Many hedge funds are in trouble. Whether due to bad security selection, issues that were once considered liquid that now “trade by appointment” or by jittery LPs, managers are having to generate cash to meet a flood of redemption requests. This has placed tremendous pressure on managers who are not only depressed to see management fees drop while high-water marks remain far out-of-reach, but who have hard decisions to make about which assets should be converted into cash.
One way managers can delay the inevitable: putting less-liquid assets into “side pockets” and shifting them from main funds into long-term liquidation vehicles. These assets generally attract management fees but not performance fees until sold. The more assets that are classified in this manner the less cash that is available to meet investor requests, and the longer investors are locked-in to the managers whom they’ve decided they no longer want to be in business with. Hedge fund investors have unwittingly been turned into private equity investors, forced to stay invested for an indeterminate period of time. Certainly not what they thought they were signing up for.
This concept was briefly touched on in a recent Wall Street Journal article, but it is an issue that requires far more consideration and analysis.
“I don’t think people are selling their less-liquid holdings to meet redemptions, they’re just telling investors they can’t have that portion of their money or that it’s in a liquidating class,” (emphasis mine) says Brett Barth, who helps run BBR Partners, a firm that manages money for wealthy families.
The hedge fund manager argument for side pockets: “Being forced to sell illiquid assets in a “fire sale” damages all investors.” While this is surely true, what about those investors who want to fully cash out, regardless? What about investors who got cash prior to the re-classification of certain assets as “illiquid,” getting a better deal than those who unfortunately delivered their redemption notices a little later? The first issue can be dealt with by creating a vibrant secondary market in side-pocket investments, just like the market in LP interests for hedge, private equity and venture capital funds. The second issue is more complicated, and will invariably result in a spate of lawsuits by LPs saying they were treated unfairly relative to other investors by the GP. And this doesn’t take into account the “side letters” that frequently exist between large LPs and GPs, often providing preferential liquidation terms and fee concessions. This isn’t a terrible time to be a hedge fund attorney: it’s just that the business mix has changed from new fund formation to litigation.
Conceptually, however, does the “side pocket” concept make sense? Did LPs really think that GPs would fully use those illiquid asset allocations provided for in their fund documents? Think about the percentage of illiquids relative to total fund assets now – likely way beyond the amount stipulated in fund documents as the mostly liquid assets are being sold to meet redemptions while the remainder is left behind as a long-term liquidating stub. This stub, as noted earlier, has private equity-like characteristics, yet LP allocations did not take this shift in liquidity profile into account. My guess is that new hedge funds, when they emerge, will likely have much tighter documents than those cut in this decade, with greater restrictions concerning illiquid asset percentages and rules for shifting assets from the main fund into side pockets. But the issue of current side pockets will continue to loom large, as many of their holdings will be worked out over many years.
One of the first posts I ever penned discussed the convergence of hedge and private equity funds, where hedge funds were becoming greater participants in buyouts, venture capital and structured investments. I keyed on the issues of valuation, compensation and disclosure as being three vital elements for hedge funds successfully making this transition. But this was in the context of all assets being held in the main fund, not in side pockets. Today’s situation is far more complex, especially as hedge funds did not take my advice back in Summer 2006. LPs are getting upset and will only get more so in the coming months. But given the latitude offered most of their GPs, they’ve got no one to blame but themselves.