Wasn’t it easier in the old days? Perhaps the memory plays tricks – and hedge funds were always this complicated. But in the early days of the industry, it was certainly the case that most strategies were relatively simple – being macro funds or other directional strategies such as CTAs, or long/short equity funds focusing on liquid, large-cap stocks.
Those were the days: management fees were low – usually 1% a year (not 1.5% or 2%, as is commonplace today); and redemption terms generally easy – with investors able to exit monthly or, at worst, every quarter.
The great benefit of those early strategies was, of course, liquidity. Even if the manager messed up, the portfolio could usually be liquidated quickly.
But, over time, ever more managers have launched funds with longer and longer investment horizons across an ever-widening array of strategies, asset classes and instruments, often with widely varying degrees of liquidity.
Gate provisions
And this has meant investors agreeing to lock up money for longer periods; or to accept longer notice periods before they can make redemptions; or gate provisions that limit the amount that can be redeemed at any one dealing date; and/or side pocket provisions that allow the manager to suspend redemption terms for a portion of the portfolio.
The end-result has been a latent liquidity mismatch between the investment terms required by an increasing number of funds and what investors are able to bear. This was not a problem so long as performance was generally good.
But there were always fears that investors would suffer – and complain loudly – if they suspected a manager had been taking performance fees at artificially high NAVs, and then locking them in to take further management fees or charging extortionate penalties for redemption.
And so it has come to pass, following the credit crunch and a period of negative returns from certain strategies, that there has been something of a brouhaha surrounding some funds facing higher than usual redemptions.
In various of the more high-profile cases – such as Polygon, Tisbury and Pendragon – the managers have received some negative press coverage for the way they handled the issue. This was in spite of the fact that, in each of these three particular cases, the managers actually came to quite different decisions about how they should respond.
And, although their responses were all different, it seems to me that they each probably did more or less the right thing because they were not facing quite the same problem.
Domino effect
In the case of Polygon, assets have reportedly dropped this year by more than $1.5 billion, or around 25%. This sharp rise in redemptions was stimulated, it is rumoured, by the decision of one major investor (said to be a very large European fund of funds) to redeem. This caused a mini domino effect as some other investors tried to get redemption notices in too – so as not to be blocked by the fund’s 10% gate provision for each quarterly dealing date.
Polygon’s solution to what founding partner Paddy Dear described as this "prisoner’s dilemma" was to create a new share class, guaranteeing each and every investor that they can redeem a minimum of at least 12.5% (and in normal market conditions, up to 100%) at each dealing date, rather than being subject to the 10% collective limit. The move was well received, with 85% of investors switching to this new class.
As for Tisbury, the fund was hit by massive redemption requests – amounting to some 70% of the $2 billion the fund was managing at the end of 2007. Tisbury also had a 10% gate provision. But, in its case, the team decided it would be wrong to block so many investors trying to redeem.
To stay in the game for the longer term, Tisbury decided 85% of the money could go immediately, with the remaining 15% side-pocketed in less liquid investments that would be worked out over a longer time frame. With relevant redemption penalties paid back into the fund, this met with strong approval from the remaining investors.
With Pendragon, the degree of redemptions was more similar to Polygon’s – at about 25% to 30% of the fund – cutting assets to about $2 billion. But Pendragon had always maintained relatively easy liquidity terms – applying no gate or penalty on redemptions up to 20% at each quarterly dealing date. But in its original provisions, it did warn that it would be at the discretion of directors whether or not to apply a penalty if redemptions exceeded 20%.
After discussion internally and with investors, Pendragon ultimately decided to impose the penalty – resulting in some criticism in the press, despite the fact that investors could roll over the relevant amount above the 20% ceiling to the next dealing date if they wanted to avoid it.
Small print
It was a debatable response, because redeeming investors would no doubt have been very pleased if the fee was waived. But imposing it was certainly in the interests of remaining investors, and they were in the clear majority.
No doubt these and other cases will act as a strong reminder for investors to study the small print in every fund prospectus more closely.
It might also serve to boost the popularity of more liquid strategies – such as macro funds and CTAs – which have generally been doing very well this year, and remind investors that illiquidity should only be accepted at the right price.