Broadening the Multi-Strategy Mandate - Where do Hedge Funds end and Private Equity Funds begin?
July 21, 2006
Broadening the Multi-Strategy Mandate - Where do Hedge Funds end and Private Equity Funds begin?
I don’t think it’s any secret that larger, multi-strategy hedge funds are investing in an increasingly broad (and unusual) array of assets - loans for leveraged buyouts, PIPES and convertible structures for later-stage venture-backed companies, purchase of life insurance payouts and even financing for litigation. Hedge funds are even battling directly in the buyout world, as evidenced by the recent scrap between Fortress and Polygon over the UK-based telecom equipment provider Telent. I wonder what Alfred Jones, the father of the hedge fund industry, would think of these gymnastics. From my vantage point it appears that two principal motivations are driving this phenomenon: (1) reaching for returns in a very crowded and difficult market; and (2) trying to create increasingly non-correlated (read: alpha generating) portfolios when most public-market asset classes, regardless of geography or place in the capital structure, are moving more in lock-step than they have in years. Oh, and by the way, it is also true that private equity complexes are spending more time in hedge-fund land than ever before, whether it is the build-up of Blackstone Group’s highly successful alternative asset management group or Texas Pacific Group’s hedge fund venture with Dinakar Singh in the formation of TPG-Axon. This, in addition to Eric Mindich’s mega-launch of his Eton Park hedge fund, whose offering document I am told provided that up to 30% of the fund’s assets could be invested in illiquid securities. To say that a blurring of the lines between hedge funds and private equity has occurred (and one, might argue, banks themselves, given the increasing role both private equity and hedge fund firms are playing in the first-loan market) is the understatement of the century.
While this is kind of interesting, I think what is more interesting is to look at the structural differences between hedge fund firms and private equity firms and how this might impact performance-based compensation, disclosure and regulation. Private equity firms generally collect commitments for investment, draw on those commitments, make investments, and get paid performance fees as those investments become liquid over time, e.g., perform. Seems to make sense - match the payment for success with the successes themselves. Hedge funds, interestingly enough, grew up differently, as the concept of a “hedge fund” generally meant buying good stuff (long) and selling bad stuff (short) in an effort to minimize the impact of the broad market on performance (beta) and isolating the manager’s skill (alpha). Since this buying and selling, by necessity, took place in the public markets, there were readily ascertainable values for the hedge fund’s positions at each reporting period. It was these values that were used to compute the payment of performance fees (the net asset value or NAV). As long as the portfolio is liquid, fair values are readily observable and, in theory, the entire book could be liquidated at the NAV (absent bid-offer spread). But as I mentioned above the world has changed - a lot. Hedge funds now have portfolios that are a mish-mash of liquid assets, somewhat liquid assets (where one could go and get bids from 5 dealers and obtain a fair value) and totally illiquid assets (where the value is highly subjective a dealer would not be willing to provide a 2-way quote). So how have hedge fund compensation customs changed to reflect these altered portfolio characteristics? Not much.
Now, I am firmly convinced that this trend - hedge funds and private equity firms looking more and more alike - will not stop, and I am also a strong believer in market-based regulation (as opposed to ill-conceived legislation developed by bureaucrats who don’t understand the investment business). But this issue - getting paid on NAV when NAV itself is highly questionable - is a real problem. It looks bad. Real bad. The implications extend beyond compensation. For instance, if you can’t arrive at a fair value for an asset, a “thumb in the air” method is used like book value minus an illiquidity haircut. This approach dear friends, is not very scientific and is extremely prone to error. Beyond error, once an approach is used for a particular asset that approach tends to be used again and again and again. This has two potentially adverse effects upon disclosure and compensation: (1) compensation may be overstated because NAV might be much lower that the level reflected in the NAV calculation; and (2) volatility of returns will be understated since this asset, whose value invariably is moving up and down but whose value is difficult to measure, is being valued in the same way quarter after quarter after quarter. This is called autocorrelation. This skews the analysis of fund returns and makes a fair comparision across different firms and different strategies nearly impossible. Does any of this sound good?
And if the industry doesn’t take steps to address this issue, my sense is that the issue will be dealt with for them by constituencies they’d rather not deal with (read: the SEC or Congress). It is just too big a problem to be ignored, and the problem is growing every day as more funds pile into less liquid assets for the reasons mentioned above. One way to possibly deal with this is to create a fund with two share classes - one which tracks the liquid assets (and therefore has a calculable NAV) and another which captures the illiquid assets (which does not have a readily calculable NAV). The liquid asset class could attract performance compensation in the same way hedge funds are paid today, which is generally quarterly. The illiquid asset class, however, could be treated much the way private equity compensation is handled today, based upon realization of the value of the illiquid investments. A manager could then report two NAVs, one for each share class. This would seem to restore the original intention of hedge fund compensation model, while providing for a better matching of performance generation and performance payment. This would also be a great PR move for the industry, proactively dealing with an issue before it becomes a PR nightmare.
Hedge fund managers are generally super smart and excellent asset allocators. But today’s changed world calls for a new model - a fairer model, a more sensible model. Just as the most innovative managers have been pushing the edge of new and different asset classes, they should aggressively lead the charge in pushing best practices on this rapidly growing and influential industry.
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Comments
Noah, based upon my earlier posts clearly I agree with your first point. My contention has nothing to do with what’s right, but that the issue of portfolio valuation is a “hot button” issue for both the SEC and Congress given the rise of pension dollars into hedge funds. By extension, they view this investment as being on behalf of unsophisticated investors which to me places added pressure on fiduciaries (warranted) as opposed to burdening hedge fund managers with what’s likely to be ill-conceived regulation (unwarranted).
Concerning your second point, I am planning on devoting a separate post to this important issue. If sidepockets were only used for the purpose you described, that would be fine. But this is not what happens in practice. Often sidepockets hold new strategies in incubation whose benefits are not shared with existing fund investors, and can hold “best trades” vehicles for larger investors who are invited to participate but which are not offered to all fund investors. So, to be clear, if sidepockets were limited to illiquid assets held for the benefit of all investors, that would be a possible solution. But I am not sure that sidepockets are always used in this way.
Roger - I have enjoyed your blog which was distributed to me as a member of NYAngels. Two comments on “Broadening the Multi-Strategy Mandate - Where do Hedge Funds end and Private Equity Funds begin?” First, investors in hedge funds are sophisticated types. By law they have to be, or at least say they are. If they feel that they are being ripped off, or not getting enough information from/on the managers they select, then they can simply take their investment capital elsewhere. That is the way the market works and seems to have done a good job so far. Second, there already are many funds that do exactly as you suggest by establishing two differnt NAV’s via a sidepocket for their illiquid investments. Compute the NAV of the sidepocket at cost until realized, and things should be reasonably transparent. If not, see my first point. neg