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Significant hedge fund redemptions – will your funds be ready?
1st February 2012...Over the past several weeks there has been much speculation that a significant number of hedge fund investors will withdraw their capital from under performing funds.
While there certainly are negative consequences associated with institutional hedge fund redemptions, forward thinking fund managers could use this period of uncertainty as an opportunity to implement their best practices and position themselves to reap the rewards by being ahead of the curve in a down market.
While the vast majority of redemptions will come from under performing funds, the associated impact on the industry is not completely known, and it is unclear on how much money redeemed will flow back to the alternative investment funds and be reinvested with more successful managers. In addition, it is possible that if funds experiencing redemptions are focused on certain niche investment strategies, there may be significant and negative impacts to those markets and as a consequence, managers not impacted by the initial wave of redemptions may experience lower liquidity and depressed asset values.
Given the issues experienced three years ago, managers need to ask themselves if they are operationally ready to deal with a significant run on alternative fund assets.
Three years ago, the knee-jerk response of managers under duress from heavy redemptions was to freeze redemptions and install gates into their funds; this was understandably unpopular with investors. Proactive communications may assist if a manager believes that they have an asset class at risk of significant, but temporary valuation decline due to redemptions from other funds. The manager could consider proactively communicating with investors now around those active steps they are taking to minimize any impact while offering assurances that the actions will not compromise the objectives of the fund.
Additionally, there are a host of operational issues that managers should consider when assessing their back office readiness for a heavy redemption period and a down market, including:
* Have valuation models for harder-to-trade assets been stress tested, has the third-party pricing vendor list been scrubbed to determine if prices can be obtained from secondary sources if their primary source is not available
* Have consideration been given to moving assets to a direct custodial arrangement, or if that is not feasible, consider asking the fund’s prime broker to move assets to a segregated non-margining account, which provides some additional protection and also prevents securities from being loaned out
* Have collateral requirements been reviewed, and are they exposed to any “super collateral” requirements under ISDA agreements and has there been a recent review of ISDA agreements to ensure that they are properly executed. Also, if the fund is in the position has the manager called on collateral from their counterparties to the fullest extent possible.
* Does the fund hold assets that, while are relatively liquid now, should be moved into a non-redeemable side pocket, which might mean giving up some fees now, but could prevent a fire sale of illiquid assets later. In addition, it may be worthwhile considering whether potential increased use of side pockets is permissible or consistent with the investment strategies detailed in the fund’s offering documents.
* Has there been a recent review of fee agreements and have high-water mark calculations been updated.
Addressing these and other operationally focused questions may assist in being able to present an informed and confident face to the fund’s investors and in turn present a needed air of calm in an otherwise volatile and taciturn marketplace.
From mcgladrey.com.
