Hedge Funds Want a Pony, Um, Permanent Capital, as More Investors Exit

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An new article in the Financial Times illustrates the degree to which hedge fund managers, accustomed to calling the shots, seem constitutionally unable to adapt to the idea that their business has become a buyers’, not a sellers’, market.

The latest fantasy, even as funds are facing high levels of redemptions when super-low and negative rates ought to make them on of the places to be, is that they should get even better terms. Their pet ask is “permanent capital” as in really long lockups. Yes, and I would like to have a pony. When times are tough, vendors give concessions rather than increase their demands. There’s no indication that the fund managers who want to tie up investor money are prepared to give a big break commensurate with the loss of liquidity, like considerably lower fees.

The Financial Times story does point out that many funds now have monthly redemptions, which looks like a symptom that the fundraising environment has become more difficult than hedgies want to admit. In the early 2000s, only fledging funds offered monthly liquidity; quarterly was the norm, and some funds could limit redemptions to once a year. Monthly redemptions can be highly disruptive, since investors will be tempted to use the hedge fund as a source of liquidity independent of fund performance. Having investors sell (and put funds back) on short notice not only makes it hard to run an investment strategy (which assets do you sell?) but it can lead to cascading sales. If one investor sells enough, it may put another investor at over 10% of fund assets, which is prohibited by the investment policies of many institutional investors. So that investor will have to sell to get back down to 10%, which has the potential to trigger more partial exits.

However, there is a world of difference between getting away from disruptive monthly liquidations and “permanent capital.” George Soros, one of the fathers of the hedge fund industry, always ran his funds with the view that he could liquidate them readily if needed. Despite his successes, he’d never seemed to have forgotten his childhood experience of fleeing the Nazis. Being able (in theory) to shutter his business and take his winnings on short notice was important to his sense of security.

Yet we hear unsubstantiated claims that hedge funds are just about to become the place to be:

Several participants bemoaned institutional investors’ skittishness and tendency to pull money after short bursts of underperformance, and there were warnings that investors may be giving up on hedge funds just at the time they are about to prove their worth as a portfolio diversification tool in a down market.

First, these are not “short bursts of underperformance.” A Financial Times story yesterday pointed out that hedge funds had undershot the stock market 22 out of the last 28 quarters. And since 2012, hedge fund performance overall has become more highly correlated with the stock market, belying the claim that they offer much in the way of portfolio diversification. And in the 2008, investors saw that all correlations became one: risky assets nosedived all together, and quite a few celebrated hedge funds failed. Moreover, we’ve also stressed that if the aim is to obtain a differentiated return profile, there’s no justification for paying lofty hedge fund fees to achieve that result; it can be constructed far more cheaply than that.

And get a load of this:

Some famed managers are raising capital for new funds that will lock in investors for much longer periods, so they can make private equity-style investments or more complex trades in illiquid markets, according to private comments.

So now hedge funds want to become Johnny-Come-Lately in the private equity business, where managers are already warning that returns in the coming years will be disappointing? What advantages do these newcomers bring beyond their mastery of sales patter? But you can see that they’ve clued in on one of the phony advantages of private equity, namely that it looks less volatile than it is because general partners overstate the valuations in bad markets. Worse, investors openly acknowledge that they love this bogus accounting. From a post late last year:

Bob Maynard, Chief Investment Officer, Public Employees Retirement System of Idaho: We’re I think more skeptical of private equity ….

Ah, in fact, ah, we recognized however that we were going to get some pressure to look at local investments in private side, we did know that our actuaries and accountants would accept the smoothing that the accounting would do. It may be phony happiness, but we just want to think we are happy and they actually do have consequences for ah, ah, actual contribution rates we are going to be able to put in place. So we’re looking for it even if it just gave public market returns, we’d be in favor of it because it has some smoothing effects on both reported and actual risks, as seen that way.

As you can see, this is an unusually straight-forward acknowledgment that what is driving the selection of private equity is accounting treatment that Maynard admits is “phony.” And he does not expect to get any other benefit from private equity.

In addition, a Financial Times reader, Jakeyboy, pointed out the last time he hedge fund industry made a go of permanent capital, investors were burned:

Hedge funds tried the permanent capital route, particularly back in 2005-2007, when numerous listed hedge fund and funds of hedge funds were launched. However the majority of those funds have either been wound up or currently are in run-off returning money to shareholders.

