The quarter past: Editorial Analysis of Recent Market Developments
Lipper HedgeWorld Staff.
Although plenty happened between the start of April and the end of June, all anyone ended up talking about was Bear Stearns and the meltdown in the subprime mortgage lending sector.
Bear Stearns Cos. Inc. on 22 June said it would provide up to $3.2 billion in financing for a struggling hedge fund it manages, but sources said a second fund was still working out a restructuring plan with creditors. The bailout news sent financial markets into a tizzy, spurring investors to sell shares, particularly of investment and commercial banks, and buy safer Treasury Bills.
Bear Stearns, the fifth-largest US investment bank, held tense negotiations with creditors for more than a week after two funds suffered big losses from bad investments in securities linked to subprime mortgages and other forms of debt. Creditors had threatened to seize assets from the funds and sell them off, even after Bear Stearns said it would add $1.5 billion of its own capital, sources said. Merrill Lynch went so far as to sell $100 million of assets from the funds, after seizing some $850 million of securities. Bear said it provided secured financing to the High-Grade Structured Credit Strategies Fund, which, according to a source familiar with the matter, was down about 5% through the end of April. Sources said that the financing would eliminate exposure that banks, including Citigroup and Barclays plc, had to the fund. But many banks still had exposure to a sister fund, High-Grade Structured Credit Strategies Enhanced Leverage Fund. That fund was down 23% for the year by the end of April.
By late June, it seemed Bear Stearns would salvage some portion of its failing structured credit portfolio by de-levering slowly after buying the debt back from creditors. So far the bank has bought the debt of only the less geared-up version of the strategy — the High-Grade Structured Credit Strategies fund. But even the less leveraged fund’s investments were large compared to its equity capital. How large? There isn’t enough information to gauge a long-term leverage, but a snapshot rough estimate is possible.
The two funds went long and short on collateralised debt obligations, including notes on pools of subprime mortgage bonds. Overall, they were heavily bullish. One way to measure the leverage is to compare the net long investments to capital. By this yardstick, the less debt-dependent pool, High-Grade Structured Credit Strategies, had net long investments equal to six times its equity in March, according to a calculation by HedgeWorld. The corresponding rate for the more heavily geared-up High-Grade Structured Credit Strategies Enhanced Leverage Fund was 11 times equity. Taking the two Bear funds together, total equity capital added up to $1.6 billion. To get another perspective, total exposure to the structured credit market on both the long and short sides by the two funds was nearly $30 billion in March. That indicated the effect of all sources of levering. Total net long positions for the two funds amounted to $12.7 billion.
Exiting Hedge Fund Incubator Models
Peter D. Astleford, Chris Carrodus and Peter Draper, Dechert LLP, London.
Incubation suggests transience, a hatching, a ‘forced growth’ into something bigger or more advanced. One would, therefore, expect parties who enter into such arrangements to be aware at the outset that incubation is just a temporary phase; that it will not last forever; that sooner or later, there will inevitably be an exit. Remarkably, this is often overlooked.
There can be a variety of causes for exit. It may occur through lapse of time if the incubation was for a set period, by formal termination, whether for breach of agreement or relationship breakdown (inter- or intra-party), by desire of one party for whom it becomes too expensive or intrusive to be sustainable, or because it is disrupted by external factors such as a market crash, other liquidity issues, or a takeover (or even insolvency) of one of the parties.
This article focuses on incubation arrangements for hedge funds and their managers. In the hedge fund investment management world there are many different forms of incubation model and the structure of the model will, ultimately, impact on the exit decision and strategy.
All models pre-suppose that one party needs something, money or services, which the other can provide. However, the needs or objectives will be different from the perspective of the incubatee, whether fund or manager, and the incubator. If this difference in needs is fully appreciated when the arrangement is established, formulating appropriate exit provisions becomes much easier.
