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…