paper said investments from the mass affluent and high-net-worth individuals in emerging markets, as well as sovereign wealth funds and defined contributions schemes, would be forthcoming.