Needs and objectives of the incubatee
The objectives of a hedge fund or hedge fund manager seeking to enter into an incubation agreement will typically include one or more of the following:
• Seed capital: A start-up fund or manager, especially one with no independent track record, will often require some form of seed capital to reach critical mass in order to make the venture viable. In this case the seed capital will often be in the fund (providing an income and, more importantly, a viable showcase to other investors) rather than in the capital of the investment manager, where capital needs are typically low. Seed capital will also be useful for a start-up manager who either does not have the skill or resources required for fund-raising or who is pre-occupied with trading his portfolio and does not have the time, skill or inclination for marketing. At a later stage in a fund’s or its manager’s life, the incubator’s access to capital might help shift a fund to a different league, thereby making them more attractive to bigger or more institutional investors. After the track record has been established, the fund has grown to a viable size and/or the manager has developed his own fund-raising skill and resources, the seed capital may no longer be required and the manager may look to exit. Here the exit pre-supposes that the initial need for seed capital has passed and that alternative sources of capital are available (or available on better terms) and to achieve such an exit successfully, the fund or manager has to be able to sever (or at least be prepared to live with) any strings which come attached to the seed capital.
• Regulatory umbrella: Managers will frequently require some form of regulatory umbrella to work under until the resources are acquired to achieve their own authorisation from the Financial Services Authority or other regulator. A manager (at least one sited in a regulated jurisdiction) will also require compliance expertise and personnel and the required level of regulatory capital, all of which are available from many incubators. A successful exit from this type of incubation will be contingent on the manager obtaining its own regulatory cover and, therefore, the manager needs to plan ahead and understand what is required to achieve this (and take account of the necessary lead times).
World's Unions Debate: are Hedge Funds 'Locusts' or 'Termites'?
Christopher Holt, Holt Capital Advisors Ltd., Toronto.
AllAboutAlpha’s Christopher Holt argues that recent knee-jerk calls to eradicate hedge fund ‘locusts’ are like spraying toxic pesticide on global capital markets — well-intentioned, but sure to produce unintended consequences.
Recently, hedge funds have been tacitly accused of putting the global financial system at risk. But in a curious twist, the UN released a report on 21 June that raises the ‘global capital flows’ warning flag not on hedge funds (per se), but on pension plans. Yes, pensions. Working men and women of the world, it is you, not the hedge fund managers who are the real problem in today’s Wild West of global capital flows. We stumbled across this report (released mid-June) by the Brussels-based International Trade Union Confederation (ITUC), which responds to the potential global financial calamity that might be caused by the seemingly benign pension fund community. The report is called Where the House Always Wins: Private Equity, Hedge Funds and The New Casino Capitalism. To access the report in its entirety, go to www.ituc-csi.org/IMG/pdf/ITUC_casino.EN.pdf.
We’re obviously biased toward private equity and hedge funds at AllAboutAlpha.com. But we’re also sensitive to their impact on other stakeholders. Private equity, by its very nature, will always be a tug-of-war over economic output between the owners of capital and other stakeholders (employees, suppliers, neighbours, NGOs etc.) Given the massive and sudden growth in private equity and hedge funds, there is no doubt that these issues will need to be addressed sooner rather than later. In fact, we know of various multi-lateral initiatives tackling these problems right now.
However, while this report attempts to make an important contribution to the global debate, it makes excessive use of fallacies and half-truths that reveal a populist anger over bigger issues of economic inequality. The resulting potpourri of socio-economic beefs does little to advance a rational dialogue on the role of hedge funds and private equity funds.
Before cracking the cover, we took a wild guess that the ITUC wasn’t crazy about alternative investments. And since many of you may not be crazy about unions (or reading the report’s dense 52 pages), we distilled a few of the more colourful claims below.
The ITUC’s overall feelings about hedge funds and private equity can be summed up in the following excerpt from the report:
In what now appears as the early days of the leveraged buy-out boom, private equity and hedge funds were compared to a swarm of locusts. More recently, it has been remarked by some that is an insult to the locusts: the protagonists of financialisation are more like termites. They leave nothing behind to yield new crops but destroy everything on their way. Whether termites or locusts, such comparisons are a clear call for revamping regulation. That call will be echoed in the last chapter of this report.
