Saturday, August 29, 2009

Restructuring allows some hedge funds to survive the crisis

Market illiquidity and hedge fund redemptions tend to coincide. That combination of events, together with poor performance, was bringing the hedge fund industry to its knees in late 2008. Many funds had the cash or enough liquid instruments to meet these redemptions, but many chose not to. Here is the reason: if a fund uses its cash or liquid securities to let those investors who want out to redeem, the remainder of the fund becomes increasingly less liquid. The redemption disadvantegas those who either chose to stay in the fund or whose lockup periods have not yet ended. It also forces the manager to sell securities at liquidation prices, forcing the remaining investors to realize losses too early. Thus all the "loyal" investors end up holding the illiquid portion of the portfolio, with all the cash going to those who got out.

The hedge fund community came up with two types of restructuring solutions to address these conflicts.

Solution I: The approach was to create what amounts to be a side pocket (or an illiquid fund) and a liquid fund. Everyone gets their pro rata share of the two funds. Anyone wishing to redeem from the liquid fund can do so at any time (or at least when lockups permit them to do so). The illiquid fund however operates like a private equity fund (or has a long lock-up), with payments to investors only upon monetization of the illiquid investments.

Here is an example of this type of restructuring:
Tudor Investment Corp., the firm run by Paul Tudor Jones, temporarily suspended client redemptions from the $10 billion BVI Global Fund Ltd. as it plans to split the hedge fund into two.

Tudor is proposing to put hard-to-sell investments, mostly corporate bonds and loans from emerging markets, into a new fund called Legacy...

Solution II: After suspending redemptions (or putting up gates) the manager splits up the portfolio into two separate but identical funds with pro rata holdings. One would hold the portfolio belonging to those who stay in (sometimes called the continuation portfolio), the other would belong to the liquidating investors (sometimes called the realization portfolio). Then the "liquidating" fund would sell all it can and return most of it's cash to the investors. This way the illiquid investments are shared pro rata between those who redeem and those who don't. The redeeming investors would then need to wait (possibly for years) until their illiquid holdings get sold. The manager would charge a minimal fee (say 50 bp) to oversee a gradual liquidation. In the mean time those who chose to stay, still have their share of the cash and liquid securities in the fund. The bulk of the managers' own funds would get moved into the continuation portfolio to align their interests with investors who stay (although some of the manager's money may go into the "realization" fund to assure those who get out that they will get the best value from the liquidation.)

These two funds would therefore start with identical holdings, but quickly diverge to meet the needs of the various investors without creating a conflict. Those who stay in the fund are asked to agree to a lockup (maybe 2 years) in return for reduced fees (something like 1.5% management fee and 15% incentive fee).

Here is an example:
Indochina Capital published information last month on a possible division of the company’s portfolio into a continuation portfolio and a realisation portfolio.

The problem with Solution-II comes in when those who had to stay in the fund because of previous lockups decide to get out when their lockups end. The manager then needs to split the fund again, creating a separate "liquidation fund". The process becomes a management nightmare. The manager would have to manage the main fund plus two or more liquidation funds with divergent interests and holdings.

But such restructuring doesn't work when investors completely lose faith in a fund's future. Cerberus recently attempted solution #2: From the WSJ

...the main hedge fund run by the firm, called Cerberus Partners, lost 24.5% in 2008. It is up about 3% in 2009. Since December, Cerberus has faced a wave of withdrawal requests by investors spooked by the markets and Cerberus's own losses. Cerberus refused to return cash, saying that weak market conditions would mean low prices if it sold holdings.

Responding to the clamor from its investors, Cerberus last month began a restructuring plan that opened a window for investors who wanted to leave the funds. Cerberus hoped it could persuade them to move their assets to a new fund with longer asset "lockups" but lower fees [this is the continuation portfolio]. At the time, the Cerberus bosses expected to retain more than half the assets of the funds, known as Cerberus Partners, in the new vehicle. Mr. Feinberg has personally called Cerberus clients over the past two weeks to discuss his firm's plans to retool the Cerberus Partners hedge funds, according to investors in the funds.

Investors' response was an overwhelming "we want out":

Clients are withdrawing more than $5.5 billion, or nearly 71% of the hedge fund assets, in response to big investment losses and their own need for cash, according to people familiar with the matter.

At this stage, with 71% redemptions and a 3% return for the year, their options are limited. Cerberus may end up scrapping the proposal to restructure, forcing investors to stay in by keeping redemptions suspended. If they choose to do so, their hedge fund business is finished. In fact managing illiquid assets in a hedge fund (vs. private equity type fund) may be the thing of the past for the whole industry.

But for those funds that still have an ongoing business, these restructuring solutions allowed a more fair treatment of redeeming and continuing investors, who would normally be at conflict within the same fund vehicle.

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