Pension funds are joining other institutional investors in grabbing an increasing share of secondary hedge fund market, as David Walker reports
Institutional investors such as pension funds are increasingly tapping into private secondary markets for hedge funds, as stakes in funds continue to go cheap after the financial crisis.
At present, pensions comprise the minnow’s share of the activity on secondary markets. However, practitioners say institutional investors overall provide 10% of trade volume on central trading venues such as Hedgebay, compared to just 3% last year.
A lot of funds have had to sell stakes at huge discounts because their investments had been suspended
A recent survey by Credit Suisse of a broad array of investors suggested their greater willingness to consider, and use secondary markets. Some 12% of respondents were already actively buying positions, up from only 6% a year ago. Active sellers doubled from 5%.
Pension funds are definitely most welcome at Dutch auctions such as those held by Credit Suisse, at central trading exchanges such as Hedgebay, and in making transfers of interests through facilitators such as Tullett Prebon and Citco Markets. Some investors have transacted directly between themselves in addition to these other secondary routes.
After the credit crunch as hedge funds limited redemptions, all four methods of getting exits for investors blossomed.
Discounts to net asset value (NAV) on some impaired-asset hedge funds blew out to 73% by June 2009, according to Hedgebay.
Some fund managers allocating pension fund cash prepared products to buy up stakes in discounted funds cheaply from peer investors who wanted to get out of them.
Permal Group was primary among those who put funds together, but many more rivals said they would invest in hedge funds via secondary markets for pension clients where it made sense.
Credit Suisse managing director and head of capital services Edgar Senior, said stakes still change hands at about 15% to 20% below NAV, a year on from the crisis.
The average discount to NAV on exchange-listed hedge funds, by comparison, was 8.5% in the middle of April, according to Royal Bank of Scotland, meaning the potential for uplift by using private secondary markets is greater if the discount narrows.
Although one secondary market stake changed hands at a premium to NAV on Hedgebay last month, Senior said investors should not expect a quick return to the days of 2007, when paying over the odds often occurred for funds otherwise closed to new investors.
Secondary markets in their current states, where discounts prevail, allow new investors to buy in cheaply.
They allow existing investors happy with their allocation to build on their stakes at a discount.
And the manager whose fund changes hands benefits as prospective – often irritated – redeemers receive an exit often sooner than gates, side pockets or other redemption curbs on the fund allow.
This may be so in the ongoing auction of the flagship Special Situations fund of London’s RAB Capital – under the auspices of Credit Suisse – after investors acceded to a three-year lock on their capital from 2008.
Andrew Weir, senior analyst at US$2.7bn institutional fund of funds Stenham, said his firm would not buy impaired funds, but could use secondary markets to top up existing holdings, even if at a slight premium to NAV, as Stenham did in one case back in 2007.
Weir said: “A lot of funds have had to sell stakes at huge discounts because their investments had been suspended [but] we would not generally buy into something that has a problem related to it. You need pretty good transparency to make a call on a fund like that.”
He said: “We were an existing investor in the fund we bought. We may use markets again if the price is right…and if it is not a big premium to pay.”
Hedgebay co-founder Elias Tueta, said thorough due diligence was required when using secondary markets, and particularly when buying assets in side pockets, which are legal structures used to isolate assets from pricing and forced sale, often because markets in them have become extremely thin.
Tueta added most institutional investor interest now is in selling of stakes, and secondary markets could act as a type of risk control mechanism for pension funds.
He said: “In 2008, pension fund managers realised something had to change in how they managed risk. Although they have a long time horizon, and they have been able to invest in relatively less liquid assets, what has changed is their ability to sustain volatility swings.
“Pensions are now more subject to transparency reports. They have to use risk management tools, and the secondary market is one of those used to tactically reshuffle their portfolio, manage their risk and after the crisis to get rid of legacy positions or side pockets they do not want.”
There was a small rush to sell stakes in December before year-end reports had to be prepared and holdings accounted for, he said.
Tueta added stakes traded on Hedgebay typically exceed $20m in size, with interest in credit, asset-backed and event-driven funds waxing, while that for global macro and equity long/short funds is on the wane.
But Credit Suisse’s Senior added at present relatively little secondary market activity comes from pension funds compared to other investors. He attributed this to pensions’ lead time to invest.
Broad public auctions, of which there have been about six, often have to work quickly, and last three to six weeks – often too quickly if the pension fund’s investment managers do not already know the fund well.
Senior said pensions that wanted to use secondary markets should understand receiving stakes is not as straightforward as a direct subscription. It can involve extensive due diligence if the fund is not well known, paperwork and complex infrastructure.
He added: “Where pensions already have a holding and see an opportunity to increase it, they may, [but] it can be more operationally complicated, it is not like buying a security.”
On top of all the due diligence and pricing analytics required, some, but not all, transfers require manager consent, he said.
Some managers may prefer to redeem shares compulsorily, and disperse them to existing holders or those waiting to invest whom the manager actively wants in the fund, rather than accepting unknown buyers using secondary markets into their portfolio.
Mercer principal Robert Howie said some institutionally-focused funds of hedge funds have used secondary markets to access managers not only for the discounts available, but also because the high water mark set for the incumbent investor may be kept in place for the secondary market entrant.
Investors usually only incur charges of 20% of fund profits after hedge funds have repaired past losses – called reaching their high water mark. New subscribers to the fund incur the levy from day one, but those who come in via the secondary market can sometimes negotiate to have the old high water mark kept in place. And if the fund is below this mark, the secondary market buyer would pay no incentive fee until the manager breaches it – which in some cases could mean many months of fee-free profits.
However, Howie said the key to good investing in hedge funds remains uncovering good managers, whether or not they are accessed through secondary markets.
Who are the players in secondary markets?
Three main motivations have underpinned participants in secondary markets.
Credit Suisse’s Edgar Senior said one group of investors has sought to build holdings in funds at a discount to their NAVs, to hold as the managers’ fortunes turned around. The hedge funds may have been restructuring, or had exits temporarily closed, hence their appearance on secondary markets.
“If you buy a hedge fund at a 10% discount, that is an uplift on performance you get from it,” Senior said.
Additionally, since the financial crisis some funds have raised enough fresh capital to close to new investors again. Lansdowne Partners’ UK Equity fund and Nevsky Capital are among such portfolios, leaving the secondary market as the primary route in.
A second group of buyers, one participant said, established funds deliberately short-term in nature to buy units and sell them at a profit as conditions, and discounts to NAV, improved.
In some months, this strategy would have made handy profits. The average discount to NAV on Hedgebay narrowed by 4.4% in October and 9.3% in January, assuming funds could be bought and resold in just months.
However, traders would have lost about 6% last September on a widening of the average discount to NAV, and another 6% in December.
The third group of investors, said the market participant, were experts in asset classes such as credit, and bought into funds to agitate for in specie redemptions. This is where managers paid out redeeming investors by distributing to them instruments from the portfolio, rather than distributing cash.
Such payouts occurred in a handful of cases, typically because the markets were too illiquid to make a sale at fair value practicable.
The participant said: “In early 2009, a number of products suspended or gated funds, and some managers of those funds redeemed by delivering instruments to investors. Some investors wanted to buy the distressed fund’s shares, then force [this] payment in kind.”
Many investors such as pension funds had little way of managing a handful of securities directly, but for investors who did, they could receive the distribution of their proportion of the fund’s underlying investments, and either manage it themselves, or sell it down over time.
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