Hedge funds wrong to fear secondaries

By Josh Friedlander

Wed Aug 22, 2012

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Brian Shapiro talks to AR about his recent survey of investors and what a more robust market for trading hedge fund stakes could mean for the evolution of the industry.

  Brian Shapiro (Photo: Simplify)
Trading in the secondary stakes of hedge funds, funds of funds and other alternative investment partnerships has grown to $65 billion in annual notional volume, but the process remains slow, costly and inefficient, according to a recent survey conducted by Simplify LLC, a provider of software to institutional investors.

That survey, announced by AR in May, garnered a significant sample size-489 responses from investors representing $416.7 billion in investible capital-55% of which have traded at least one hedge fund stake. If the process were simpler and cheaper, the results could be extremely beneficial for hedge funds, says Simplify founder and chief executive Brian Shapiro.

"If investors actually saw an 'exit' sign, they'd be more apt to allocate to the funds," he says.

Instead, the process is cumbersome. About 60% of respondents who had traded a private fund stake said it took an average of more than 90 days to complete the transaction, while 20% of all respondents said they'd been denied a transfer of interest by the general partner of a fund. These trades weren't small, with most falling in the range of $1 million to $5 million, and with 25% of respondents saying they've traded stakes exceeding $5 million. 

A common perception is that these transactions are fire sales by desperate investors seeking liquidity and trading with vultures. The study shows buyer/seller motivations to be less extreme. Only 18% of respondents said they were motivated to trade a stake based on a fund being in distress, and 29.2% said liquidity issues forced a sale. A statistically equivalent number said they wanted to rebalance their portfolios (26.8%). Buyers wanted to enter closed funds (36.3%) or add to existing positions at a discount (54.5%), among other reasons.

AR asked Shapiro what effect the hurdles he quantified were having on the growth of the hedge fund industry, and what effect a robust secondary market would have on the ability of hedge funds to raise capital.

AR: Your survey seems to indicate that most investors would love a more liquid secondary market. Why don't we have one? Is it because hedge funds are unwilling to set up revolving doors, or for some other systemic reason?

Shapiro: A combination of both really. Larger brand name funds see active secondary trading as a negative because, as one of them told me, "it erodes the exclusivity of our brand." Additionally, the large firms don't want to see their funds potentially trading at a discount to their net asset value. They feel it would send a negative message about the actual value of the funds. But active secondary trading would more accurately represent the price of a particular fund since it would not just be based on NAV but also on the duration of that fund's lockup, the volatility of its assets, and actual interest among investors.

On the other side of the coin, a true secondary market doesn't yet exist due to the operationally prehistoric unpinning of the industry. The reluctance among the industry as a whole to accept a more digital means of subscription and redemption processing is a clear impediment. Unfortunately, too many players, including service providers, rely on a nearly 100% physical process in order to make money. All this is despite the obvious end benefit to both investors and funds if there were a real exchange and central clearing capability.

You said that 60% of respondents who have traded a private placement interest at least once say the average time to complete the transaction was 90+ days. Can you give the range?

A small percentage were able to close a transaction in as few as 15 to 30 days, but the vast majority (more than 60%) said it took more than 90 days. From listing to settlement, we see transactions typically taking 120 days.

So what is taking so long on the high end? Again, is this a manager issue or a negotiation issue among the buyers/sellers?

To start, the brokering process can take a while. Remember, right now you have brokers flying solo on exclusive offer or bid mandates. They don't co-broker and show what they've got on a central venue. So their ability to move interest quickly is limited to the size of each of their respective Rolodexes. The one-off negotiation process along with due diligence is also time consuming. The shortest cycle one can hope for is one where the bidder is adding to an existing position. The predisposition and existing knowledge of the underlying fund and manager means they can spend less time on due diligence. But also the simple process of preparing Transfer of Interest and GP authorizations seems to take forever. Again, service providers, specifically lawyers and administrators in this case, bog the process down significantly.

We estimate that the largest U.S. hedge fund firms ($1bn+ in AUM) manage about $1.4 trillion. How much larger do you think the large firms would get if there were a highly liquid secondary market for hedge fund stakes? How much would such a market help smaller firms?

We think the market overall would see an immense benefit from a more identifiable liquidity venue as well as centralized clearing and settlement. If liquidity in this opaque market were more visible, the underlying belief is that secondary trading as opposed to redemption would become more the norm. If investors actually saw an 'exit' sign, they'd be more apt to allocate to the funds since they'd know the 36 months might actually only have to be 18 if they so desired or required. This could entice many, including insurance companies who have long avoided hedge funds because of the asset-liability mismatch, to begin making allocations.

Centralized settlement and custody along the line of mutual funds would also be boon, since several trillion dollars of unallocated wealth remains on the sideline simply because hedge funds and private equity funds are not certificated products that can easily be managed by their operations groups.

The "eBayization" of bank debt markets and now Swaps, CLOs and other structured product has shown conclusively that liquidity aids overall market growth. It's an inevitability the industry must begin to accept. One would think that hedge funds would be quicker to embrace this, since they already directly benefit from the effect in asset classes in which they invest.

What's the likelihood that more public investment vehicles ('40 Act, ETF replicators, UCITS) are going to render this discussion moot? Are LP structures really here for the long term?

UCITS initially benefited from early promises of transparency and liquidity, and while these benefits are real, the general mediocre performance -rising only 1.42% during the past two years-has turned investors away. UCITS are also a distinctly European product, and can't provide the same benefits to U.S. limited partners or U.S. issuers.

As for '40 Act funds, they're the least attractive option for managers. They're expensive to form and market, they eliminate the incentive fee, and they cannot promise to deliver enough capital since they're distributed on a best-efforts basis. Couple these factors with the high cost of operation and diminished returns since the managers need to stay more liquid at the asset level, and it all adds up to an unpalatable choice.

ETFs are hot, there's no denying that, with returns that are tightly correlated to the broad indexes (and they're positive right now), as well as lower fees and daily liquidity. We continue to see investors, even funds that use them as a hedge, continue to flock to them. But can they ever replace the full range of hedge fund strategies? We'd argue they can't and are primarily useful for replicating highly liquid strategies that are inherently liquid on the hedge fund level already, such as long/short equity or CTAs. And you're not going to see the transformation of a substantial number of existing hedge fund vehicles into ETFs. You need a ton of up-front capital and huge distribution networks to sell them at a retail level. It's a big boys game.

Creating a truly tradable environment for classic domestic LP and LLC structured funds is really the best of both worlds and can benefit LPs and GPs alike. In no other manner could we more closely align the objectives of both constituencies. LPs could receive liquidity and protection from other LPs who, as it now stands, may force performance erosion in funds should they have to or want to redeem a significant portion of capital, forcing the manager to sell assets. With a liquid secondary market, the GP gets the "permanence of capital" effect with secondary liquidity ultimately becoming the primary exit, allowing them to make the longer-term investment decision they need to in order to generate the returns they've promised. It also allows them to retain the biggest economic benefit-that being the incentive fee. Operationally, things could of course be done better, but whole industries have grown up supporting these structures. To essentially "throw the baby out with the bath water" in favor of less efficient product structures would be a mistake. We need to adapt the legacy construct and figure out ways to advance its benefits while incorporating new ones.