Recent Developments in the Regulation of Hedge Fund Managers in Australia
Scott Charaneka and Gregory Wong, Deacons, Australia.
Overview of Australian hedge fund industry
Australia’s A$62.7 billion hedge fund industry, which forms part of Australia’s A$1.03 trillion managed funds industry, has grown rapidly in recent years to become the largest in Asia.1 A number of distinct trends have emerged as a result: the industry has tapped into the pool of savings managed by large institutional investors, in particular, mandatory pension fund schemes or superannuation funds; hedge funds themselves have evolved as the industry has grown, with more commoditised products being offered by established financial institutions; and hedge funds are also playing a greater role in financial markets.2 All these developments follow international experience.
However, despite the growth in the Australian hedge fund industry, there are a number of factors which overseas- domiciled fund managers should be aware of when considering whether to enter the Australian hedge fund market. These include the following:
• Regulator concerns — Australian regulators have repeatedly expressed concerns about the complexity of certain hedge fund products and the lack of transparency involved in the underlying asset or stock selections.3 This article will outline some of these regulatory issues.
• Volatility in performance — Australian investors’ awareness of the volatility of returns from hedge funds may limit the amount of funds they are willing to invest in hedge funds. There is a great disparity in the returns of individual hedge funds in Australia, and the spread between the best and worst performing funds each month has averaged around 17 percentage points per month in Australia over the period from 2000 to 2006.4
• Role of asset consultant — In relation to investments from institutional investors, particularly superannuation funds, asset consultants play an important role in the allocation of the amounts of funds to a fund manager. In order to ensure that an asset consultant selects a particular hedge fund as an investment for an institutional investor, fund managers will need to be aware of the overall investment strategy of such an institutional investor, so that the strategy of the hedge fund is consistent with it. Furthermore, fund managers should be aware that an asset consultant may already have predetermined asset weightings in certain asset classes for the institutional investor, and therefore, only a small proportion of the funds of the institutional investor may be invested into a hedge fund.
Regulation of hedge funds in Australia
Hedge funds in Australia are most commonly structured as trusts. A hedge fund which is a trust is usually a managed investment scheme5.
Hedge funds in Australia are regulated under the Corporations Act 2001 (Act). Generally, this type of regulation involves the:
• licensing of the fund manager;6
• registration of the fund (where the fund is a managed investment scheme being offered to retail investors);7 and
• fund manager to provide investors with certain disclosure documents where interests in the fund is being offered to retail investors, including a Product Disclosure Statement8, Financial Services Guide9 or Statement of Advice10.
Wien's Advice: 'Seek $100 million and Volatile Returns'
Martin de Sa'Pinto, Senior Financial Correspondent, HedgeWorld.
Byron Wien, chief investment strategist at Pequot Capital Management Inc., passed on a few interesting takeaways to investors at a conference earlier this year put on by the Chartered Financial Analyst Institute (CFAI). Among them was the idea that while the hedge fund industry will continue to attract the best and brightest asset managers, its fee structure makes it an alluring destination for more average managers as well. For most funds, however, management fees are not going to be enough to ensure survival; they must also perform.
The high profile of the hedge fund industry is clearly attractive for asset managers, Mr. Wien noted, and it is now drawing more talent from conventional fields. Furthermore, he said, this trend is being accelerated as hedge fund managers find new ways to make money, including capitalising future earnings through initial public offerings, with many US hedge funds looking to follow Fortress’ lead. Also, ‘the growth in hedge funds is likely to reach a steeper gradient’, he predicted.
But despite the influx of talent in the industry and the growing number of funds — and hence the increased competition for assets — Mr. Wien said he doesn’t see hedge fund fees dropping any time soon. On the contrary, ‘some of the new practitioners charge higher fees than many established funds’, he noted. ‘I don’t think we’ve seen the upper limits of prices’.
