Hedge funds warned on attempting to replicate private equity strategies
Hedge fund managers should not seek to replicate private equity investment strategies amid concerns there could be a liquidity mismatch, it has been warned.
A growing number of hedge funds have been adopting private equity characteristics, and investing in illiquid assets such as unquoted companies and real-estate. A study of its hedge fund clients in February 2014 by New York-based law firm Seward & Kissel highlighted this growing convergence between the two asset classes.
The study found newly launched US hedge funds were imposing tougher redemption terms on investors. Eighty-nine per-cent of new funds restricted redemptions to a quarterly or longer-term basis in 2013 compared with 64% in 2012, added the Seward & Kissel report. The number of funds employing a hard lock up, usually of one year, rose dramatically from 8% in 2012 to 27% in 2013, according to Seward & Kissel.
“By and large, hedge funds should be wary of illiquid assets typically preferred by private equity and real estate funds. A typical private equity structure will have a 10 year lock-in for its investors. The liquidity terms being offered by these hedge funds, who are making acquisitions in illiquid private companies, are not appropriate for the type of investments they are making. The lock-ups are usually one or two years at a stretch. This risks a serious liquidity mismatch,” said David Bailey, founder of Augentius, a London-based private equity fund administrator.
A report by the prime brokerage arm of J.P. Morgan in March 2013 acknowledged there had been a surge in hybrid fund structures buoyed by growing investment opportunities in less liquid distressed assets. Basel III and various national regulations are forcing banks to deleverage and restructure their balance sheets by devolving themselves of illiquid, non-core assets such as collateralised loan obligations and residential mortgage backed securities. Managers scooping up these high-yield illiquid securities are also generating quality returns. Nonetheless, investor interest has remained static, said the J.P. Morgan study.
Bailey urged hedge funds to exercise caution. “Let us not forget that hedge fund managers have attempted to replicate the private equity model before, prior to the financial crisis, and many found themselves stuck with illiquid assets much to the frustration of their investors. Hedge funds at the end of the day are traders who buy and sell stocks, and they have limited experience in operating companies or corporates. Private equity managers, on the other hand, spend their lives sitting on the boards of companies and creating value through the enhancement of the operations of their investments. Hedge funds do not have this skillset,” explained Bailey.
Investors appear to have taken note. The J.P. Morgan study noted allocators remained apprehensive of these hybrid structures and were not rushing into them. The bulk of this limited investment, added J.P. Morgan, was coming from funds of hedge funds, family offices, foundations and endowments. While pension funds had expressed a muted interest in these products, many prefer to invest in hybrid funds through single –LP vehicles or funds of one.