Although I have never been a marketer, and am firmly on the buy side, being part of First Avenue Partners, effectively a marketing firm active in hedge funds, private equity and real estate, as well as a hedge fund seeder, gives me a very interesting view on what investors want. Being responsible for due diligence and manager selection for the hedge fund practice, I spend most of my time looking at the hedge fund industry, but I also keep track on the private equity and real estate fund management industry as there are often interesting overlaps.
It was very clear that in 4Q 2008, investors simply wanted out, they wanted to redeem from their managers and they often wished they had never been invested with the funds they were invested with, that they had never got involved in the dreadful investment game, and that they should all have been dentists instead. You get paid for pulling teeth, patching teeth, straightening teeth, and poking around in teeth. But the more teeth you pull, patch, poke or straighten, the more you get paid. In those times, investing was like having your teeth pulled and paying for the pleasure, a bit like being on the other side of the drill. It was not material which investment strategy you were in whether it was equity long short, merger arbitrage, relative value, event driven, credit, fixed income or macro. The pain was less in macro and risk arb, although so widespread was the pain and so punchdrunk were investors by the end of 2008 that many did not even realize that risk arb actually turned in a relatively strong performance, losing some money but mostly protecting capital for the year. Global macro made money, but even macro as a group saw investors making net withdrawals from the strategy. Investors wanted out. They just wanted to sell sell sell. Put or Call? Doesn’t matter. Sell sell sell. The redemption terms of hedge funds made it possible to forecast the degree of outflows since there is usually a long notice period of anywhere from 15 days to 180 days, although its more usually clustered around 30 to 45 days. Also, in the industry, people talk. And misery likes company. The anticipated and realized redemptions for September 2008 was high, but December saw a crescendo. Sentiment was terrible. And then some managers started suspending redemptions and applying gatesand side pocketing illiquid investments. For the most part, if you were in ‘traditional’ hedge fund strategies such as equity long short, merger arbitrage, statistical arbitrage, relative value, convertibles, global macro and CTA’s, you would have lost money but you would have got your money back. If you were in the less liquid end of credit, levered loans, LCDS, private convertibles, PIPEs, quasi private equity (PE without control, lovely), asset based lending, chances are your manager would not be able to get you your money back even if they wanted to. And to be fair some of them wanted to.
Human beings are predisposed to extrapolation. Estimates for the March 2009 redemption volumes ran to the fanciful. In the end, over a 6 to 9 month period ending March 2009, a 2 trillion USD industry had been halved. Hedge fund managers who once were Masters of the Universe were humbled. Funds that were closed to new investment were open again and their managers had to suffer the ignominy of presenting at capital introduction events.
The long notice periods provided by hedge funds provides the investor with a bit of an option. The investor can put in a redemption order and at the last moment, rescind the order. In good times, the hedge fund manager would tell the investor where to go, execute the redemption and move on to take in money from the next investor. In the last 9 months, the prevaricating investor is treated like royalty, thanked for their cancellation of redemption order and sent free stuff like umbrellas, hats, t-shirts and card holders. At last count, at the end of April 2009, anecdotal evidence is that not only areredemptions slowing, but a significant number of investors are cancelling their redemption orders. On top of that, investors are coming back into the market. We have seen evidence of interest in distressed credit, global macro, equity long short and convertible arbitrage.
Distressed credit is a strategy which according to investor survey’s conducted earlier in the year continue to see a lot of investor interest. In fact, distressed credit was a strategy offered in volume in late 2007 and which in 2008 burned a lot of investors. One factor in the disappointment was the lack of corporate defaults in 2008. Distressed investing worked only if you were ultra selective and if you went where the defaults were underway and not where they were waiting to occur. The place to be was arguably in the ABS market where RMBS and their CDO’s were already defaulting . In corporate credit, default rates are only now accelerating. The market expects default rates in double digits by the end of the year, arguing that investors were too early in 2008 but are likely to be right this time.
Global macro is a strategy I had dealt with separately in my article of 17 April, Global Macro in 2009. Think againwhere I argue that the easy trades are done, that the opportunities are still there, but the way one captures them, and the subspecies of manager required for the job, are different. But who am I to argue with the legions of investors who want to invest in Global Macro?
Equity long short is a perennial strategy. In the turmoil of the last 12 months, the strategy has had mixed success. The traders have done well as equity markets abandoned fundamentals and traded almost purely on psychology. There are signs that idiosyncratic risk is beginning to rise and that the day for the stockpicker is not far away. Of course the holy grail is finding the investment manager who both understands fundamentals and has the ability to trade, who has a full arsenal and can deploy the right weapon for the right battle for the winning of the war. As investors restore their risk, equity long short is one of the strategies that ranks high.
One area of surprising risk aversion is merger arbitrage. Since private equity was bruised and left for dead and LBO receded into memory, investors have shunned merger arbitrage. This despite it being one of the top 3 hedge fund strategies last year (short sellers excluding.) Deals spreads are attractive despite leverage being scarce and deals being friendly; but option markets have their eye on systemic risk and not on deal risk and for the more sophisticated traders represent an interesting opportunity. Also, has anyone noticed that this year alone we have Wyeth-Pfizer, Schering Plough – Merck, Liberty – Direct TV, Endesa – Enel, Sun – Oracle, Rio – Alum Corp of China, Lion Nathan – Kirin, not to mention a slew of parent sub consolidations? Still, no investor interest. This will of course change with
In the area of hedge fund fees, an area of particular interest to me from the perspective of principal-agent theory, and on which I have written earlier in Hedge Fund Fees. Suggestions for the Future, the hedge fund survey’s find that there is a significant preference for lower fees, particular on funds of hedge funds, but also on the underlying funds themselves. My own anecdotal experience is that investors do not so much object to the level of fees but rather feel that fees could be better designed to be fairer and more efficient at aligning the interests of the manager with those of the investor. There is an argument that talent is relatively scarce, and that the current environment highlights this and therefore that fees should be more differentiated. I am fortunate to sit in the middle of a private equity, real estate and hedge fund practice and have the benefit of assimilating best practice from all three areas. PE style fees which pay on realization and are subject to clawbacks are attractive but should be used carefully lest they introduce unexpected and adverse behavior by the manager. Let the fee design fit the fund structure, fit the strategy. What we are seeing among investors is a definite improvement in the level of sophistication and understanding with regard to fee design.
In the area of liquidity, the recent hedge fund investor surveys point unequivocally to a preference for liquidity. Long lock ups, side pockets and gates are definitely not preferred. Fund of funds in particular, are having to restructure their portfolios for greater liquidity to meet the terms they offer their investors. Institutional investors are also leaning heavily in the direction of strategies with better liquidity as they face balance sheet issues. It is left therefore to the private investors, the family offices, who have more flexible investment processes and mandates to take advantage of the value of liquidity. Longer gestation strategies are seeing considerable value, almost certainly because of the dearth of capital exploiting these very opportunities. Fortunately, it is heartening to see, among some investor groups, the appetite for longer duration investments. Arbitrage is a terrible thing to waste.
While investors remain cautious, there are clear signs that they are no longer in selling mode but are more in watching and waiting to invest mode. As always, this generalization hides a multitude of situations. The willingness to assume risk is a good thing. A cautious attitude to assuming risk can only be a good thing.