Part of the industry’s problem is that it continues to attract managers because it is so much more lucrative than the traditional asset management industry, Mr. Wien said. The question is, who is going to manage the long-only money?
The fact that the hedge fund industry continues to attract asset managers has made the capital-raising environment much tougher, however. ‘It’s harder to start a fund these days, and almost nobody has achieved their capital raising targets over the past couple of years,’ Mr. Wien said. ‘There are still a lot of start-ups… [but] there are fewer $1 billion-plus launches’.
Even so, he observed, the biggest funds are getting bigger, and the institutions tend to go to them. Paradoxically, he said, there is a growing suspicion that the bigger those funds get, the more average their performance becomes.
Institutional demand for hedge funds really started picking up when institutions such as pension funds realised that many hedge funds had had positive returns in the 2000 through 2002 period, as the world’s stock markets languished. Hedge funds delivered on the promise of positive returns in a negative market environment at the same time that pension funds were watching their own asset-liability mismatches growing to alarming proportions as stock prices plummeted.
Factor Exposures and Hedge Fund Operational Risk: the Case of Amaranth
Bhaswar Gupta and Hossein Kazemi, CISDM, Isenberg School of Management, The University of Massachusetts, Amherst, MA.
Hedge fund performance and risk measurement continue to present intriguing challenges to both academics and practitioners. Risk-return measures that are solely based on historical return series tend to provide limited information, and the marginal new information revealed by another quantitative measure tends to be small, and approaches zero once three or more measures are considered. In this article, we will examine the risk exposures and performance characteristics of Amaranth Advisors LLC. Amaranth Advisors LLC was created in 2000 as a multistrategy hedge fund. Beginning operations with approximately $600 million in capital, it sought to employ a diverse group of arbitrage trading strategies, particularly featuring convertible bonds, mergers and utilities. In 2002, Amaranth added energy commodity trading to its slate of strategies with JP Morgan Chase clearing its commodity trades. On 4 August 2006, New York Mercantile Exchange (NYMEX) examined Amaranth’s positions and calculated that Amaranth held about 51% of the open interest in the September natural gas futures contract which would expire at the end of the month. NYMEX decided that this was too large and on 8 August NYMEX compliance officials notified Amaranth of their concerns. Amaranth complied with NYMEX’s directions and subsequently reduced its September and October positions. However, at the same time Amaranth increased its positions in September and October Intercontinental Exchange (ICE) contracts, such that their overall positions in natural gas rose. The events that followed in late August and September led to huge losses with Amaranth losing significant value.
Introduction
Hedge fund performance and risk measurement continues to present intriguing challenges to both academics and practitioners (Kazemi and Schneeweis [2003]). Gupta [2005] examines the interdependence of several measures for various hedge fund strategies and concludes that, in most cases, these measures do not reveal any unique information and portfolio selection based on many of these measures result in highly-correlated portfolios. This implies that risk-return measures that are solely based on historical return series tend to provide limited information and the marginal new information revealed by an additional quantitative measure tends to be small, and approaches zero once three or more measures are considered.
Further, quantitative risk-return measures that are solely based on historical returns very often fail to provide the tools that investors need to protect themselves against serious losses. One of the main reasons for this failure is the unique nature of hedge fund strategies and related operational issues in executing each strategy. Consider, for example, the recent problems at Amaranth Advisors, LLC. Even though the firm emphasised that its fund was multi-strategy, most of the recent losses were driven by adverse natural gas trades. Prior to this debacle, most investors who viewed reports from this firm saw no reason to worry about its performance, although some privy to their portfolio positions expressed concern. The compound annual return for the period September 2000- November 2005 according to media reports (Morgensen and Anderson [2006]) was 14.72% net of all costs. Clearly, knowledge of the fund’s returns did not enable investors to assess the fund’s unique risks correctly. Note, however, that Amaranth’s misfortunes were solely a result of poor risk management. Note, also, that even though the firm lost over $6 billion in a matter of days, the losses had minimal impact on the industry as a whole.