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.
||Brian Shapiro (Photo:
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
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
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
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
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
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
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
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.