The biggest problem were the huge discounts to NAV, as high as 50%, during 2008-2009 as investors sought out liquidity after being gated in many of their direct hedge fund investments. There was simply no support from the market and the prices collapsed relative to NAV.

The huge discounts triggered various discount control mechanisms which ultimately forced these types of funds to return capital to shareholders. I don’t think any investor wants to see the return of such discounts in volatile markets on top of mediocre NAV performance.

I was on a panel at Eurohedge in Paris in 2007 and stated, much to the chagrin of several fund managers, that there’s no such thing as permanent capital.

However, memories are remarkably short in investor land, and the Financial Times story, in keeping, tried to present this general-partner favoring strategy as pro-investor. There’s a sucker born every minute…

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  1. Harry

    I like the pony comment cos is true. But there is a poker game here rather than just a negotiation. The clients want something to and I don’t have any idea how they get it either. The clients want high enough returns to meet their obligations to pensioners. Well……

    I guess its hard to con an honest man.

  2. MikeNY

    It is exceedingly difficult for me to understand the social utility of the hedge fund industry, much less why it should mint so many multimillionaires and billionaires. It is almost the Platonic form of speculation. For every one George Soros who proves himself reliably smarter than the market, there are probably ten John Paulsons, who get it right once, but by that stroke of luck walk away with vaults of gold.

    The only argument I know that justifies its existence at all is that it works to enforce market efficiency. I’d suggest that this benefit is offset entirely by multiplying market volatility and, due to absurd tax policy and the idiocy of investors, grotesquely widening inequality. (Not to mention attracting insider traders and crooks like bears to honey.) Like PE, the hedgie industry has grown far to big to reliably outperform the market. We need to shrink it. Permanent capital is not the answer; higher taxation is the answer, along with prosecuting and jailing crooks like David Tepper, of which I’m sure there are many more.

  3. Jim A

    Investors signing up for long lockups in turbulent markets would seem to rhyme with people getting adjustable rate mortgages when rates are at historic lows…So who knows it might work. but I wouldn’t bet on it. And even if they persuaded people to do that I think that the ending would be similar.

    They should call the PONY funds…. Persistently Overpriced, Negatively-Yielding

    1. Clive

      It reminds me of the story doing the rounds (which I always believed to be true, it certainly sounded credible to me) of a London-based hedge fund which had a long-term lock-in or else eye-wateringly high early redemption penalties. Unfortunately, one of their investors was a particularly thuggish Russian (with, so the tale went, gangster connections or was even an outright Mafiosi). When the fund started tanking after the GFC, he wanted his money out.

      No, the fund manager advised, you can’t take your money out of the fund, contract-this terms-that, the fund will recover, you just have to ride out the market, blah-di-blah.

      The next evening he received a visit to his family home from a gentlemen who apparently was a graduate of the Ramsay Bolton charm school. With a sawn-off shotgun too, just to emphasise the point. He advised the fund manager that his boss would really appreciate it if he could have his money back, to be wired to his Swiss account the next day. And how it would be especially inconvenient if he had to call round again, and disturb the fund manager plus his wife and family at such a late hour. Well, let’s just say the fund manager reconsidered their stance on redemptions.

      That certainly was an “adjustable” rate product.

  4. Christopher Tobe

    I think the hedge funds will get their pony. They are in 280 U.S. Public Pensions, sure the top 20 with somewhat knowledgeable staff may complain, but the other 260 will sign up for worse terms if the right political wheels are greased. Since Citizens United every state and city politician who has control or influence over a public pension has their own Super-Pac that can take anonymous gifts up to $4999, and/or non-profit that can take unlimited secret donations. Chasing returns is the surface answer but politics is underneath. We have 3 Private Equity Governors, Rauner,Raimondo, and Baker.

    1. JIm A

      And like I always say, pension fund managers don’t need high returns. They just need PROMISES of high returns, and those are easy to get.

  5. Larry

    This amounts to putting lipstick on a pig. The industry has been exposed as overcharging for underwhelming returns. But they have naive customers still in their thrall, so they need to double down on the marketing speak about how existing and potentially future customers are savy investors. What will the hedgies and their well paid and abundant staff do if they cop to the factual truth?

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